Internal Advice Request for Valuation Methodology for Transactions between Related Parties; Transfer Pricing Study

HQ H243689 January 9, 2014 VAL-2 OT:RR:CTF:VS H243689 RSD CATEGORY: VALUATION Port Director U.S. Customs and Border Protection Port of Norfolk 101 E. Main Street Norfolk, Virginia 23510 RE: Internal Advice Request for Valuation Methodology for Transactions between Related Parties; Transfer Pricing Study Dear Port Director: This is in response to your memorandum dated July 15, 2013, forwarding a request for internal device from Katten Muchin Rosenman, LLP on behalf of an importer of home appliances concerning the appropriate customs valuation methodology for certain related party transactions. Counsel 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. FACTS: The seller in this case is a U.S. subsidiary of a global joint venture between two European companies. The joint venture is a globally known manufacturer of home appliances including refrigerators, freezers, dishwashers, ovens, washers, dryers, and other similar types of machines for household use. The company has manufacturing facilities located in the United States and a number of other countries in Europe and Asia. The particular merchandise that is the subject of this internal advice are finished household appliances, and certain accessories for household appliances. The company is the exclusive U.S. distributor of this merchandise. It purchases and imports the subject merchandise from related manufacturers located throughout the world. The shipments of merchandise are entered through multiple U.S. ports, but primarily through the Port of Norfolk, Virginia. The price charged for the subject merchandise is based on a global transfer pricing policy established by the company’s European based parent entity. A “resale-minus” pricing method designed to provide the company’s distribution entities with a targeted benchmarked sale margin on the resale of imported merchandise is used to set the price of the imported merchandise. Although the company is a manufacturer of home appliances, it is also considered to be a distributing entity under the company’s global transfer pricing strategies for purposes of this request. The company’s European parent calculates transfer prices at the start of each fiscal year, which in this case is the calendar year. Upon its establishment, the transfer price is projected to the end of the year and a forecasted end-of-year sales margin is determined. These transfer prices are again reviewed in May and August. If the projected sales margins are forecasted to fall outside a benchmark range, they may be adjusted during these review periods. All adjustments are applied only prospectively, so the company does not report any retroactive price adjustments to Customs and Border Protection (CBP). The transfer pricing methodology that the company uses for determining value of its purchases from related entities has been reviewed by independent international accounting firms for purposes of determining its compliance with the “arm’s length” requirements for related party transfer prices under Section 482 of the United States Internal Revenue Code. To conduct its analysis of the related party transactions, the accounting firm used the “comparable profits method” as defined in the IRS regulations. The accounting firms have concluded that the company’s operating margin ratio falls within the acceptable range of ratios established for comparable uncontrolled U.S. distributors based upon its analysis of the company’s transactions with related entities using IRS approved methods. Counsel for the company notes that although the transfer prices may satisfy the IRS’s “arm’s length” requirements, they have not been analyzed under the CBP valuation regulations to see if they meet the requirements of “arm’s length” transactions under the Customs valuation law. Thus, Counsel believes that appraising the imported merchandise using transaction value would not be acceptable under the Customs valuation law. Instead, Counsel maintains an alternative method of valuation should be applied, and that under the Customs’ valuation hierarchy, the most appropriate method for appraising the imported merchandise would be to use the deductive valuation method. ISSUE: What is the proper method of appraisement for the transactions between the Company/Importer and its related party suppliers (affiliates)? 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). Transaction value is an acceptable basis of appraisement only if, inter alia, the buyer and seller are not related, or if related, an examination of the circumstances of the sale indicates that the relationship did not influence the price actually paid or payable, or the transaction value of the merchandise closely approximates certain “test values.” 