Internal Advice Request; Transaction Value; Related Party Transactions; Post-Importation Adjustments

June 3, 2014 HQ H228298 OT:RR:CTF:VS H228298 YAG CATEGORY: Valuation Dina M. Amato, Assistant Port Director U.S. Customs and Border Protection Miami International Airport, Trade Operations 6601 NW 25th Street Miami, FL 33122 RE: Internal Advice Request; Transaction Value; Related Party Transactions; Post-Importation Adjustments Dear Ms. Amato: This is in response to your internal advice request, dated July 24, 2012, inquiring as to whether the Importer/Buyer’s [***] basis of appraisement of the imported merchandise is acceptable under transaction value. We regret the delay in responding. The Importer/Buyer has asked that certain information submitted in connection with this internal advice request 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: The Importer/Buyer [***] is a wholly owned subsidiary of [***] (the “Seller”), a publicly traded Japanese corporation. The Importer/Buyer’s primary business is the sale of machine tools, manufactured by its parent company in Japan, the Seller, through its U.S. distributor network. The company’s products are comprised of certain machine tools and replacement parts, including CNC lathes, grinding machines, accessories, automation, vertical and multi axis machine centers and [***] Advanced Programming Production Systems. The Importer/Buyer uses transaction value method to appraise the imported merchandise, and values are based on sales prices between the related parties (the U.S. Importer/Buyer and its related Seller in Japan). In accordance to the Importer/Buyer’s submission, the parties establish an annual price list annually at which the Importer/Buyer purchases the machine tools and replacement parts from the Seller. The methodology for determining product prices relies on the Suggested Retail Price as a starting point. The Seller in Japan typically sets customer list prices at the beginning of a product life cycle based on market indicators and research information compiled by the Importer (for example, the company considers average selling price for similar products, production costs, and industry reports). The Importer provides its input in setting the prices. Additionally, in setting the agreed price list, the Seller in Japan considers anticipated end customer prices, as well as the standard costs of the distributor. Prices are set on a model basis in a manner to return an operating margin to the distributor that falls within the acceptable range specified in the company’s bilateral Advance Pricing Agreement (“APA”). Prices may be adjusted based on market conditions. It is stated that the starting point and the elements involved in the price-setting process are dependent on factors external to the parties’ relationship, such as customer end prices, production costs and expected industry operating margins for comparable companies. In other words, it is the cost of production and the market conditions for the products that are controlling factors in deriving the prices paid by the Importer/Buyer to the related Seller. The Importer/Buyer claims that the company sets its prices in accordance with the normal pricing practices of the industry. The Importer/Buyer further states that the companies in the machine tool industry follow a similar approach to organize their business operations: product innovation, research and development, and manufacturing activities are governed at the parent company’s (foreign manufacturer’s) level. The U.S. distributors primarily perform routine distribution functions. As a result, machine tools manufactured by the global companies in the industry are priced to allow the in-country distributor to recover its costs and receive a consistent and routine return appropriate for the limited risks taken. The balance of the overall profit from sales to end customers is paid by the distributor to the parent company (foreign manufacturer) as the purchase price of the imported machine tool. As support, a paper, “Industry Practice Report – Machine Tool Industry,” dated October 2012 and prepared by Ernst & Young, LLP, was submitted for our review. Additionally, the Importer/Buyer provided its bilateral APA between the Internal Revenue Service, the Importer, and the Japanese Tax authorities for our review. This APA covers the sales of machine tools and machine tool replacement parts to the Importer/Buyer as well as the Importer/Buyer’s performance of installation, warranty, repair and other services incidental to the sale of such machine tools and parts, and the performance of research and development and technical services by the Importer/Buyer for the Seller. The tested party is the Importer. The term of the importer’s APA is for seven tax years from March 31, 2005 through March 31, 2011. 