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

U.S. Department of Homeland Security Washington, DC 20229 U.S. Customs and Border Protection HQ H265779 March 20, 2018 OT:RR:CTF:VS H265779 YAG CATEGORY: Valuation Field Director U.S. Customs and Border Protection Office of Trade, Office of Regulatory Audit, Miami 11232 NW 20th Street Miami, FL 33172 Re: Internal Advice Request; Applicability of Transaction Value; Related Party Transactions Dear Field Director: This is in response to your internal advice request, dated June 15, 2015, regarding the proper method of appraisement of imported merchandise, purchased by [***] Corporation ([“***”] or “the Company”) from its related supplier in [***], [***]. This decision is issued in response to multiple submissions filed by the Company’s counsel, dated September 1, 2015; September 8, 2015; June 13, 2016; and, June 14, 2016; as well as a subsequent conference call with this office. The Company has asked that certain information submitted in connection with this internal advice request be treated as confidential. This request for confidentiality is approved. The information contained within brackets and all attachments to this internal advice request, forwarded to our office, will not be released to the public and will be withheld from published versions of this decision. FACTS: The Company is based in [***] and is a market leader in providing home storage and organization solutions to its customers, such as wire and laminate/wood storage systems for use throughout the home, office, and garage. The Company is a subsidiary of [***], a parent company, located in [***]. The Company sources some of its wire baskets and systems for use in the home storage systems at issue from a related supplier in [***] and resells the merchandise to retailers in the United States. The Company’s related supplier sells its wire baskets exported to the United States mainly to the Company. However, on a lesser scale, the related supplier also sells similar products directly to an unrelated retailer in the United States, [***]. The Company also sells some products to unrelated Original Equipment Manufacturers (“OEM manufacturers”). However, those products are made specifically for the OEMs and are significantly different from the baskets and systems sold to the Company. Thus, the only unrelated purchaser of identical or similar products exported to the United States is [***]. On October 30, 2014, U.S. Customs and Border Protection (“CBP”), Office of Regulatory Audit in Miami initiated an audit of the Company for the period of October 1, 2013 through September 30, 2014. As part of the audit, CBP determined that the Company’s documentation supporting its position that the related party transaction was conducted at arm’s length was insufficient. Consequently, CBP concluded that the Company failed to support the transaction value method of appraisement. The Company disagreed with Regulatory Audit’s conclusions and submitted the following documents for CBP’s review in the course of the internal advice request (this list also includes the documents obtained and analyzed by the Office of Regulatory Audit): (1) Entry package for Entry No. [***] (including CBP Form 3461, CBP Form 7501, bill of lading/air waybill/sea waybill, commercial invoice, packing list, freight bill); (2) Another subsidiary’s [***] Transfer Pricing Study (2011 study and 2011 and 2013 appendices) to support the appropriateness of the profit claim; (3) [***] Group Organizational Chart; (4) [***] Corporation Policies and Procedures Manual referencing the intercompany pricing standards; (5) the Company’s valuation and assists manual, ensuring compliance with [***] transfer pricing policy; (6) Summary cost data used to develop the transfer price between the relates parties; (7) Second cost data sheet converting the currency to U.S. dollars; (8) Examples of bills of material for 4 of the 18 products, breaking out the material costs, labor and overhead factors included on the summary cost reports; (9) A narrative of the product cost standards rollup that generates the transfer price; and, (10) The Company’s 2012 Profit and Loss (“P&L”) Statement. The Office of Regulatory Audit also provided a summary of their relevant correspondence with the Company’s counsel for our review. The Company states that for sales of the product to the Company, the related party supplier develops a spreadsheet of cost information that includes the following: all direct and indirect costs of the operation; raw materials; direct and indirect labor; transportation; utilities; managerial costs; overhead costs; selling, general and administrative (“SG&A”) expenses; and, [*]% profit. The related party supplier provides this cost information to the Company’s marketing group. The marketing group either accepts the price or requests that a different raw material be used to reduce product costs. The Company states that this is a normal procedure, used to quote the price to both related and unrelated buyers. The sum of all these costs plus a profit