Internal Advice Request; related parties; transaction value

HQ 548095 September 19, 2002 RR:IT:VA 548095 MMC CATEGORY: Valuation Area Director U.S. Customs Service JFK Airport, Building 77 Jamaica, New York 11430 RE: Internal Advice Request; related parties; transaction value Dear Area Director: This is in response to your February 7, 2002, memorandum requesting internal advice pertaining to the appraisement of the merchandise covered by entry number 765-1332202-4. The merchandise consists of handbags of various materials, scarves and belts. The merchandise was imported by [XXX] USA (VUSA/importer) and obtained from its related company [XXX] SpA (VSpA) for sale to the importer's customers, some of whom are related companies, in the United States. Counsel for the importer submitted comments in letters to your office dated April 19, September 10, and November 7, 2001. These letters were in response to January 30, and May 9 2001 Requests for Information and an October 12, 2001 Notice of Action. Although the declared value was based on the price VUSA paid VSpA, the Notice of Action indicates that the merchandise is properly appraised at the price paid by the ultimate consignee in the U.S. Counsel disagrees with that conclusion and claims the declared value is correct and has submitted documentation to support the claim that the VUSA-VSpA related party price is an acceptable transaction value. In reviewing the matter, this office has considered all documents from the port including the entry package. Additionally this office held a March 29, 2002, conference call with importer's counsel. As a result of the conference, counsel provided an April 1, 2002 supplemental submission that included among other things a complete copy of a transfer pricing study. We are assuming that there are no other Agreements, inter-company agreements, memorandum of understanding or pricing documents between or among the parties other than those contained in the file. Business proprietary information provided with this request will be accorded confidential treatment pursuant to 19 C.F.R. § 177.2(b)(7). Such information is designated by brackets, and will be redacted from the public version of this letter FACTS: [XXX] Group is an Italian multinational group in the high fashion industry in the business of designer apparel, perfume, cosmetics, watches, optical wear and shoes. It is wholly owned by [XXX] HS.p.A. [XXX] is acknowledged worldwide as one of the leading brands in the high fashion sector and a significant symbol of Italian fashion. According to counsel, the importer's major competitors are other prominent fashion houses including Versace, Ungario, Gucci, Christian Dior and Channel. Finally, counsel indicates that VSpA is the licensor of the Valentino trademark. The [XXX] Group has entered into contract manufacturing agreements with related party manufacturers in Italy and a limited number of unrelated 3rd parties that presently manufacture [XXX] products on the basis of the specific design and quality requirements provided for by the [XXX] Group. VUSA is a company within the [XXX] Group. Its functions include acting as a holding company that controls several corporations that operate U.S. boutiques. Additionally, it carries out trading activities including selling goods both to wholesalers and retailers. While not involved in the production cycle, VUSA is responsible for marketing and branding, outbound logistics, and sales. VUSA sells the imported merchandise to unrelated wholesalers in the U.S.(approximately 75% of volume and revenue) with the remainder sold to [XXX]'s U.S. boutiques. VUSA purchases the imported goods from [XXX] S.p.A (VSpA/seller). VSpA is also a member of the [XXX] Group. VSpA is responsible for the production cycle of the merchandise. Its activities include management and coordination of high fashion activity, design and creation of patterns, choice and development of fabric and accessories, coordination of all fashion events, and advertising and trademark protection. Additionally, it manages contract manufacturers including their selection, quality control and inventory. The goods include designer apparel, perfume, cosmetics, watches, optical wear and shoes. Services include promotion and advertising. On December 26, 2000, an entry of handbags of various materials, scarves and belts was made. In a January 20, 2001 request for information and a follow up request dated May 9, 2001, Customs asked the importer for a sample of one of the items covered by the entry at issue, documents concerning that style, and copies of all contracts, agreements etc. that were relevant to the transaction. Additionally, Customs asked the importer to answer a series of specific questions. In response, counsel provided two separate submissions dated September 10, 2001 and April 19, 2001. These submissions included a portion of a Transfer Pricing Study, a Distribution and Service and Supply