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. In its APA, the Importer/Buyer identified the comparable profits method (“CPM”) as the best method for evaluating its related party or controlled transactions. The profit level indicator selected is the operating margin. The Importer/Buyer’s operating margin is defined as follows: the sum of the Importer/Buyer’s operating profit from the combined results of covered transactions for all years in the APA term, divided by the sum of the Importer/Buyer’s sales revenue from covered transactions for all years in the APA term. According to the APA, the arm’s length range is between [***]. This arm’s length range was established on the basis of an objective, third-pricing data for distributors (comparable companies) of industrial products, which perform similar functions and assume similar risks as the Importer/Buyer. The search for comparable companies resulted in seven (7) companies that sell their products to a variety of industries. It is important to note that although the companies that perform similar functions, incur similar risks, use similar intangible assets as well as sell similar products were considered for the analysis, the final set of comparable companies represents a set of companies that sell a variety of products from air conditioners and heating equipment to plumbing supplies. While comparable companies sell the industrial products, the Importer/Buyer belongs to the machine tool and metal equipment industry. Its product categories include die cutting machines, drilling and tapping machines, grinding machines, machining centers, turn/mill machines, and turning centers. Further, the APA states that the Importer/Buyer’s cumulative margin must be tested and if the cumulative margin is outside the acceptable range, then the amounts reported on the Importer/Buyer’s tax return must include an adjustment to bring the cumulative operating margin within the acceptable range. It is the Importer/Buyer’s position that these post-importation adjustments are all part of an objective formula used to determine transaction value. Additionally, the Importer/Buyer asserts that it met the circumstances of the sale test by showing that the prices between the Importer/Buyer and the Seller were not influenced by the relationship between these companies. The Port disagreed with the Importer/Buyer’s analysis, and this internal advice request followed. The following documents were provided for our review: (1) the Importer/Buyer’s APA for the years 2005 through 2011; (2) Circumstances of the Sale Analysis, issued by Ernst and Young, LLP; (3) copies of Prior Disclosures, dated January 7, 2010 and September 20, 2010; (4) formal response provided by the Importer/Buyer’s counsel to the Port; (5) email correspondence between the Port and the Importer/Buyer; (6) the Importer/Buyer’s U.S. Consolidated Profit and Loss Statement for APA years March 2005 through March 2011; (7) the Importer/Buyer’s FY 2010 Profit and Loss Statement; (8) Office of Regulatory Audit, CBP, Importer Self-Assessment Report; (9) credit memorandums for FY 2010, which detail the post-importation adjustments made; and, (10) copies of reconciliation entries filed by the Importer/Buyer in 2010. Moreover, in response to CBP’s request for additional information, the Importer provided the following: (1) the Importer/Buyer’s 2010 Income Tax Return; (2) the Importer/Buyer’s work papers to show that the Cost of Goods Sold (“COGS”) amount reported on the tax return included the Cost of Sales in which the FY 2010 transfer pricing adjustment was recorded; (3) screen shot of the accounting entry that was made to record the FY 2010 transfer pricing adjustment; (4) the company’s consolidated financial statement; and (5) the Importer/Buyer’s calculation schedule, illustrating how the post-importation adjustments were determined. The Importer/Buyer reports its adjustments to CBP via the Reconciliation program. ISSUES: 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 price actually paid or payable by the Importer/Buyer to the Seller is 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 affected 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. The Port of Miami has not questioned whether a bona fide sale for exportation to the United States has occurred; accordingly, we will only examine the related party price. Is the related party price fixed or determinable pursuant to an objective formula at the time of importation for purposes of determining transaction value? As noted above, the annual transfer pricing study has been prepared using the CPM. As a consequence of utilizing the CPM approach, the Importer/Buyer is required to make retroactive price adjustments (downward and upward) to meet its federal tax obligations and to show that its prices are at arm’s length. In Headquarters Ruling Letter (“HRL”) W548314, dated May 16, 2012, CBP examined the issue of claiming post-importation adjustments to value in related-party sales. CBP held that companies may claim compensating adjustments and other post-importation adjustments based on tax transfer pricing documentation and APAs. In HRL W548314, CBP found that the Importer’s transfer pricing policy constituted an objective formula provided the company’s transfer pricing policy meets certain factors. Thus, effective July 30, 2012, CBP allows both upward and downward post-importation adjustments to related-party sales prices made pursuant to a formal transfer pricing policy that meets the following criteria: A written “Intercompany Transfer Pricing Determination Policy” is in place prior to importation and the policy is prepared taking IRS code section 482 into account; 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; 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; The company maintains and provides accounting details from its books and/or financial statements to support the claimed adjustments in the United States; and, No other conditions exist that may affect the acceptance of the transfer price by CBP. An adjustment formula must satisfy all five criteria in order for CBP to accept it as objective. In this case, the Importer/Buyer provided certain information to satisfy the above-referenced