represents the transfer price reported to CBP and invoiced to and paid by the Company. The Company states the profit percentage is deemed a reasonable profit for a contract manufacturer, as reviewed by the parent company’s corporate staff and corroborated by the transfer pricing study on similar manufacturing arrangements in the country of exportation [***]. The sales price to the Company is updated annually, based on the related supplier’s costs of manufacturing the product and operating its facility. Section 4.1 of the Company’s Valuation and Assists policy indicates that the Company “follows guidelines set forth in the Company’s Corporate Policies and Procedures (“CP&P”) policies 162.07 and 570.02.” The Company’s CP&P 570.02 section IV subsection D defines “arm’s length standard” as follows: the arm’s length standard is met if the results of the intercompany transaction in question are consistent with the results that would have been realized if non-controlled entities (i.e., third parties) had engaged in the same transaction under the same circumstance. Generally, a separate determination as to whether the arm’s length standard is met must be made for each different type of intercompany transaction. However, as the Company’s total intercompany transactions with its related supplier were less than the threshold amount of $[***], the relationship was considered minor, and in accordance with the Company’s policy, no transfer pricing study was prepared for the related parties at issue. Nonetheless, the transfer pricing study was provided to CBP; however, this transfer pricing study was prepared for another [***] business unit located in [***], [***]. Thus, since the transactions between the related parties were below the necessary threshold, the results of another entity’s, [***], study were used to determine the appropriate prices for the related party transactions in question. [***] is [***] largest operation in [***], and it performs a broad spectrum of activities including contract manufacturing similar to the related supplier in this case. PricewaterhouseCoopers (“PwC”) prepares a transfer pricing study for [***] every three years and updates the comparable results periodically. The transfer pricing study provided indicates that the Transactional Net Margins Method (“TNMM”) was selected as the most appropriate method to test the arm’s length nature of the tested transactions for tax purposes. For the [***] manufacturing operations, full cost mark-up (“FCMU”) was identified as the appropriate product level indicator (“PLI”). A benchmarking exercise to compile a set of independent companies performing functions comparable to those performed by [***] was performed on a regional basis, with the final set of comparable companies including manufacturers from [***]. The [***] transfer pricing study (or updates) did not identify comparable companies based on product comparability for customs purposes. In fact, most of the comparable companies identified distribute air conditioning machines and refrigerator equipment, high voltage transformer and switch gear, kitchen equipment, large scale integration and system machinery, electrical motor transformers, and induction coils, etc. Based on the transfer pricing study prepared for [***] for the fiscal year 2011 and the functionally comparable set of unrelated companies in [***], the three-year weighted average full cost mark-up interquartile range was determined to be from 4.81% to 11.40%, with a median of 7.6%. The updated results for fiscal year 2013 indicate that the three-year weighted average was from 3.73% to 11.42%, with a median of 7.07%. Counsel states that at [*]%, the related seller’s profit falls within the range. In addition, to support the profitability of the seller, the Company provided for our review the related seller’s audited P&L Statement, indicating that the seller earned an operating profit of [*]% in 2013 and [*]% in 2014, with a two-year average of [*]%. Counsel explains that even though the Company sets an [*]% profit under the terms of the transfer pricing study, the actual profit realized fluctuates year to year due to the costs of labor and material, but should fall within the established range. The Company also provided the profitability analysis of the related seller by customer. The seller in [***] sells to three companies: to the Company and one unrelated buyer in the United States, and one buyer in [***]. Excluding the profits related to the OEM products, the related seller’s 2014 operating profit was [*]% for sales to the Company in the United States and [*]% for sales to the related party in [***], with a total profit of [*]%. The Company’s P&L Statements for 2012-2014 indicate that it earned a [*]% to [*]% profit. Finally, in order to illustrate that the transfer prices between the related parties were settled in a manner consistent with the way the related supplier settles prices with the unrelated buyer in the United States, the Company provided the following detailed documentation for two (2) identical products sold