Agreement between VSpA and VUSA, a Royalty Agreement between VSpA and [XXX] VCI the precursor to VUSA, a December 12, 2000 freight invoice to VUSA for the shipping costs of the goods from VSpA to VUSA, and a Licensing Agreement between VCI and a third party. According to the importer's transfer pricing study, all of the importer's transactions are conducted as follows: The related manufacturer purchases raw materials and then makes them into goods. The goods are then sold by the manufacturer to VSpA. VSpA then pays the manufacturer. After making payment to the manufacturer, VSpA sells the goods to VUSA. The goods are then drop-shipped from the manufacturer to VUSA. VUSA then pays VSpA for the goods. VUSA issues its purchase orders via computer directly to VSpA. No hard copy is available. Proof of payment was submitted as part of the April 19, 2001 submission. Freight and insurance documents for the transaction were provided. In response to the additional questions, counsel indicated that the importer would not incur any additional costs for assists, buying commissions or selling commissions in connection with the subject shipment, and no additional proceeds would accrue to the seller (VSpA). Although counsel indicates that the importer would not in its estimation incur additional costs for assists, it is not clear whether in fact the importer did supply assists to other parties in the transaction. With respect to the remainder of the questions, Counsel indicated that "portions of the transfer pricing study (study) are directly responsive" to the questions. Essentially, it is the importer's position that the study, which compares VUSA's profitability to that of other companies, establishes that the related party sale is an arm's length transaction. The study provides four main categories of information. The first section is an overview of the [XXX] Group, including its organizational and operational structure, and an explanation of inter-company transactions for both tangible goods and services. The second section describes worldwide operations, including the high fashion industry in Italy and the U.S. The third section discusses a "comparable companies search". This search includes the identification of potential comparable companies, short business descriptions of each, the actual identified comparable companies, a financial analysis of them, and an analysis of VUSA's budget. The fourth and final section provides an explanation of the IRS §482 Regulations and available Methods under those regulations and an explanation for the method chosen and its application to the subject goods. For the transaction between VUSA and VSpA the comparable profits method (CPM) was chosen. According to the study, the selection of the CPM method was done largely because distribution (wholesale) returns of the comparable companies at the operating profit/margin level (as opposed to gross margin under the full resale price method) provided a reasonable reference point for VUSA. The study states that the search for comparable companies looked for independent designers and wholesalers of men's, women's and children's apparel. Companies that act primarily as manufacturers and retailers were not deemed functionally comparable to VUSA. Comparable companies included those with the Standard Industrial Code (SIC) 5137-wholesale distribution of men's, women's and children's clothing and accessories, including hosiery, lingerie, millinery and furs, and 5136-companies engaged in the wholesale distribution of men's and boys' apparel and furnishings, sportswear, hosiery, underwear, nightwear, and work clothing. The initial search was under SIC code 5137 but only produced 36 companies so the search was broadened to include the second SIC category and broadened the number of companies to 56. Of these, the comparable companies had to be a wholesale clothing distributor, with no retail or manufacturing activities. In addition, they had to source goods from unrelated manufacturers and own no intangibles (trademarks) etc. Based on the criteria the field was narrowed to 16 of which 6 where chosen. The six were Active Apparel Group, Aris Industries, Donkenny Inc, Happy Kids, Inc. Niches, Inc. Stage II Apparel Group. Counsel indicates that the study concludes that the operating margins earned by VUSA (net profit as a percentage of net sales) are "comparable" to those earned by "other companies in the apparel industry who purchase from unrelated suppliers under similar circumstances." When the CPM method was applied, the operating margin for the unrelated companies was between -0.15% and 10.16%. VUSA's operating margin is 4%. The Distribution Agreement (Agreement) indicates that VUSA is the non-exclusive distributor for the covered products in the U.S. and Canada. VUSA's obligations include distribution, promotion, and sales for the goods. The agreement refers to a "recommend price list" in several sections, although