With global trade wars raging, many people overlook the fact that throughout much of the history of the U.S., trade wars were often the rule rather than the exception. One of the first acts of the U.S. Congress in 1789 established the federal government. To pay for it, another act followed to impose the “tariff,” which served as the primary source of revenue for the U.S. government from 1789 until the enactment of the income tax in 1913.
Throughout this period, tariffs and trade wars usually played a prominent role in most presidential campaigns, and embargoes, steep customs duties, and combative trade practices were frequently the global norm.Fast forward to 2019, and one can see history coming full circle. The so-called “China tariffs” imposed by Executive Order under the Trade Act of 1974 on goods of Chinese origin (25% and 7.5 % ad valorem, depending on the tariff code of each individual product) and the “national security tariffs” imposed by Executive Order under Section 232 of the Trade Act of 1962 (25% on steel raw materials and 10% on aluminum raw materials, again based on individual tariff codes) approach the levels of those imposed by the Smoot-Hawley Tariff Act of 1930 (now widely credited with precipitating the Great Depression of the 1930s and the global economic depression that followed).
However, much has changed since the early years of American history, including the establishment of the General Agreement on Tariffs and Trade (now the World Trade Organization, or WTO) in 1947 that led to a rules-based global trading system where transparency and predictability provided the touchstones which led to unparalleled growth and prosperity throughout the second half of the 20th century. Today, the WTO member nations number 164, including the U.S. and China.
Concurrent with this explosion in global trade, corporations—by necessity—started “going global” and needed a rules-based approach to managing global income tax liability. As private sector-related party transactions grew, global tax authorities recognized the need for uniformity in determining whether intercompany pricing was “arm’s-length” such that income was captured in jurisdictions where it was truly earned—and the appropriate amount of income tax was paid. Since 1935, U.S. tax regulations have included the concept of the arm’s-length standard. Regulations issued in 1968 provided further guidance on how to apply the arm’s-length standard along with transfer pricing methodologies. Later, revised U.S. transfer pricing regulations were issued under Treasury Regulations Section 1.482 in 1994. In 1995, guidelines were introduced by the Organization for Economic Cooperation and Development (OECD) based upon the arm’s-length standard. Today, most countries around the world have adopted local transfer pricing rules that follow the OECD Guidelines.
TRANSFER PRICING FRAMEWORK
When buyers import merchandise into the U.S. from a related party seller, the intercompany pricing is governed by a set of methodologies provided under the U.S. transfer pricing rules for determining whether the pricing is arm’s-length. When analyzing transactions between related parties, the U.S. transfer pricing rules require the taxpayer to select the most reliable or “best method.” Due to its ease of use and the readily available external data from which to apply the methodology, the comparable profits method (CPM) is often selected as the best method for determining an arm’s-length price for the purchase of product for distribution into the U.S. market.
For example, in the case of a product imported from a related party manufacturer in China, for distribution into the U.S., one application of the CPM entails comparing the profit earned by the (commonly controlled) U.S. distributor upon re-sale of the imported merchandise to unrelated end customers to a set of uncontrolled U.S. distribution companies deemed comparable. The profit level indicator, or “PLI,” typically used to compare the taxpayer’s profit to that of the set of comparable distribution companies is the operating margin (OM), defined as operating profit before interest and taxes divided by net sales, although other financial ratios can be used if they are deemed to provide a more reliable result.
YEAR-END TRANSFER PRICING ADJUSTMENTS
One mechanism used to facilitate the proper reporting of income using the CPM (or, in general, any other transfer pricing method) is the year-end adjustment. That is, the intercompany prices from the related-party manufacturer to the U.S. distributor would be adjusted up (higher prices) if the U.S. distributor was determined to be earning an above-arm’s-length level of profit on its resales, and the intercompany prices would be adjusted down if the U.S. distributor was earning less than an arm’s-length level of profit.
The adjustment mechanism is certain to take on added significance for fiscal year 2019 given the impact of the Section 301 and Section 232 tariffs on the bottom line of importer/distributors. For many companies, these tariffs (which are paid in addition to any normal trade relations (NTR) rate of duty, as well as any antidumping and countervailing duties) have wiped out all operating profit and have reportedly forced some smaller importer/resellers into bankruptcy.