19 U.S.C. §1401a(b)(2)(B); 19 CFR §152.103(l). While the fact that the buyer and seller are related is not in itself grounds for regarding transaction value as unacceptable, where CBP has doubts about the acceptability of the price and is unable to accept transaction value without further inquiry, the parties will be given the opportunity to supply such further detailed information as may be necessary to support the use of transaction value pursuant to the methods outlined above. “Test values” refer to values previously determined pursuant to actual appraisements of imported merchandise. Thus, for example, a deductive value calculation can only serve as a test value if it represents an actual appraisement of merchandise under section 402(d) of the TAA. Headquarters Ruling Letter (“HQ”) 543568, dated May 30, 1986. In this instance, no information regarding test values has been submitted or is available; consequently, the circumstances of the sale must be examined in order to determine the acceptability of transaction value. Under this approach, the transaction value between a related buyer and seller is acceptable if an examination of the circumstances of the sale indicates that although related, their relationship did not influence the price actually paid or payable. The CBP Regulations specified in 19 CFR Part 152 set forth illustrative examples of how to determine if the relationship between the buyer and the seller influences the price. In this respect, CBP will examine the manner in which the buyer and seller organize their commercial relations and the way in which the price in question was derived in order to determine whether the relationship influenced the price. If it can be shown that the price was settled in a manner consistent with the normal pricing practices of the industry in question, or with the way in which the seller settles prices with unrelated buyers, this will demonstrate that the price has not been influenced by the relationship. See 19 CFR §152.103(l)(1)(i)-(ii). In addition, CBP will consider the price not to have been influenced if the price was adequate to ensure recovery of all costs plus a profit equivalent to the firm’s overall profit realized over a representative period of time. 19 CFR §152.103(l)(1)(iii). These are examples to illustrate that the relationship has not influenced the price, but other factors may be relevant as well. In order to establish the normal pricing practices of the industry, CBP has noted that the Importer must have objective evidence of how prices are set in the relevant industry and be able to present evidence that the transfer price was settled in accordance with these industry pricing practices. See HQ 542261, dated March 11, 1981 (CBP determined that the transfer price was defined with reference to prices published in a trade journal (the posted price) and other buyers and sellers commonly used the posted price as the basis of contract prices). The pricing practices must relate to the industry in question, which generally includes the industry that produces goods of the same class or kind as the imported merchandise. HQ 546998, dated January 19, 2000; and HQ 548095, dated September 19, 2002. CBP does not consider the industry in question to consist of other functionally equivalent companies if those companies do not sell goods of the same class or kind. See HQ 548482, dated July 23, 2004. In this case, the importer submitted a transfer pricing study for our review and consideration. We note that the existence of a transfer pricing study does not, by itself, obviate the need for CBP to examine the circumstances of sale in order to determine whether a related party price is acceptable. See HQ 546979, dated August 30, 2000. However, information provided to CBP in a transfer pricing study may be relevant in examining the circumstances of the sale, but the weight to be given this information will vary depending on the details set forth in the study. See HQ 548482, dated July 23, 2004. A significant factor, by way of example, is whether the transfer pricing study has been reviewed and approved by the IRS. See HQ 546979, dated August 30, 2000. Whether products covered by the study are comparable to the imported products at issue is another important consideration. See HQ 547672, dated May 21, 2002. The methodology selected for use in a transfer pricing study is also relevant. HQ 548482, dated July 23, 2004. Thus, even though the transfer pricing study by itself is not sufficient to show that a related party transaction value is acceptable for CBP purposes, the underlying facts and the conclusions reached in the transfer pricing study may contain relevant information in examining the circumstances of the sale. We note that we have no indication that the transfer pricing study submitted to CBP by the Company has been reviewed by the IRS, leaving CBP unaware as to whether the assumptions on which the study is based and the conclusions derived would be acceptable to the IRS. See HQ 548482, dated July 23, 2004; see also HQ H032883, dated March 31, 2010. Further, all of the transfer pricing studies utilize the Comparable Profits methodology (CPM) to evaluate distribution and manufacturing activities of the buyer and the seller. Although CBP has, in the past, given some weight to an importer’s transfer pricing methodology when it has been based on the CPM, special circumstances were present. See HQ 546979, dated August 30, 2000. It is important to note the following special circumstances or other factors that were present in HQ 546979: 1) the transfer pricing methodology had been approved by the IRS through the Advance Pricing Agreement program; 2) Customs participated in the APA pre-filing conference between the importer and the IRS, and had access to the information provided to the IRS throughout the APA process; 3) the importer provided Customs with a waiver that enabled access to the documents that were submitted to the