Internal Advice Request; Applicability of Transaction Value; Related Party Transactions

HQ H065015 April 14, 2011 OT:RR:CTF:VS H065015 YAG CATEGORY: Valuation Ms. Betty C. Williams, Field Director Office of International Trade Regulatory Audit 555 Battery Street, Room 313San Francisco, CA 94111 Re: Internal Advice Request; Applicability of Transaction Value; Related Party Transactions Dear Ms. Williams: This is in response to the internal advice request, initiated by [***] (the “Company”) transmitted to our office on June 10, 2009, regarding the proper method of appraisement of merchandise imported by the Company from its two foreign affiliates, [***], located in Singapore and [***], located in the United Kingdom. We regret the delay in responding. The Company [***] has asked that certain information submitted in connection with this internal advice be treated as confidential. Inasmuch as the request conforms to the requirements of 19 CFR §177.2(b)(7), the company’s request for confidentiality is approved. The information contained within brackets and all attachments to the internal advice request, forwarded to our office, will not be released to the public and will be withheld from published versions of this ruling. FACTS: The Company [***] develops and markets instrument-based systems, consumables, software, and services for the life science industry and research community. The Company’s customers use these products and services to analyze nucleic acids (DNA and RNA), small molecules, and proteins to make scientific discoveries, develop new pharmaceuticals, and conduct standardized testing. The Company was incorporated in 1998 under the laws of the State of Delaware. It was comprised of two business segments: (1) the [***]; and (2) the [***]. Effective July 1, 2008, the Company separated the [***] group business from the Company, and the [***] became the Company’s only business. The Company changed its name to [***] on July 1, 2008. On November 24, 2008, [***] merged with another corporation, [***], to form a new company, [***]. This new company, [***], currently operates two divisions: [***] and [***]. The Company [***], who is also the Importer, is a parent company that purchases the imported merchandise from its affiliates in Singapore and the United Kingdom, [***] [***], for resale to unrelated customers in the United States. On March 31, 2009, the Office of the Regulatory Audit in San Francisco, California, completed a Focused Assessment (“FA”) Follow-Up Audit of the Company. The Office of the Regulatory Audit determined that the Company does not declare its accurate and complete values to the U.S. Customs and Border Protection (“CBP”). The Company flags its entries for reconciliation at the time of importation and adjusts these entries after the importation on the basis of transfer pricing studies, prepared for the Internal Revenue Service (“IRS”), to determine the final value of the imported merchandise. During the FA Follow-Up Audit, the Company first used these studies to justify that its final values established through reconciliation were appropriate transaction values. After the Office of the Regulatory Audit found this procedure to be noncompliant with the regulations for transaction value, the Company attempted to demonstrate, by use of the same studies, the same final price under the computed value method of appraisement. The Office of the Regulatory Office rejected the Company’s arguments, and this internal advice request followed. This decision is being issued subsequent to our review of the following documents: (1) Distribution and Service Agreement between the Company’s affiliate in Singapore [***] and the Company [***], effective July 1, 2001; (2) Distribution Agreement between the Company [***] and the Company’s affiliate in the United Kingdom [***], effective July 1, 2000; (3) The Company’s [***] Finance Manual; (4) the Company’s Routine Return Analysis of Asian Manufacturing Comparables, dated December 8, 2004 (prepared by PricewaterhouseCoopers LLP); (5) the Company’s FY 2006 Asian Manufacturing Comparable Analysis, dated March 15, 2007 (prepared by Baker & McKenzie Consulting, LLC); (6) Analysis of [***] Manufacturing Comparables in the United Kingdom, dated January 20, 2005 (prepared by PricewaterhouseCoopers LLP); (7) the Company affiliate’s in the United Kingdom FY2006 [***] Comparable Analysis, dated March 14, 2007 (prepared by Baker & McKenzie Consulting, LLC); (8) the Company’s Intercompany Pricing Study for fiscal year 2005, dated March 14, 2006 (prepared by PricewaterhouseCoopers LLP); (9) the Company’s FY 2006 [***] Distribution Comparables Analysis, dated March 14, 2007 (prepared by Baker & McKenzie Consulting, LLC); (10) the Company’s [***] Customs Disclosure for FY 2006 ([***] and [***]); and, (11) Cost Build-Up (Singapore and the United Kingdom Manufacturing Locations). Moreover, on September 16, 2009, in response