For commonly controlled importers of tangible goods, the annual adjustment is usually booked to cost of sales or cost of goods sold (COGS) to raise the inventory basis where the taxpayer’s income is too high, i.e., above the interquartile range of targeted OMs when using the CPM (for U.S. taxpayers) or transactional net margin method (for non-U.S. taxpayers). Conversely, COGS is decreased when the taxpayer’s operating margin is too low and additional income is needed to bring the margin up to within the interquartile range.
Whether these year-end adjustments were reportable to U.S. Customs & Border Protection (CBP) as part of the declared value for imported merchandise remained unclear for many years. Though, as discussed below, this matter was finally settled in a landmark CBP Headquarters ruling in 2012. A thorough understanding of this ruling, along with the customs valuation rules, is key to finding solutions to the challenges posed in today’s high-tariff environment.
CUSTOMS VALUATION FRAMEWORK
Merchandise imported into the U.S. is valued in accordance with Section 402 of the Tariff Act of 1930, as amended (19 U.S.C. Section 1401a). The preferred method of appraisement (valuation) is the transaction value method, defined as “the price actually paid or payable for merchandise when sold for exportation to the United States,” plus certain enumerated additions when applicable (19 U.S.C. Section 1401a(b)(1)(A)-(E); 19 C.F.R. 152.103(b)(1)). The regulations further state that “the price actually paid or payable will be considered without regard to its method of derivation. It may be the result of discounts, increases or negotiations, or may be arrived at by the application of a formula, such as the price in effect on the date of export in the London Commodity Market” (emphasis added) (19 C.F.R. 152.103(a)(1)).
The majority of imports into the U.S. (measured by value) now involve transactions between related parties. The customs valuation statute directs that transaction value may not be used if the buyer and seller are related, unless the relationship did not influence the terms and conditions of sale, the price includes non-cash consideration that cannot be valued, or compensation is dependent in whole or in part upon the price realized upon the occurrence of a future event that cannot be quantified in a reasonable period of time (19 U.S.C. Section 1401a(b)(2)(A)).
To validate the arm’s-length nature of the “transaction value,” importers purchasing from related sellers must demonstrate through an examination of the “circumstances of the sale” of the imported merchandise that the relationship between the buyer and the seller did not influence the price paid or payable. Traditionally, these three examples provided the roadmap for importers to use in applying the “circumstances of sale” test:
1. Customs will consider pertinent details of the transaction, e.g., the manner in which the parties organize their commercial relations and the methodologies utilized to derive the price in question to determine whether the relationship influenced the price actually paid or payable. Interpretive Note 1 – 19 C.F.R. 152.103(l)(1)(i).
2. In making this determination, Customs will also seek evidence that the price has been settled in a manner consistent with the normal pricing practices of the industry in question, or with the manner in which the seller settles prices for sales to unrelated buyers. Interpretive Note 2 – 19 C.F.R. 152.103(l)(1)(ii).
3. Furthermore, if it is shown that the price is adequate to ensure recovery of all costs plus a profit that is equivalent to the seller’s total profit realized over a representative period of time, in sales of merchandise of the same class or kind, then Customs will accept that the relationship did not influence the price. Interpretive Note 3 – 19 C.F.R. 152.103(l)(1)(iii).
CBP broadened its approach in 2009. Pursuant to HRL H029658 (Dec. 8, 2009), the agency now reviews all relevant aspects of the import transaction and the totality of the evidence based on the facts and circumstances of each transaction.
CBP’S LANDMARK 2012 HEADQUARTERS RULING
In two significant rulings issued in 2000 (HQ 546979) and 2003 (HQ 548233), importers booked year-end transfer pricing adjustments pursuant to the intercompany pricing formula mandated in bilateral advance pricing agreements (APAs) that each taxpayer had executed with the Internal Revenue Service and the respective foreign taxing authority. In both rulings, CBP held that any year-end adjustments must be reported to the agency as part of the entered value (transaction value), and in the 2003 ruling clarified that both upward and downward adjustments must be reported. However, CBP provided no guidance on how these adjustments were to be reported, such as via a protest (the administrative mechanism used by importers to challenge a decision of CBP when seeking a duty refund), the reconciliation program or a prior disclosure (the administrative mechanism used to report a material false statement or omission to CBP and tender any duties owed).
