RELATED PARTY PRICING / TRANSFER PRICING: Customs vs. IRS

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RELATED PARTY PRICING / TRANSFER PRICINGCustoms
vs. IRS

• Presented to the NYSSCPA
• International Taxation Committee
• June 17, 2008

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Alan Goggins

• Barnes, Richardson Colburn475 Park Avenue
  South
• New York, NY 10016
• 212-725-0200 Ext 118
• agoggins_at_barnesrichardson.com

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Both Customs (or CBP) and the IRS can scrutinize
related party prices to determine if such prices
are arms length

• The tests are similar in theory but drastically
  different in the details

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Why is this important?

• Any sale from an overseas exporter to a related
  U.S. importer implicates both the CBP and the
  IRS.
• An overseas version of the IRS in the country of
  exportation may also be involved

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Why is this important?

• CBP has recently announced its intention to step
  up enforcement in this area
• Having an APA in place is no longer sufficient to
  convince CBP

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Goals for today

• Compare methods employed by CBP and IRS
• Determine what types of documentation can satisfy
  both

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Relationship Test

• Control 5 of voting stock threshold
• Parent subsidiary and subsidiaries of
  subsidiaries
• Sister companies under common control of a parent
  company

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CBP Valuation Issues

• Value for CBP purposes is almost always
  determined under the transaction value method
  19 U.S.C. 1401a
• Statute requires use of transaction value if
  applicable
• Transaction value price paid or payable when
  sold for export to the U.S.

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If parties are related, CBP can question
acceptability of prices

• Circumstances of sales test 3 variations
• Test values test 3 variations
• Only need 1 to pass, and any 1 will do
• Pass / Fail unlike IRS, CBP cannot adjust
  prices must accept or reject
• If rejected must use alternative valuation
  method

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First Sale Appraisement

• Method of avoiding CBP inquiry (and saving duty)
• If unrelated factory sells to exporter, may be
  able to use factory or first sale prices instead
  of prices from exporter to related importer
• No duty paid on exporters margin

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First Sale Appraisement

• Transaction between factory and exporter must be
  a sale
• Must be for exportation to the U.S. factory
  must know the goods are destined to the U.S.
• Labeling, shipping instructions, separate P.O.
  for U.S. market goods

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Circumstances of Sale Test

• The analysis reveals that the relationship
  between the buyer and the seller did not
  influence the prices paid

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Circumstance of Sales Test Variation 1

• Related party prices settled in a manner
  consistent with the normal prices practices in
  the industry
• Example commodities prices tied to public
  market quotations
• Documentation public market quotes

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Circumstance of Sales Test Variation 2

• Related party prices settled consistent with the
  way the seller settles prices to unrelated buyers
• Example exporter sells same merchandise to
  unrelated buyers in U.S. (preferred) or in third
  countries at similar prices
• Same pricing formula - related unrelated

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Circumstance of Sales Test Variation 2
(Continued)

• Same level of trade
• compare sales to related and unrelated
  distributors
• OR related and unrelated wholesalers
• OR related and unrelated retailers
• Otherwise, make a level of trade adjustment
• Documentation Comparative analysis converting
  prices to a common currency plus the invoices

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Circumstance of Sales Test Variation 3

• Related party price adequate to ensure recovery
  of all the exporters costs plus a profit
  overall profit in sales of the same class or kind
  of merchandise
• Cost of production analysis
• Business segment or product line profit rather
  than overall profit

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Circumstance of Sales Test Variation 3
(Continued)

• Cost of production analysis required for every
  product imported
• Documentation a mountain of paper required
  invoices, ledgers, journals, cost accounting
  records, etc.

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Test Values

• Related party prices are acceptable to CBP if
  such prices closely approximate a test value or
  an appraised value if one of the secondary bases
  of valuation were used
• Transaction value of identical or similar
  merchandise, deductive value, computed value

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Test Values Transaction Value Identical or
Similar Goods

• Transaction value identical goods same exporter
  sells same goods to unrelated buyers in U.S. (?
  how is this different from COS Variation 2?)
• Transaction value similar goods ask your
  competitor what he pays for imported goods and
  ask for his customs entries (do not hold your
  breath)

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Test Values Deductive Value

• Start with importers most common U.S. resale
  price and work your way back to a proxy for the
  purchase (import) price
• Deduct NDCs
• Deduct importers SGA
• Deduct importers profits in U.S.
• Try to narrow focus to product line costs

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Test Values Computed Value

• This is also an exporters cost of production
  analysis
• ? How is this different from COS Variation 3?

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Test Values Roadblock

• CBP policy will not accept any test values
  unless the secondary appraisement method was
  actually used in a previous importation

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Test Values Roadblock

• Statute requires use of transaction value first
  only get to secondary methods if transaction
  value rejected
• By then, per CBP, too late to use test values
• CBP policy erases test values from the statute

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IRS Transfer Pricing Tests

• Unlike CBP, IRS can propose adjustments to prices
• IRS also requires taxpayer to establish that the
  method used provides best and most reliable
  measure
• Profit-based methods
• Transaction-based methods

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IRS Transfer Pricing Tests Profit-Based Methods

• Comparable profits
• Comparable profit split
• Residual profit split
• Profit comparisons between related parties or
  between related parties and competitors
• None acceptable to CBP because must have a
  customs value for each imported article

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IRS Transfer Pricing Tests Transaction-Based
Methods

• Comparable uncontrolled price (CUP)
• Compares related party prices to prices in sales
  to unrelated parties
• Similar to COS Variation 2 and can be met with
  the same type of documentation (comparative
  analysis with invoices and prices converted to a
  common currency)
• Here, CBP would likely accept the APA if given an
  explanation

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IRS Transfer Pricing Tests Transaction-Based
Methods

• Resale price method used for a reseller
• Compares gross margin in related party sales to
  gross margin in unrelated party sales
• Exporter must have sales to related and unrelated
  parties
• Would need substantial explanation to demonstrate
  an APA here also meets CBP possibly COS
  Variation 2

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IRS Transfer Pricing Tests Transaction-Based
Methods

• Cost plus method used for a manufacturer and
  compares gross margins in sales to related and
  unrelated parties
• Somewhat similar to COS variation 3 or computed
  value mountain of documents
• Would again require substantial explanation to
  demonstrate APA here also met CBP

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CBP vs. IRS

• APA or transfer pricing study alone will not
  satisfy CBP
• Must also demonstrate how a CBP method is met
• Like an APA, importer can apply for a CBP ruling
  in advance

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CBP vs. IRS

• The only method that appears to readily satisfy
  both CBP and IRS is Circumstances of Sales
  Variation 2 / CUP test

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CBP vs. IRS

• 26 U.S.C. 1059A
• Inventory costs of imported merchandise for a
  related party importer taken into account for IRS
  purposes must not exceed value declared to CBP
• Does not apply to first sale method
• Example failure to declare an assist results in
  double penalty CBP underpaid duty and IRS
  disallows expense deduction

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Concluding Thoughts

• Companies spend significant time and resources
  preparing for the day the IRS knocks on the door
• Comparable effort not made in preparing for the
  day CBP questions related prices
• CBP has served notice be prepared!

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Questions?

• Alan Goggins, Esq.
• Barnes, Richardson Colburn
• 475 Park Avenue South
• New York, NY 10016
• 212-725-0200 Ext 118
• agoggins_at_barnesrichardson.com