to both unrelated and related buyers in the United States: (1) a spreadsheet of cost information between the companies to the related and unrelated transactions; (2) a photo of the product at issue (SKU [***] [***] wall rack with baskets) sold to the related party (provided as an example), including a summary cost sheet and the supporting bill of materials, a copy of an invoice and related CBP Form 7501, and the proof of payment; (3) summary cost data sheet, the bills of materials, invoice, support for the labor and overhead factors, and proof of payment of the identical product (SKU [***] [***] wall rack with baskets) sold by the Company’s related supplier to the unrelated customer in the United States; and, (4) comparison between the operating profit earned by the related supplier on sales to the Company and the operating profit earned by the supplier on sales to the unrelated party in the United States. The records indicate that the Company paid $[***] to its related party supplier for the wall rack 2014, and the unrelated buyer in the United States paid $[***] for the same item in the same period, with the difference of 11 cents between the prices. ISSUE: What is the proper method of appraisement for transactions between the Company and its related supplier? 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 C.F.R. § 152.103(l). In this case, there are no “test values” available to us; therefore, the Company provided information examining the circumstances of the sale. For the circumstances of the sale approach, the Customs Regulations specified in 19 C.F.R. Part 152 set forth illustrative examples of how to determine if the relationship between the buyer and the seller influences the price. See also Headquarters Ruling Letter (“HQ”) H029658, dated December 8, 2009; HQ H037375, dated December 11, 2009; and, HQ H032883, dated March 31, 2010. 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 C.F.R. § 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 C.F.R. § 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 this case, the Company argues that it meets the circumstances of the sale test because its prices are adequate to ensure recovery of all costs plus a profit since: (1) the related supplier’s profit falls within the profitability range established by the transfer pricing study of the related business unit in the country of exportation; and (2) the equivalency between the seller’s operating profit and the Company’s profit shows that the prices were at arm’s length. Finally, the Company argues the prices between the related parties are settled in a manner consistent with the way the related party supplier settles its prices to the unrelated buyer in the United States. All costs plus a profit The “all costs plus a profit” method examines whether the related party price compensates the seller for all its costs plus a profit that is equivalent to the firm’s overall profit realized over a representative period of time in sales of merchandise of the same class or kind. A very important consideration in the all costs plus a profit example is the “firm’s” overall profit. In applying the all costs plus profit test, CBP normally considers the “firm’s” overall profit to be the profit of the parent company. Thus, if the seller of the imported goods is a subsidiary of the parent company, the price must be adequate to ensure recovery of all the seller’s costs plus a profit that is equivalent to the parent company’s overall profit, in the sale of merchandise of the same class or kind. See HQ H065015, dated April 14, 2011; HQ 546998, dated January 19, 2000; and, HQ 542792, dated March 25, 1983. Pursuant to 19 C.F.R. § 152.102(h), the merchandise of the same class or kind means merchandise (including, but not limited to, identical merchandise and similar merchandise) within a group or range of merchandise produced by a particular industry or industry sector. In this case, three aspects of the Company’s methodology are problematic for the accurate application of the all costs plus a profit method in 19 C.F.R. § 152.103(l)(1)(iii). First, we have previously ruled that the focus of interpretive note (iii) of 19 C.F.R. § 152.103(l)(1) is the seller’s costs and profit, and CBP regulations examine whether the seller received a price that enabled the recovery of all costs, plus a reasonable profit. HQ 548482, dated July 23, 2004; HQ H017761, dated September 27, 2007; HQ H029658, dated December 2009; and HQ H260036, dated February 24, 2015. Accordingly, we find that comparing the related supplier’s profitability under the TNMM method to the profitability of functionally comparable companies in this case does not satisfy the all costs plus a profit test for customs purposes. Second, the Company uses the other entity’s transfer pricing study to set its profit margin. We note that this transfer pricing study does not cover the transactions at issue and pertains to another related party in [***], a larger manufacturer. We do not view the profit information established by the transfer pricing study of the