Application for Further Review (“AFR”) of Protest 0401-07-100180; Transaction Value; Related Party Transactions; Post-Importation Adjustments

March 18, 2013 HQ H018314 OT:RR:CTF:VS H018314 YAG CATEGORY: Valuation Port Director U.S. Customs and Border Protection Port of Boston, Massachusetts 10 Causeway Street - Room 603Boston, MA 02222 RE: Application for Further Review (“AFR”) of Protest 0401-07-100180; Transaction Value; Related Party Transactions; Post-Importation Adjustments Dear Port Director: This is in response to your correspondence, dated September 13, 2007, forwarding the Application for Further Review (“AFR”) of Protest 0401-07-100180, timely filed by [***] (“Protestant”). We regret the delay in responding. Protestant has asked that certain information submitted in connection with this AFR be treated as confidential. Inasmuch as this request conforms to the requirements of 19 CFR §177.2(b)(7), the request for confidentiality is approved. The information contained within brackets and all attachments to this ruling request, forwarded to our office, will not be released to the public and will be withheld from published versions of this decision. FACTS: Protestant is a U.S. based company with headquarters in [***]. Protestant imports contact lenses into the United States and declares import values based on the transaction value method of appraisement. The contact lenses imported by the Protestant are subject to multiple sales overseas: Protestant places orders for contact lenses with [***], a related Barbados holding company, which in turn fulfills the orders from [***], a related contract manufacturer, located in the United Kingdom. All companies to this transaction are related parties within 19 U.S.C. §1401a(b). A related company in Barbados from which Protestant purchases the contact lenses does not produce the merchandise but serves as the “middleman” in the transaction. Protestant does not purchase the imported contact lenses from any other parties; however, the middleman in Barbados sells the same contact lenses to an unrelated party in Japan. Transaction value is declared based on the related party sale between the middleman and Protestant. The export sales price from the manufacturer to the middleman is determined by a cost-plus methodology, or a total of the standard production cost plus an operating profit margin of approximately [***]%. Further, the transfer prices between the middleman and the Protestant (importer) are set at the beginning of each fiscal year based on the budgeted financials. The transfer prices are set so that Protestant earns a return consistent with its annual transfer pricing study. A copy of Protestant’s (importer’s) transfer pricing study, dated October 31, 2005, prepared by the Ballentine Barbera Group (“Ballentine”) is provided by the Protestant for our review and consideration. The transfer pricing study, prepared by Ballentine, covers Protestant’s purchase of contact lenses from the middleman for subsequent resale into the U.S. market. With respect to Protestant’s distribution activities, the Comparable Profits Method (“CPM”) was chosen as appropriate for analyzing the arm’s length nature of the transaction. The CPM examines whether the amount charged in a controlled transaction is an arm’s length price for tax purposes, by comparing the profitability of the tested party to that of comparable companies. Protestant was chosen as a tested party because the middleman in Barbados owns significant valuable non-routine intangibles. The profit level indicator selected was the operating margin. Protestant’s operating margin is calculated as follows: operating profit divided by net sales. Under the CPM, Protestant’s operating profit of [***]% on its distribution activities falls within the interquartile range of comparable companies’ operating profit results of 1.5% to 4.7%, with a median of 2.9%. This arm’s length range was established on the basis of an objective, third-pricing data for distributors (comparable companies), which perform similar functions and assume similar risks as the Protestant. In selecting comparables for its analysis, Ballentine searched Standard & Poor’s Compustat database and focused on companies under the following Standard Industrial Classification (“SIC”) codes: 5040 (professional and commercial equipment); 5046 (commercial equipment, not elsewhere classified); 5047 (medical, dental, hospital equipment and supplies); 5048 (opthamalic goods); 5049 (professional equipment and supplies, not elsewhere classified); 512X (drugs, drug proprietaries, and druggist’s sundries); 5160 (chemical and allied products); 5162 (plastic materials and basic forms and shapes); and, 5169 (chemicals and allied products, not elsewhere classified). This search generated a set of 64 unique companies out of which a final set of 6 comparable companies was selected, whose financial data was used to determine