IRS in the APA process; 4) all of the importer's imported products were covered by the APA; and 5) the transfer pricing agreement was a bilateral agreement for which the transactions had been examined and accepted by the taxing authorities of both the United States and Japan. A similar outcome was achieved in HQ H029658, dated December 8, 2009 in which CBP determined, based on these unique circumstances and the overall structure of the transaction, that the circumstances of the sale were satisfactory. None of the factors relied upon in HQ 546979 and HQ H029658 are present in this case. Counsel concedes that the transfer pricing studies does not analyze the pricing of the company’s importations on an entry-by-entry or product-by-product basis. Instead, the profitability of the company’s distribution activities are provided on an aggregated basis. Furthermore, the company is the tested party in the transfer pricing studies and such studies focus on its operating profits rather than on the profit level of the foreign seller relative to comparable uncontrolled companies. The focus of interpretative note (iii) of section 152.103 (l)(1), is the seller’s costs and profit. In order to determine whether the transaction at issue was conducted at "arm’s length," CBP regulations examine whether the seller received a price that enabled it to recover of all costs, plus a reasonable profit as described in detail in interpretative note (iii). See HQ 548452 dated July 23, 2004. CBP recently considered transfer pricing studies, which utilized the importer’s profits (operating profits or gross profits, depending on the circumstances of the case) in analyzing as to whether the relationship of the parties influenced the price under the circumstanced of the sale test. See HQ H029658, dated December 8, 2009; HQ H037375, dated December 11, 2009; and, HQ 219515, dated October 11, 2012. However, in these rulings CBP did not strictly rely on the importers’ profits or the importers’ transfer pricing studies, but held that the importers showed that the sales price was not influenced by the relationship for the purposes of the circumstances of the sale test, based on the totality of the information considered, and CBP’s review and examination of all relevant aspects of the transaction, including the way in which the importers and the related parties organized their commercial relations and the way in which the price in question was arrived at. The evidence presented by the importers did not fall strictly within a single illustrative example, specified in 19 CFR §152.103(l)(1)(i)-(iii), such as the normal pricing practices of the industry; nevertheless, taken together, the documents provided by the importers assisted CBP in reaching its conclusion that the relationship of the parties did not influence the price. In this case, the transfer pricing study submitted by counsel, on behalf of the buyer/importer, does not by itself provide CBP with the information necessary to conclude that the relationship between the buyer/importer and the seller did not influence the price charged for the imported merchandise. Thus, we find that the information presented does not support acceptability of using transaction value to appraise the imported merchandise. When imported merchandise cannot be appraised on the basis of transaction value, it is appraised in accordance with the remaining methods of valuation, applied in sequential order. 19 U.S.C. 1401a(a)(1). The alternative bases of appraisement, in order of precedence, are: the transaction value of identical or similar merchandise (19 U.S.C. 1401a(c)); deductive value (19 U.S.C. 1401a(d)); computed value (19 U.S.C. 1401a(e)); and the “fallback” method (19 U.S.C. 1401a(f)). The transaction value of identical merchandise or similar merchandise is based on sales, at the same commercial level and in substantially the same quantity, of merchandise exported to the United States at or about the same time as the merchandise being appraised. See 19 U.S.C. § 1401a(c). Based on the information available, there are no previously accepted and adjusted transaction values of identical or similar merchandise on which to base appraisement of the imported home appliances. As stated in 19 C.F.R. §152.102(i), "similar merchandise means merchandise produced in the same country and by the same person as the merchandise being appraised, like the merchandise being appraised in characteristics and component material, and commercially interchangeable with the merchandise being appraised. If similar merchandise cannot be found, merchandise produced in the same country as, but not produced by the same person as the merchandise being appraised may be treated as similar merchandise." See also 19 U.S.C. §1401a(h)(4); 19 C.F.R. 152.104(c). We note that no information was provided for our review with respect to this issue, and thus the merchandise cannot be appraised using transaction value of identical merchandise or similar merchandise. The next method of appraisement is deductive value. Under the deductive value method, merchandise is appraised on the basis of the price at which it is sold in the U.S. in its condition as imported and in the greatest aggregate quantity either at or about the time of importation, or before the close of the 90th day after the date of importation. 