to our request for additional information, the Company [***] set forth additional arguments concerning the proper method of appraisement of the imported merchandise. The Company, [***], purchases finished products from its affiliate in Singapore, [***], pursuant to the terms of a Distribution and Service Agreement, effective July 1, 2001. The products purchased pursuant to this agreement and imported into the United States consist of instruments related to the Company’s [***] Core Polymerase Chain Reaction, Sequence Detection, Nucleic Acid Synthesis, Microfluidics Control Delivery, and Gene Expression Array systems. The Company [***] purchases finished products from its affiliate in the United Kingdom [***] pursuant to the terms of a Distribution Agreement, effective July 1, 2000. The products purchased pursuant to this agreement and imported into the United States consist of reagents and consumables that are used with the Company’s [***] life science instruments. Pursuant to these Distribution Agreements, the Company [***] acts as the U.S. distributor of the instruments manufactured by its affiliate in Singapore [***] and the reagents and chemicals manufactured by its affiliate in the United Kingdom [***]. The Company [***] purchases its merchandise only from its related manufacturers, [***] and [***]. The Company does not buy its merchandise from unrelated suppliers, and [***] and [***] do not sell to the unrelated distributors in the United States. The intercompany prices between the Company [***] and its affiliates in Singapore and the United Kingdom, [***] and [***], are based on an average list price less a distributor’s discount. In order to establish the intercompany transfer prices, each legal entity creates a forecasted Profit & Loss statement at the beginning of the year. These projected P&L statements include projected sales revenue, anticipated cost of sales, anticipated operating expenses, etc. Based on these projections, the transfer price is established in SAP by taking each product’s standard cost and multiplying it by the uplift factor needed to arrive at the average unit price (“AUP”) (i.e. the average sales price to third party customers) minus [***]%. The uplift factor is the percentage that is multiplied against the standard cost to arrive at the intercompany transfer price. The amount of the uplift is meant to cover costs other than standard costs (e.g., production variances) as well as profit. The list price represents the price at which the Company believes it can sell the articles to third parties. The average unit price is the average of the list prices for the same article (since the list price can vary by jurisdiction). The list price is reviewed on an annual basis. The discounts are designed to help ensure that the Company/U.S. Importer [***] covers its distribution costs and earns an appropriate arm’s length profit when the articles are resold to third parties. The Company states that this method, in turn, helps ensure that its manufacturing affiliates, [***] and [***], each cover their respective costs and earn an appropriate, arm’s length profit on their respective sales to the Company [***]. No information concerning negotiations of the above referenced prices was presented. Distribution Agreements also refer to sales commissions. The Company stated that sales commissions are only due when its affiliate in Singapore [***] makes direct sales into the Company’s [***] territory. The Company argues that these commissions would be paid by the seller, not the importer; therefore, they would not be relevant for U.S. Customs purposes. No further explanation was provided. Thus, it is not clear what these sales commissions represent, to whom they are paid, and if they are included in the profit calculations for both companies. Additionally, as mentioned in the FA Follow-Up Audit, there might be an issue of the inclusion of the royalty payments in the value of the imported merchandise, however, no further explanatory information was provided concerning this issue. The Company’s [***] margins are reviewed on a quarterly basis (beginning with the end of the second quarter) in order to determine whether transfer pricing adjustments might be required. An adjustment would be required if the financial results for the legal entity indicate that it will earn a profit that is inconsistent with the arm’s length range (i.e., too much profit, or too little profit). If adjustments are required, they are generally booked in expense and asset/revenue accounts. Pursuant to the Company, adjustments are generally made through journal entries booked to “Costs of Sales” and “Intercompany Receivable/Payable” accounts. Therefore, the Company is adjusting the transfer price of the articles sold between legal entities and is participating in CBP’s reconciliation program, effective November 4, 2005. The Company submitted multiple transfer pricing studies