a target operating margin range for the Protestant. The final set of comparable companies represents a set of companies that sell pharmaceutical products, disposable medical, dental, veterinary supplies, health and beauty aids, and surgical supplies. According to the Protestant, the middleman invoices the Protestant for products on a monthly basis. On a fiscal quarterly basis, the prices charged for the goods sold to the Protestant are recomputed to take into account fluctuations in market prices or operating costs. It is stated that the Protestant settles prices with its middleman through an inter-company “netting” process based on the results of the “true-up.” The “true up” is an adjustment from the original invoiced price to the final purchase price, made in order to realize the operating profit of [***]%, as referenced in Protestant’s transfer pricing study, which provides Protestant with the operating margins it should maintain for that fiscal year. The “true up” is completed on a quarterly basis and is reflected as part of reconciliation. Thus, Protestant submits quarterly reconciliations to adjust for the differences between the price used for importation and the price actually paid to its middleman. In this case, Protestant claims downward post-importation adjustments to the price declared to CBP. These adjustments are booked as a credit to the Protestant’s Cost of Goods Sold (“COGS”) and as a debit to the middleman. However, according to the Protestant, due to the business constraints of changing the price in the Protestant’s system every quarter, as the adjustments are minimal on a per unit level, the invoiced price to the Protestant remains unchanged after the reconciliation (even though all adjustments to value of the contact lenses imported from the middleman take place and are reported to both the Internal Revenue Service (“IRS”) and the U.S. Customs and Border Protection (“CBP”)). On March 9, 2007, Protestant received a Notice of Action from CBP, questioning the sufficiency of documentation to support the use of transaction value as a basis for valuing the imported merchandise. On September 13, 2007, Protestant filed this Protest with the Port of Boston, which was forwarded to our office for further review on October 4, 2007. The company is protesting CBP’s decision to liquidate six (6) reconciliation entries without taking into account the downward post-importation adjustments on the reconciliation entries. Entry No. [***], the subject of this protest, was randomly selected by Protestant to form the basis of this protest under 19 CFR §174.13(b). This Entry was filed with CBP on June 10, 2005 and liquidated on March 23, 2007. It is Protestant’s position that these downward post-importation adjustments are all part of an objective formula used to determine transaction value and as such should be allowed to reduce the entered value on the underlying entry summaries. In support of its position, Protestant submitted the following documents: (1) Protestant’s powerpoint presentation prepared for the CBP meeting held on April 19, 2007; (2) Purchase orders; (3) Entry Summary (Entry No. [***]); (4) Commercial invoices; (5) KPMG Submission, dated July 29, 2003; (6) Transfer Pricing Analysis (study), for the fiscal year ending October 31, 2005, prepared by Ballentine; (7) November 1, 2002 Amendment to Distributor Agreement, dated August 1, 1999 between the middleman and Protestant; (8) Manufacturing Service Agreement between Protestant and the middleman; (9) Third Amendment to Manufacturing Agreement between the middleman and Protestant; (10) Copy of Reconciliation Entry No. [***]; (11) Copy of Reconciliation Entry No. [***]; and, (12) copy of Section 1.1059A of the Tax Code. Additionally, Protestant provided a document, entitled “Memorandum of Understanding” (“MOU”), dated May 1, 2007. This document memorializes an agreement that allegedly has been in effect since August 1, 1999 between the Protestant and its middleman. The MOU specifies the formula the companies use to set the transfer price. The equation to calculate the transfer price is as follows: transfer price = sales – operating expense – target return. Protestant states that it did not have the written documentation regarding the formula specified in the MOU until requested by the reconciliation team in Boston. However, Protestant claims that the MOU merely documented the Protestant’s existing practice concerning formula returns. Moreover, in order to claim the post-importation adjustments, Protestant provided the following documentation in order to satisfy the criteria, enumerated by CBP in Headquarters Ruling Letter (“HRL”) W548314, dated May 16, 2012: (1) Memorandum from Ernst &Young, addressing the 5 factors, dated August 13, 2012; (2) Excerpts from Protestant’s Transfer Pricing Report (Study) for the Fiscal Year Ending October 31, 2005; (3) Excerpts from Protestant’s