19 U.S.C. §1401a(d)(2)(A)(i)-(ii). If the merchandise concerned is sold in the U.S. in its condition as imported, but not sold at or about the date of importation, the price at which the merchandise is sold in the greatest aggregate quantity after the date of importation, but before ninety days after such importation, is utilized. 19 U.S.C. §1401a(d)(2)(A)(ii). The unit price at which merchandise is sold in the greatest aggregate quantity means the unit price at which it is sold to unrelated persons at the first commercial level after importation. 19 U.S.C. §1401a(d)(2)(B). Furthermore, the price determined under 19 U.S.C. §1401a(d) is to be reduced by an amount equal to the following: (i) any commission usually paid or agreed to be paid, or the addition usually made for profit and general expenses, in connection with sales in the United States of imported merchandise that is of the same class or kind, regardless of the country of exportation, as the merchandise concerned; (ii) the actual costs and associated costs of transportation and insurance incurred with respect to international shipments of the merchandise concerned from the country of exportation to the United States; (iii) the usual costs and associated costs of transportation and insurance with respect to shipments of such merchandise from the place of importation to the place of delivery in the United States, if such costs are not included as a general expense under clause (i); (iv) the customs duties and other Federal taxes currently payable on the merchandise concerned by reason of its importation, and any Federal excise tax on, or measured by the value of, such merchandise for which vendors in the United States are ordinarily liable" 19 U.S.C. §1401a(d)(3). Thus, it is necessary to determine what profit and general expenses can be deducted and whether the claimed deductions are appropriate to deduct from the price of the merchandise. Counsel for home appliance importer has proposed calculating a deductive value based the U.S. resale value of the imported merchandise less sales deductions, warranty costs, fixed administrative costs variable administrative costs and target sale margin profit. Target sale margin of finished goods and accessories has been determined in the IRS transfer pricing studies conducted outside accounting firms and is comparable to profit margins in sale between unrelated U.S. distributors. Although your office has indicated that deductive value is the most appropriate method of valuing the imported merchandise, you should obtain the necessary information from the Importer in order to be sure that the technical requirements are satisfied to appraise the merchandise under the deductive value as specified in 19 U.S.C. §1401a(d), and verify whether the final accounting of all pertinent revenue and expenses figures are maintained in accordance with generally accepted accounting principles ("GAAP"). We note that Counsel has pointed out in computing a deductive value, the profitability level indicated in the transfer pricing study may provide a basis for the amount of profits that should be deducted from the U.S. selling price because the transfer pricing studies indicate that the company’s profit and general expenses are consistent with those of similarly situated imported merchandise of the same class or kind. We note that Counsel has requested that the company be permitted to use the reconciliation prototype At the time of entry, the company intends to report the transfer price it paid its related entity for the merchandise, while flagging entries for reconciliation. The company indicates that the reconciliation entry would be filed within the 21 month period. Reconciliation is a process that allows an importer to identify undeterminable information (other than that affecting admissibility) to CBP, and provide the outstanding information at a later date. Modification and Clarification of Procedures of the National Customs Automation Program Test Regarding Reconciliation, 67 Fed. Reg. 61,200, 61,201 (Sept. 27, 2002). Importers notify CBP that an entry summary is subject to Reconciliation by flagging the entry summary for Reconciliation. The flagged entry summary is liquidated for all aspects of the entry except those issues that were flagged. The means of providing the outstanding information at a later date relative to the flagged issues is through the filing of a Reconciliation entry. We suggest that the company be advised to consult with your office concerning the proper procedures for using reconciliation entries. HOLDING: The acceptability of transaction value based on the related party sale between the Importer and Manufacturer/Seller has not been demonstrated. Accordingly, an alternative basis of appraisement must be used. The imported merchandise should be appraised using deductive value under 19 U.S.C. §1401a(d), provided the technical requirements for appraising the merchandise under 19 U.S.C. §1401a(d) are met. You are to mail a copy of this decision to the importer no later than 60 days from the date of this letter. On that date Regulations and Rulings of the Office of International Trade will take steps to make the decision available to CBP personnel, and to the public on the CBP Home Page on the World Wide Web at www.cbp.gov, by means of the Freedom of Information Act, and other methods of public distribution. Sincerely, Monika R. Brenner, Chief Valuations and Special Programs Branch