it does not indicate which party(ies) created the list. The Distribution Agreement is silent as to the nature of the relationship between VUSA and VSpA, be it principal/agent or buyer/seller. Section 3 of the Agreement is entitled " Remuneration." It states in pertinent part that: US (VUSA) shall be entitled to an arm's length gross margin, which shall result from SPA(VSpA) granting a resale price discount off the recommended Price List applied by US in the Territory. The resale price discount that US shall receive for the SPA products for the period this Agreement is in force shall be set at an amount that permits US to earn a gross margin to achieved [sic] a budgeted operating margin of 4.0% with respect to the sale and distribution of the SPA products on the wholesale market; and 0.0% with respect to the sale and distribution of SPA products on the retail market. With specific regard to the sale of goods between SPA and US for the retail outlets, the parties agree that if the volume and project revenues of the retail operations of US do not allow SPA to recover its costs of production, either those born directly by it or those for which it pays another party, then the transaction price will be set such that SPA recovers only its costs of production. Further, the Parties acknowledge their mutual responsibility to be in the retail market in the Territory with the aim of increasing market awareness of SPA trademarks and products. The break-even budget for the retail line of business respects the fact that the retail outlets are historically loss leaders for growth and development of the wholesale line of business of US from which both SPA and US benefit. The transaction price for the SPA products charged by SPA to US will be calculated based on annual budgets, prepared by US and confirmed by SPA, of revenues with respect to the sale and distribution of the SPA products, and the related operating expenses incurred by the US; and volumes per collection. The budgets will clearly segregate the forecast results of the retail operations from the wholesale operations. The budgets will be mutually agreed between US and SPA in the normal course of the budgeting cycle of the [XXX] Group. Based on the confirmed budget, a resale price discount percentage on the prices charged to the Customers, as set forth in the recommended Price List, is calculated to determine the transaction price charged by SPA so that US achieves the budgeted margin with respect to the sale and distribution of the SPA products at the retail and wholesale levels. The difference in the supply price to US of SPA products and the selling prices charged by US to its customers represents an arm's length margin of US for expenses including, but not limited to: customs duties, freight, and brokerage; development and maintenance and operation of retails [sic] outlets and associated selling and operating expenses; development and maintenance of the wholesale distribution organization and associated operating expense including administrative expenses; maintenance of the showroom facility and other promotional allowances; compensation for development and maintenance of a sales organization fixed and variable expenses associated with warehousing and logistics; and other fixed and variable expenses incurred in operating the business in the Territory including any fee for services rendered by SPA to US pursuant to Subsection 3(f). As the resale gross margin and resulting transaction prices are based upon budgets, to the extent that actual results vary from budgeted results, such variance is for the account and risk of the relevant Party. There will be no retroactive adjustment to transaction prices unless the variance from budget (either positive or negative; either in terms of volume or revenue) is greater than or equal to 20%. However, the Parties agree that transaction prices may be adjusted for prospective sales at any time by agreement between SPA and US should either party evidence to the satisfaction of the other that budget variance requires an adjustment to the transaction price. For promotional and advertising planning services rendered by SPA to US during any period, US will pay SPA an arm's length commission equal to fifteen percent (15%) of the investment in advertising spaces made within the Territory. Said media buy is included in the total advertising program of the [XXX] Group as prepared by SPA for all group companies and confirmed by each group company, including US, for their respective markets. IN addition, to the extent that SPA incurs direct production cots directly related to, but not limited to, artwork and photography in support of the media plan as applicable to US, such costs will be charged at cost to US during the period. The expense incurred by US relative to these services provided by SPA are included in the cost base for the margin calculation pursuant to Subsection 3(d). Section 4 is entitled "Purchasing and Payment" it states in pertinent part that: Prices charged by SpA to US for products shall be in United States Dollars ($). All prices are calculated for delivery Ex-Works SpA port of shipment. The products are shipped with a duty list that reports Ex-Works prices. As such SpA export licenses, approvals or both shall be obtained by US at its cost. Similarly, all import licenses, approvals, or both shall be obtained by US at its cost. Prices to US do not include any federal, state, or local taxes that may be applicable to SpA products. US shall bear the expense of any applicable customs duties. Every shipment of SpA products will be accompanied by an original invoice from SpA to US. Cost of freight and duty shall be separately invoiced. Section 6 is entitled "Delivery, Title, Risk of Loss, and Returns". It states in pertinent part that: (a) Firm purchase orders are to be placed by US with SpA. Products shall be shipped as SpA shall deem appropriate, or as otherwise directed. As shipments are Ex-Works SpA port of shipment, title and risk of loss for SpA products shall remain with SpA until such time as the products are made available to US at SpA's premises, at which time title and risk of loss will shift to US. In this regard, US shall duly draw up an insurance contract sufficient to cover the value of each shipment. A review of the Agreement, insurance contract and shipping documents indicate that VUSA in accordance with the Ex-Works terms of sale receives title to, and risk of loss of the merchandise from the time it leaves either SpA's premises or their designated port of shipment. According to the transfer pricing study, the merchandise is drop shipped from the manufacturer to the U.S. Although risk of loss shifts at the time of shipment, under the [XXX] Group's umbrella insurance policy the parent of both companies insures the merchandise during all intra-company shipments, including shipments to VUSA. According to counsel, the unit cost breakdown of VSpA's price to VUSA for the submitted sample is based upon the following inputs: Silk- [XXXX] L Labor- [XXXX] Lace- [XXXX] Labels- [ XX] Pkg- [XXX] _________________ [XXXX] L For goods destined to the US, counsel states that VSpA applies a mark-up of [XXX]. This multiplier is designed to recover all VSpA's additional costs not detailed above. As such counsel states that this transfer price includes all costs plus a profit. This multiplier is slightly lower than multiplier used for the VSpA's wholesale sales within Italy because according to counsel,VSpA has to recover its commissions and delivery expenses relating to the sales within the home market. According to counsel, domestic resale price is determined by adding 25% for freight and duty charges incurred by VUSA plus an additional 35% markup. Markup varies for each of the different Valentino collections and may be changed if market conditions require. Retail price equals $[XXXX].  Counsel cites 3(d) of the distribution agreement between VSpA and VUSA to indicate what expenses the domestic markup is intended to cover. In addition the mark up is calculated to provide VUSA with an annual operating profit margin of 4%. Concerning royalties, VSpA entered into the supplied royalty agreement with its related subsidiary, [XXXX]. The royalty agreement grants VCI a license to use the [XXXXX] trademark in the US and the right to sublicense the trademark to 3rd parties. VCI was merged with VUSA at the end of 2000. VUSA assumed the duty for payment for the royalties. Counsel claims that trademark royalties paid to VSpA by VCI and now VUSA relate solely to merchandise imported by unrelated 3rd parties. According to counsel, none of these royalties are paid in connection with merchandise imported by VUSA. Other agreements include one between VCI and VSpA for advertising costs incurred in the US, and a service supply agreement for advertising and promotion activity. Counsel indicated that VUSA is now responsible for payment of the fees under the "Service Supply Agreement- Advertising and Promotional Activity". Finally, counsel indicates that VSpA has an in house design and development department. All costs associated with that department are built into the multiplier. Counsel's position is that the related party sale is an arm's length transaction and thus, an acceptable transaction value. Counsel also believes that the sale between the ultimate consignee and VUSA is a domestic sale and therefore is precluded from serving as a basis for transaction value. Your position is two-fold. You believe that the evidence fails to establish that sales between members of the [XXXX] Group are free of non-market influences and that VUSA is a de facto selling agent for the [XXXX] Group. As such you conclude that the only statutorily viable sale for export is between VUSA and its ultimate consignees in the U.S. You claim that it was this sale that was the impetus for the entire prod