transfer pricing reports for 2005, 2006, and 2007 specifying how the transfer price and any adjustments are determined with respect to contact lenses for which the value is to be adjusted; (4) November 1, 2002 Amendment to the Distributor Agreement, originally dated August 1, 1999, which references the annual transfer pricing reports; (5) Global Trading Arrangement, dated June 3, 2004; (6) Relevant pages of the Customs Compliance Manual; and, (7) Protestant’s accounting details from its books and/or financial statements to support the claimed adjustments. In response to CBP’s request for additional information, Protestant further provided an explanation of how the post-importation adjustments are allocated, along with the spreadsheet from the broker, [***], showing the allocations for the first quarter of 2007, as an example. Finally, on August 29, 2012, Protestant provided the financial and tax documents (for fiscal years 2005, 2006, and 2007) to demonstrate that the adjusted cost of goods sold (adjusted prices) was used to prepare the company’s tax returns and was reported to the IRS. Furthermore, Protestant engaged Ernst & Young LLP (“E&Y”) to assess the sufficiency of documentation supporting the Protestant’s position that the adjusted or final price charged by the middleman to Protestant is at arm’s length for customs purposes and qualifies for transaction value. On March 31, 2009, Protestant submitted a detailed memorandum, issued by E&Y, describing the Protestant’s transaction flow and identifying the relevant information in support of Protestant’s position. This memorandum was accompanied by detailed charts and documentation (including income statements and financial/accounting data used to support transaction value under the all costs plus a profit methodology) supporting the Protestant’s arguments that the relationship of the parties did not influence the price. Finally, Protestant submits the following documents to substantiate a bona fide sale in this case: (1) 2006 sample entry packet, which includes a purchase order, commercial invoice, entry summary, summary of shipments, tied to the invoices, accounting documents, an intercompany reconciliation document, and a bank statement reflecting the payment for the imported goods; (2) 2009 sample entry packet; and (3) the Distributor Agreement between the middleman and Protestant, reflecting the terms of sale of the imported merchandise. ISSUES: Do transactions between the middleman in Barbados and the Protestant/Importer constitute bona fide sales? Is the related party price fixed or determinable pursuant to an objective formula at the time of importation for purposes of determining transaction value? Do the circumstances of the sale establish that the adjusted price actually paid or payable by the Protestant/Importer to the middleman was not influenced by the relationship of the parties and is acceptable for purposes of transaction value? LAW AND ANALYSIS: Merchandise imported into the United States is appraised for customs purposes in accordance with Section 402 of the Tariff Act of 1930, as amended by the Trade Agreements Act of 1979 (TAA; 19 U.S.C. §1401a). The primary method of appraisement is transaction value, which is defined as “the price actually paid or payable for the merchandise when sold for exportation to the United States,” plus amounts for certain statutorily enumerated additions to the extent not otherwise included in the price actually paid or payable. See 19 U.S.C. §1401a(b)(1). As provided in 19 U.S.C. §1401a(b)(4): (A) The term “price actually paid or payable” means the total payment (whether direct or indirect, and exclusive of any costs, charges, or expenses incurred for transportation, insurance, and related services incident to the international shipment of the merchandise from the country of exportation to the place of importation in the United States) made, or to be made, for imported merchandise by the buyer to, or for the benefit of, the seller. Section 152.103(a)(1), CBP Regulations (19 CFR §152.103(a)(1)) provides, in pertinent part, as follows: In determining transaction value, 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. However, rebates, or any other decrease in the price actually paid or payable made or effected after the date of importation are to be disregarded for the purposes of determining transaction value. 