covering the manufacturing activities of its affiliates in Singapore and the United Kingdom, [***] and [***], and distribution activities of the Company [***], who is also the Importer. All transfer pricing studies and updates are conducted in compliance with Section 482 of the Internal Revenue Code. Section 482 of the Internal Revenue Code (26 U.S.C. §482) requires that the arm’s length result of a controlled transaction be determined under the method that, given the facts and circumstances, provides the most reliable measure of an arm’s length result. The application of the best method establishes an arm’s length range of prices or financial returns with which to test controlled transactions. However, according to the Company’s [***] submission, there is no Advance Pricing Agreement with the IRS. The Company’s [***] initial transfer pricing study was prepared by an outside consulting firm, PricewaterhouseCoopers LLP, in 2006. PricewaterhouseCoopers LLP was engaged to assist the Company in determining the arm’s length character of [***] transactions with related parties, limited to the distribution of finished products imported from the Company’s affiliates in the United Kingdom and Singapore during fiscal year 2005. As stated in the Company’s [***] transfer pricing study prepared by PricewaterhouseCoopers LLP, the Comparable Profits Method (“CPM”) was selected as the best method to evaluate the intercompany tangible transactions between the Company and its foreign affiliates. The CPM examines whether the amount charged in a controlled transaction is an arm’s length price by comparing the profitability of the tested party to that of comparable companies. The Berry ratio, or the ratio of gross profit to operating expenses, was selected as the most reliable profit level indicator (“PLI”) to test the reasonableness of the intercompany pricing between the Company [***] and its foreign affiliates. The tested party under the CPM transfer pricing analysis is the entity that performs the least complex functions and faces the least amount of risk. The Company (Importer) [***] was selected as a tested party in this analysis. In selecting comparables for its analysis, PricewaterhouseCoopers, LLP reviewed publicly-available databases and focused on companies under the following Standard Industrial Classification (“SIC”) codes: 504 (Wholesale: Professional and Commercial Equipment and Supplies), 506 (Wholesale: Electrical Goods), 508 (Wholesale: Machinery, Equipment, and Supplies), 509 (Wholesale: Miscellaneous Durable Goods), 512 (Wholesale: Drugs, Drug Proprietaries, and Druggists’ Sundries), and 516 (Wholesale: Chemicals and Allied Products). The search identified 411 potentially comparable companies. In order to limit the search, PricewaterhouseCoopers, LLP excluded companies that (1) had data available for less than 2 years; (2) indicated an R&D to sales ratio of greater than or equal to 3 percent (this indicated significant investment in R&D and possible intangibles associated with that investment); and, (3) indicated an advertising to sales ratio of greater than or equal to 3 percent (this indicated significant investment in advertising and possible non-routine marketing intangibles associated with that investment). The business descriptions of the remaining companies were reviewed with a focus on functional comparability with the Company’s [***] distribution activities. This search and selection yielded ten (10) comparable companies, which distribute chemically-derived pharmaceuticals, biopharmaceuticals, brand name and generic pharmaceutical products, over-the-counter health and beauty products (personal care products), nutritional supplements, disposable medical, dental, veterinary supplies, health and beauty aids, surgical supplies, companion-pet veterinarian and rehabilitation supplies. None of the comparable companies belong to the life science and research industries. There is no indication in the transfer pricing study of any adjustments to the financial data for the comparable parties. Therefore, over the 2002 to 2004 period, the financial results of the accepted comparable distributors indicated an interquartile range of three-year weighted average Berry Ratios that extends from [***]% to [***]%, with a median of [***]%. Additionally, the interquartile range of Return on Sales achieved by the evaluated comparable distributors extended from [***]% to [***]%, with a median of [***]%. 