CBP published much-needed clarification in CBP Headquarters Ruling Letter HQ W548314 (May 16, 2012). In this ruling, CBP articulated a new standard for importers with related-party transactions: When companies use intercompany transfer prices for purchases from related party sellers, any post-importation price adjustments may form part of the customs value and should therefore be reported to CBP if the adjustments meet the requirements of the new “five-factor” test for formula pricing. In addition, importers must continue to demonstrate that the “circumstances of sale” test is met, demonstrating that the related party status does not influence the price declared as the customs value.
CBP’s ‘5-Factor Test’
CBP’s 2012 policy change focused on two main issues: (1) whether and when a related party price (determined pursuant to the importer’s transfer pricing policy) may constitute a formula at the time of importation for transaction value purposes, and (2) whether post-importation price adjustments (upward and downward) may be taken into account in determining transaction value.
In analyzing the first issue, CBP ruled that, when the transaction value is determined pursuant to a formula, the formula must be set before or at the time of importation and not be subject to revisions after importation.
CBP also articulated a new standard for the second issue regarding formula pricing: “Notwithstanding that there may be some element of control, additional considerations should be taken into account in evaluating whether an intercompany transfer pricing formula is an objective formula when it provides for post-importation adjustments to the price.” These additional considerations have come to be known as the “five-factor” test:
(1) A written “Intercompany Transfer Pricing Determination Policy” is in place prior to importation and the policy is prepared taking Internal Revenue Code Section 482 into account.
(2) The U.S. taxpayer uses its transfer pricing policy in filing its income tax return, and any adjustments resulting from the transfer pricing policy are reported or used by the taxpayer in filing its income tax return.
(3) The company’s transfer pricing policy specifies how the transfer price and any adjustments are determined with respect to all products covered by the transfer pricing policy for which the value is to be adjusted.
(4) The company maintains and provides accounting details from its books and/or financial statements to support the claimed adjustments in the U.S.
(5) No other conditions exist that may affect the acceptance of the transfer price by CBP.
HQ W548314 does not engage in an extensive general discussion of the factors listed above, but instead applies them to the specific facts presented by the ruling, making it clear that CBP will examine the above five factors on a case-by-case basis. However, CBP did clarify that, in regard to factor (1) above, “the term ‘transfer pricing policy’ refers to APAs transfer pricing studies prepared in accordance with 26 U.S.C. Section 482 (the IRS transfer pricing statute) or its foreign equivalent, and/or legally binding inter-company agreements/memoranda.”
In addition, CBP noted that factors (1) and (4) taken together “essentially require the importer to specify in its transfer pricing documentation how the adjustments are determined and maintain accounting details from its books and/or financial statements to support the claimed adjustments.” Regarding factor (3), CBP notes that it “requires the transfer pricing policy to cover the goods for which an adjustment may later be made.” For example, if the company imports vehicles and parts, CBP will not accept adjustments to the value of imported vehicles, if the company’s transfer pricing policy only covers vehicle parts.”
In the 2012 ruling, CBP stated that “the satisfaction of the factors set out above reduces the possibility of price manipulation and subjectivity in claiming post-importation adjustments,” permitting an importer’s transfer pricing policy to be considered an objective formula in place prior to importation for purposes of determining the price within the meaning of 19 CFR 152.103(a)(1). In such an instance, CBP now finds that “post-importation adjustments (both downward and upward), to the extent they occur, may be taken into account in determining the transaction value under 19 U.S.C. Section1401a(b).”
Finally, with its 2012 policy, CBP conclusively stated that any downward adjustments in the transfer price made pursuant to the valid transfer pricing study are not “rebates” for the purposes of transaction value, but instead reflect an element of the price actually paid or payable. As stated in HQ W548314, “post-importation adjustments made pursuant to the transfer pricing policy…simply reflect what should have been reported as the invoice price upon entry, had the exact price information of the imported merchandise been available at the time. Any such changes in the transfer price should be immediately reported to CBP.”