19 U.S.C. §1401a(b)(4)(B). Further, in order to use transaction value, there must be a bona fide sale for exportation to the United States. Do transactions between the middleman in Barbados and the Protestant/Importer constitute bona fide sales? Several factors are relied on to determine whether a bona fide sale exists. See Headquarters Ruling Letter (“HRL”) 546067, dated October 31, 1996. In VWP of America, Inc. v. United States, 175 F.3d 1327 (Fed.Cir. 1999), the Court of Appeals for the Federal Circuit found that the term “sold” for purposes of 19 U.S.C. §1401a(b)(1) means a transfer of title from one party to another for consideration (citing J.L. Wood vs. United States, 62 CCPA, 25, 33, C.A.D. 1139, 505 F.2d 1400, 1406 (1974)). No single factor is decisive in determining whether a bona fide sale has occurred. See HRL 548239, dated June 5, 2003. CBP will consider such factors as to whether the purported buyer assumed the risk of loss for, and acquired title to, the imported merchandise. Evidence to establish that consideration has passed includes payment by check, bank transfer, or payment by any other commercially acceptable means. Payment must be made for the imported merchandise at issue; a general transfer of money from one corporate entity to another, which cannot be linked to a specific import transaction, does not demonstrate passage of consideration. See HRL 545705, dated January 27, 1995. In addition, CBP may examine whether the purported buyer paid for the goods, and whether, in general, the roles of the parties and the circumstances of the transaction indicate that the parties are functioning as buyer and seller. See HRL H005222, dated June 13, 2007. Finally, pursuant to the CBP’s Informed Compliance Publication, entitled “Bona Fide Sales and Sales for Exportation,” CBP will consider whether the buyer provided or could provide instructions to the seller, was free to sell the transferred item at any price he or she desired, selected or could select its own downstream customers without consulting with the seller, and could order the imported merchandise and have it delivered for its own inventory. As noted in the FACTS portion of this ruling, Protestant provided numerous documents to substantiate its claim that there was a bona fide sale between the middleman in Barbados and the Protestant/Importer. In accordance to Section 2.2 of the Amendment to the Distributor Agreement, the risk of loss passes from the middleman to Protestant on the basis of FCA (Free Carrier) (shipping point). Protestant bears all costs of freight and insurance and is responsible for clearance of the imported goods into the United States. FCA terms of sale are also indicated on the purchase order and commercial review submitted for our review. Protestant acquires title to the imported merchandise in accordance with Section 4.4 of the Distributor Agreement, which states that “upon receipt of the products from [***], Distributor [***] shall, within a reasonable period of time, signify its acceptance in writing to [***]. Such written acceptance shall effect transfer of title to goods from [***] to Distributor.” Protestant makes monthly payments to the middleman for imported merchandise. Even though Protestant was unable to locate the necessary payment registers from periods more than 5 years old, Protestant provided us with a sample 2009 entry packet (including purchase orders and documents reconciling shipments to payments), which clearly matched each payment with the corresponding shipments. Protestant always buys the imported merchandise to have it delivered for its own inventory. Section 4.1 of the Distributor Agreement states that the imported goods are delivered by the middleman to Protestant pursuant to written delivery requests placed by Protestant during the term of this Agreement. Additionally, Protestant is free to sell the imported merchandise at any price desired. Specifically, Section 5.2 of the Distributor Agreement states that Protestant is free to set its prices for the Products in its sole discretion. Finally, Protestant is free to select its downstream customers without consulting the seller. Section 2.2 of the Distributor Agreement specifies that Protestant acts as an independent contractor under the terms of the Distributor Agreement. Accordingly, based on the description of the Protestant’s sales process, substantiated by the documents submitted by Protestant, we find that Protestant sufficiently proved the existence of a bona fide sale between Protestant/Importer and the middleman. Is the related party price fixed or determinable pursuant to an objective formula at the time of importation for purposes of determining transaction value? Related party transactions involve initial transfer prices that may be subject to adjustment after importation. It is common for the transfer price to be determined in accordance with the company’s transfer pricing policy. The term “transfer pricing policy” refers to Advance Pricing Agreements (“APA”s), transfer pricing studies prepared in accordance with 26 U.S.C. §482 (the IRS transfer pricing statute) or its foreign equivalent, and/or legally binding inter-company agreements/memoranda. Oftentimes such policies provide the method for determining the transfer price, which may include the setting of an initial price and then making various adjustments to the price after the importation based on specified criteria. In this case, Protestant s