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 Company (Importer) [***]. With respect to the tested transactions, the Company [***] achieved a three-year weighted average Berry Ratio of [***]% on its purchases from the manufacturers in Singapore and the United Kingdom, [***] and [***], a result that fell within the interquartile range identified by the evaluated comparable distributors. However, the Company [***] achieved a Return on Sales ratio of [***]% on the same transactions, a result that fell above the established range. The second analysis, conducted by Baker & McKenzie Consulting, LLC was to assist the Company in the development of a set of independent U.S. distributors whose activities are comparable to those of the U.S. affiliates of the Company. The CPM was affirmed as the best method to conduct this analysis. The Berry ratio, or the ratio of gross profit to operating expenses, was selected as the most reliable PLI to test the reasonableness of the intercompany pricing between the Company [***] and its foreign affiliates. The Company/Importer [***] was selected as a tested party in this analysis. A global search was conducted to identify a set of comparable companies that engaged in distribution activities similar to those of the Company’s [***] distribution activities. In selecting comparables for its analysis Baker & McKenzie Consulting, LLC reviewed the publicly available Thomson Financial Worldscope database and focused on companies under the following Standard Industrial Classification (“SIC”) codes: 504 (Professional and Commercial Equipment), 508 (Hardware and Plumbing and Heating Equipment and Supplies), and 5099 (Durable Goods, Not Elsewhere Classified). The search identified 293 potentially comparable companies. In order to limit the search to unrelated companies with the distribution activities similar to the Company, the companies were eliminated based on the following criteria: (1) companies that did not present sales data during the years 2004 or 2005; (2) the company was engaged in significant manufacturing; (3) the company was engaged in provision of services; (4) the company was engaged in the distribution of non-comparable products (however, large scale distributors of industrial products were deemed sufficiently comparable); (5) companies had significant intangible assets; and, (6) companies were engaged in unrelated activities (investment, research and development, mining, etc). This search and selection yielded fifteen (15) comparable companies, which distributed the following merchandise: personal protection and safety equipment, heating, ventilation, and air-conditioning equipment, commercial and industrial dry cleaning, laundry and steam boilers equipment, repair and operating products, and automated office equipment. None of the comparable companies discussed in this transfer pricing study are the direct competitors of the Company Group [***] or even remotely relate to the life science and research industry. This transfer pricing study concluded that the results of the analysis presented reasonably can be used by the Company Group [***] in the application of the CPM to the distribution activities of its U.S. affiliates. The range of Berry Ratios established by the comparables was [***]% to [***]%, with a median [***]%. The cost plus mark-up for the Company/Importer [***] was not provided. Furthermore, the Company provided two transfer pricing studies, which summarized the results of PricewaterhouseCoopers LLP’s review of Asian manufacturers, comparable to [***], the Company’s affiliate in Singapore. The CPM was selected as the best method to evaluate the manufacturing activities of the affiliate in Singapore [***], and the full cost mark-up ratio was chosen as PLI. The Company’s affiliate in Singapore, [***], was chosen as a tested party. A search of publicly available Global Vantage and Worldscope databases for the comparable companies was performed. The search focused on companies classified in the following primary Standard Industrial (“SIC”) Codes: 281 (Industrial Inorganic Chemicals); 2835 (In Vitro and In Vivo Diagnostic Substances); 2836 (Biological Products, Except Diagnostic Substances); 286 (Industrial Organic Chemicals); 289 (Miscellaneous Chemical Products); 3821 (Laboratory Apparatus and Analytical, Optical, Measuring and Controlling Instruments); and, 3823 (Industrial Instruments for Measurement, Display, and Control Process Variables and Related Products). One hundred and thirty (130) companies were identified. After the screening to remove the duplicate companies, related parties, companies with less than 2 years of available financial information, companies that engaged in the manufacture of products not directly related to measuring and analyzing instruments/control systems, unrelated activities, research and design, and in extensive provision of services, the search resulted in the final set of six (6) companies, comparable to the activities undertaken by the affiliate in Singapore, [***]. All of the companies are located in Japan and are in the business of manufacturing market temperature control systems, analyzing equipment, semiconductor products, fine ceramic-based censors, and electronic devices for industrial measuring. None of the comparable companies actually produce Core Polymerase Chain Reaction, Sequence Detection, Nucleic Acid Synthesis, Microflu