criteria. A written transfer pricing policy is in place prior to importation and the policy is prepared taking IRS code section 482 into account The internal advice request in question involves merchandise imported into the United States in 2010. In 2010, the Importer/Buyer declared downward post-importation adjustment, in the amount of $[***] and requested a refund of duties. The Importer/Buyer provided CBP its bilateral APA for seven tax years March 31, 2005 through March 31, 2011. This APA was executed in 2008, and, thus, became effective in 2008. The transfer price between the Importer/Buyer and its related Seller is determined in accordance with this APA, utilizing section 482 of the IRS code. Therefore, the Importer/Buyer’s written transfer pricing policy existed and the pricing method was agreed upon prior to the importation of goods in 2010. 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 In this case, the Importer/Buyer’s APA requires the company to “report its taxable income in an amount that is consistent with Appendix A (covered transactions and transfer pricing method) and all other requirements of this APA on its timely filed U.S. return.” The necessary adjustments are made on an annual basis to ensure compliance with the terms of the APA. The 2010 adjustment was made to the Importer/Buyer’s books prior to year-end closing. Since the adjustment did not result in a book/tax difference, it was not reported separately as a compensating adjustment on the income tax return. Instead, the post-importation adjustment was reported to the IRS as part of the Cost of Goods Sold (“COGS”). The Importer/Buyer provided its 2010 Income Tax Return to show the COGS reported to the IRS, as well as the supporting work papers, indicating that the COGS amount included the transfer pricing adjustment. We also note that since the adjustments are reported in the Importer/Buyer’s accounting books as adjustments to COGS, these adjustments affect the profit margins of the imported goods and specifically result in lower declared values for the merchandise. In each case, at the end of the year the transfer pricing study confirms that the prices, as adjusted, are within the arm’s length range determined by the transfer pricing study. Consequently, the adjusted prices are actually used for both financial accounting and income tax purposes. To support this assertion, the Importer/Buyer’s APA confirms that the year-end adjusted operating margin falls within the interquartile range of comparable firms’ operating margin. The Importer/Buyer uses the final financial numbers in preparing the tax returns. Upon review of the documents submitted by the Importer/Buyer, we find that there is a link between the adjusted COGS and the tax returns, the company indeed uses its transfer pricing policy in filing its income tax returns, and the adjustments are reported to the IRS and used by the Importer/Buyer in filing its income tax return. 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 Based on the information provided by the Importer/Buyer, the related party price (and the adjustments thereto) are determined pursuant to the company’s transfer pricing policy, which is based on the bilateral APA. The Importer/Buyer provided CBP with documentation showing that adjustments are made on an entry-by-entry basis and, therefore, related to specific entries. Additionally, the Importer/Buyer’s APA confirms how the transfer price and any adjustments are determined with respect to all products covered by the APA (i.e. machine tools and machine tool replacement parts) for which the value is adjusted. The company maintains and provides accounting details from its books and/or financial statements to support the claimed adjustments in the United States The Importer/Buyer provided financial and accounting records to support the claimed adjustments, as well as the detailed description of the profit allocation to individual products. The adjustments are allocated equally to all imports for the year. In other words, the Importer/Buyer applies a fixed percentage across all imported products. The Importer/Buyer reviews preliminary sales and profit annually before the books are closed and performs the following: (1) determines the required operating margin/profit based on the APA range; and (2) compares pre-adjustment profit with the required operating margin/profit to determine the amount of adjustment needed. Since the APA requires the cumulative operating margin to be within the appropriate range, the calculation is based on a cumulative formula that considers results of all APA years (years of the APA that predate the APA approval and the current year). In this case, the Importer/Buyer reviewed its Profit and Loss statement for the 2010 fiscal year in isolation and determined that a single credit of $[***] was required to increase profits earned on imports during 2010 in order to bring the operating margin for that year to the bottom of the APA range. Separately, because of delays in concluding the bilateral APA, an additional credit in the amount of $[***] was provided by the Seller with respect to the 2010 fiscal year. This amount equals one-third of the cumulative profit shortfall for the years covered by the APA but concluded before the APA was finalized (2005-2008). This represents the calculated profit amount needed to be earned in 2010 in order to make up one-third of the profit shortfall for the years prior to APA finalization. Therefore, the resulting adjustment for the fiscal year 2010