IMPACT OF TARIFFS
An increasing number of U.S. multinationals are facing additional 7.5, 10, or 25% tariffs on products imported for distribution into the U.S. market. U.S. companies have sought to reduce the impact of the tariffs through (1) purchasing excess inventory ahead of the tariff imposition date, (2) relocating production to third party or affiliated suppliers outside of China where a tariff would not apply, (3) discontinuing the sale of product lines that are subject to Section 232 or 301 tariffs, (4) negotiating pricing with foreign suppliers such that part of the tariff cost is indirectly included in reduction of the product price, and/or (5) passing all or part of the cost of the tariff onto the customer.
Many companies also sought to re-visit the proper tariff classification of the merchandise subject to Section 301 tariffs (of Chinese origin) or Section 232 (steel and aluminum raw materials), hoping that a corrected tariff code would not attract the additional duties. For Chinese-origin goods, this avenue of relief has effectively been foreclosed with the recent publication of the final list of tariff codes subject to the Section 301 tariffs. Now, nearly all tariff codes (except those covering consumer goods such as electronics and apparel) are subject to the 25% tariffs and “List 4.a” items of Chinese origin are now subject to 7.5% duties. (Again, the NTR duties also have to be paid in addition to the Section 301 and Section 232 duties.)
While U.S. companies are beginning to employ the five strategies mentioned above, changes in supply chains and revisions to existing supplier and/or customer pricing cannot be achieved overnight. Moreover, the prevailing uncertainty over the future of these additional tariffs has prompted many companies to adopt a “wait and see” approach, rather than incorporating any concrete mitigation strategies as of yet.
Many of the products imported to the U.S. are sourced from related party manufacturers in China. As a result, companies are evaluating whether their transfer pricing policies developed pre-tariff are adequate, and if any adjustments to existing policies are needed.
IMPACT OF TARIFFS ON THE CPM AND OTHER TRANSFER PRICING METHODS
U.S. distributors now subject to the 7.5 or 25% tariffs on Chinese imports or 10 and 25% on imports of aluminum and steel raw materials, respectively, are likely to see an erosion of their gross margins as the tariffs have come to be considered part of the cost of goods sold. To the extent that the tariffs cannot be passed along through higher selling prices, the increase in cost of goods sold typically results in a corresponding decrease in operating margins. As a result, the pre-tariff operating margins of U.S. distributors significantly impacted by tariffs on Chinese imports are likely to be higher than the operating margins earned after tariffs have been applied. This presents several concerns when applying the CPM as a reliable method.
Companies that were historically considered comparable distributors may need to be reconsidered if they are not subject to a similar level of tariffs as the U.S.-tested party distributor. The data to make this determination may also not be readily available. U.S. companies recently impacted by tariffs are typically including disclosures within their public financial statements, indicating that tariffs have had a negative impact on their gross margins, but they are not typically quantifying the amount of the tariffs nor the impact on margins. As a result, it is possible to determine that a potentially comparable company is now subject to tariffs on Chinese imports, however, the impact on its operating margin may be difficult to quantify. If the tested party’s operating margins are significantly impacted by recent tariffs it will be important to re-evaluate previously accepted comparable distributors to assess whether they remain comparable. This could result in revised sets of comparables when comparing post-tariff results of the tested party distributor.
U.S. transfer pricing analyses often compare three years of data from the set of comparable companies to three years of data for the U.S. distributor. If the tariffs are only impacting recent purchases from China, this may create a set of comparables where the first two years represent pre-tariff operating margins and the last year represents post-tariff operating margins. Taxpayers may want to consider separating the set comparables and the results of the tested party into pre- and post-tariff periods, if possible, to show the impact of tariffs on both.
We are likely to see lower operating margins or operating losses from comparable companies in the post-tariff years. The taxing authorities will often reject comparable distribution companies that have negative operating margins. Taxpayers will want to consider including such companies in comparable sets if it is determined that the tariffs are the primary cause of the negative margins, along with documentation explaining the rationale for inclusion of companies that are experiencing losses due to tariffs during a certain period.
Given the significant impact of the Chinese tariffs on operating margins of both the tested party distributor and sets of comparable distributors established under the CPM, it is recommended that companies considering segmenting their results into pre- and post-tariff years. Simply including the years impacted by tariffs in a three-year average of the tested party and comparable company operating margins may distort the results for the three-year period. This may require an annual analysis of the operating margin results and a determination of whether they should be combined with the other years under a three-year average or segmented out to isolate the impact of tariffs on certain periods.
IMPACT OF TARIFFS ON APAs
U.S. companies with existing unilateral or bilateral APAs that did not anticipate the introduction of tariffs, may need to evaluate whether the agreed upon pricing methodologies continue to make sense. If not, they may wish to meet with the IRS to discuss amending the original agreement and/or abandon the APA altogether and develop their audit position outside of the APA program. U.S. companies significantly impacted by tariffs that have not previously entered into an APA may wish to approach the IRS to evaluate whether they can gain certainty of how the transaction would be viewed by the IRS under audit. Bilateral APAs including China on this issue could be difficult to obtain, but a unilateral APA with the IRS may provide some clarity on their view on how tariffs should be considered. (Although the IRS generally discourages unilateral APAs, in some cases they can still be practical and advantageous for a U.S. taxpayer. CBP, however, strongly prefers bilateral APAs.)
CUSTOMS DUTY REFUNDS AND FORMULA PRICING
As noted above, the “five-factor” test established by CBP in 2012 will govern whether any potential duty refunds are available from year-end adjustments to COGS to bring importers’ OM back into the interquartile range target—provided that importers can first demonstrate that their intercompany prices declared as the customs values are arm’s-length under CBP’s rules as set forth above. Indeed, although CBP’s policy regarding transfer pricing and post-importation adjustments has been in effect since 2012, many taxpayers have overlooked these rules and continue to rely only on transfer pricing studies or APAs as the basis for supporting their customs values. Such reliance is clearly misplaced because CBP has noted time and again in its rulings that in order to validate transaction value (the only customs valuation method relevant to transfer pricing), transfer pricing studies or APAs, standing alone, will never be enough. (See, e.g., HQ H2195115 (Oct. 11, 2012) “the existence of a transfer pricing study does not, by itself, obviate the need for CBP to examine the circumstances of sale in order to determine whether a related party price is acceptable.”)
Thus, tax and trade planners should actively work together and take the following steps in setting a coherent and practical policy that can be implemented on a worldwide basis:
1. Ensure that the “macro-level” transfer pricing policy is accurately reflected on the “micro-level” (transaction-based) commercial invoices presented to customs authorities when tangible goods are imported. This often requires cooperation between the selling (parent) company and the importer (subsidiary), given that profit margins—even between related parties—are often a closely-guarded secret. Begin a conversation to determine how the profit margin reflected in the unit price is determined and tested to ensure it is returning the requisite profit required by the transfer pricing policy.
2. Profits on the “class of kind” of imported merchandise should be equivalent to the seller’s (producer’s) overall profit, or to the importer’s overall profit when it re-sells the goods after importation. (“Merchandise of the same class or kind” generally includes, but is not limited to, identical merchandise and similar merchandise within a group or range of merchandise produced by a particular industry or industry sector (19 C.F.R. 152.102(h)). This step is necessary to document the profit margin figures which CBP typically requests or examines in determining whether its “circumstances of sale” test for related party transactions are met. Note that the term “profit” is not defined in any customs authority’s regulations; thus, “operating profit,” “gross profit,” “EBIT[A]” or other measures of profit may be considered. In addition, because target profit margins for transfer pricing purposes are not normally set at the product-level, costed bills of materials may often be the only recourse to determine unit-price profit levels. These profit margins should be regularly reviewed and adjusted in accordance with the transfer pricing policy.
3. Transfer pricing analyses that use “operating profit” as the PLI typically focus on the aggregate operating profit of independent (uncontrolled) companies (typically, distributors) with the same function and risk profile as the commonly controlled importer (which is normally the tested party). CBP has consistently stated that transfer pricing studies which do not cover companies distributing the same kinds of products as the importers are of limited value. Thus, refinement of the selection of the comparable companies used as the basis of a transfer pricing’s study to include such kinds of companies would help the transfer price pass muster with CBP—and likely any other customs authority. (This step should also apply for any company that uses an APA, although the inclusion of a comparable company or companies that produce/distribute similar products may skew the outcome for income tax authorities—who may ultimately reject these kinds of comparables for inclusion in the APA’s economic analysis. Nonetheless, taxpayers can still prepare independent economic analyses that include such kinds of comparable product-profit data to meet the requirements of CBP and other customs authorities.)
4. Design and implement a practical and user-friendly procedure to test and track profits regularly on an aggregate and product-level basis. While most companies routinely perform monthly or quarterly testing to gauge profit levels for overall sales, few take this further to the product-level required by customs authorities—despite the fact that aggregate adjustments (typically booked to lower or increase COGS in order to increase or decrease profit) are part of the normal course of business for most companies. Because these adjustments are poised to represent duty refund opportunities if the “5-factor” test is met, taxpayers would be well-served to drill down to the micro-level as back-up for the aggregate-level profit testing. Conversely, duty payments may also result when profit adjustments result in higher unit prices because the distributor/importer earned too much profit.
5. Absent an APA or formal transfer pricing study, prepare a legally-binding inter-company agreement that sets forth (a) the global income tax transfer pricing policy; (b) how the policy supports the use of transaction value for customs valuation purposes (including how the “circumstances of sale” tests are met or how other evidence supports the arm’s-length price); (c) how profit levels are tested, calculated and booked to the financial statements; (d) the time period covered by the agreement; and (e) includes a detailed explanation of how profit margins outside of the targeted range are reported to customs and income tax authorities.
In addressing the steps noted above, companies that have not yet taken steps to document their intercompany pricing formula may be unsuccessful when seeking duty refunds from CBP for decreases to COGS as a result of the “hit” on operating margin prompted by the Section 301 and Section 232 tariffs. As noted above, any written formula must be in place at or prior to the date of the first import covered by any post-importation adjustment. It is unlikely that corporate planners had the clairvoyance to foresee the Executive Orders imposing these tariffs and include the impact of these additional China tariffs and “national security tariffs” in their written transfer pricing formulas. Additionally, even if a written intercompany pricing determination policy was in place, it is equally unlikely that any amendment to the written policy to account for the impact of these additional tariffs took place. Hence, CBP would likely disallow any claimed refunds because no written policy addressing the Section 232 and Section 301 tariffs was in place prior to the first imports of merchandise which were assessed with the additional 7.5, 10, or 25% duty.
Customs valuation and transfer pricing are closely connected, and their relationship may bring significant economic impacts for companies involved in imports of tangible goods from related parties. Just as in the early part of American history, we have entered into a new global trade-war era, as the relationship between the two disciplines becomes more complex and evolves each day. Accordingly, any multinational companies that use transfer pricing studies or APAs must pay close attention to the rules of CBP for arm’s-length pricing. In particular, taxpayers must document the basis for the declared customs transaction value of imported merchandise and especially how transfer prices under the IRS rules support the overarching goal of CBP’s rules: that the relationship did not influence the price of any class or kind of merchandise. Keeping up with the fast-changing U.S. and global trade policies and simultaneously ensuring that transfer pricing policies and supporting documentation are updated and compliant for both tax and customs rules is challenging—but can yield significant results, including potential customs duty refunds for year-end transfer pricing adjustments.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Damon V. Pike leads the Customs and International Trade practice within BDO’s International Tax Services group with over 30 years experience helping multinational companies navigate the complex rules governing the cross-border movement of goods and services.
Mark Schuette oversees BDO’s national Transfer Pricing practice. He has consulted with clients on business, accounting, tax, and valuation issues for more than 30 years, performing transfer pricing services for multinationals as well as U.S. domestic companies.