related business unit (a larger manufacturer as compared to the related supplier in this instance) in the same country of exportation to be pertinent to the examination of the all costs plus a profit method. Lastly, the comparable companies chosen for the analysis in the transfer pricing study (which utilizes the TNMM transfer pricing methodology, taking into account the functional comparability of the comparable companies) do not necessarily operate in the same industry and do not manufacture products of the same class or kind as the related seller in [***]. Most of the comparable companies identified distribute air conditioning machines and refrigerator equipment, high voltage transformer and switchgear, kitchen equipment, large-scale integration and system machinery, electrical motor transformers and induction coils, etc. Whether the products covered by the transfer pricing documentation are comparable to the imported products at issue is a very important consideration. See HQ 547672, dated May 21, 2002. CBP’s review of the companies deemed to be functionally comparable to the parties in this case does not lead this agency to conclude that they are engaged in the sale of the same class or kind of merchandise. As such, the all costs plus a profit test cannot be applied in this instance. Sales to the unrelated parties This example applies to situations in which the seller sells the same merchandise to both related and unrelated parties and determines the price in a consistent way. According to the Company’s submission, its related supplier in [***] also sells identical products to [***], an unrelated retailer in the United States. Counsel states that the approach to establish prices between the related parties and the unrelated party in the United States is similar, and that it is possible to compare the actual prices charged to each entity as it is for identical or similar merchandise. As stated in the FACTS portion of this decision, the related party supplier develops a spreadsheet of cost information and provides it to the Company’s marketing group. The marketing group either accepts the price or requests that a different raw material be used to reduce product costs. Counsel states that this is a normal procedure, used to quote the price to both related and unrelated buyers. The sum of all these costs plus a profit represents the price invoiced to and paid by the Company or the unrelated party and reported on CBP Form 7501 submitted to CBP. The Company states the profit percentage is deemed to be a reasonable profit for a contract manufacturer, as reviewed by the parent company’s corporate staff and corroborated by the transfer pricing study on the manufacturing arrangements of another related supplier in [***]. The sales price to the Company is updated annually, based on the related party supplier’s costs of manufacturing the product and operating its facility. The Company states that while the sales price and transfer price developed for related and unrelated parties, respectively, are both set to include an operating profit of [*]%, the actual profit realized may vary from year to year due to fluctuations in material and labor costs but should fall within the [*]% range over a period of time. For instance, the related supplier earned an operating profit on sales to the Company of [*]% for 2014 and [*]% for 2013. However, it earned an operating profit between [*] and [*]% on sales to the unrelated party for the same 2-year period. The profitability, of course, is based on the transfer pricing study, which covers transactions of a different business unit and is not by itself persuasive for customs valuation analysis. Nonetheless, the Company provided detailed documentation for two identical products sold both to the related and unrelated suppliers in the United States. Specifically, the Company provided sales prices per item for the particular wall racks that the related supplier sold to the unrelated and related parties. The supplemental documentation concerning the wall racks sold to the related and unrelated parties included a picture of the item, a summary cost sheet, the supporting bill of materials (supporting material, labor, variable and fixed overhead and variable and fixed SG&A costs and profit), all illustrating the nexus between the price on the cost data sheet (to related and unrelated purchasers in the United States), the invoice and the entry, and the proof of payment. As can be seen from this documentation, the price for the wall rack sold to the related party was $[*] in 2014. On the other hand, the sales price from the related supplier to the unrelated purchaser, [***], during 2014 was $[*]. The difference of 11 cents between the prices is negligible. The Company states that the difference is due to two factors. The first factor is that the sales prices to the unrelated party date back to August 2011, when the price was set using the method described above, and the related supplier has not increased the sales price to [***] since that time, as a business decision. We note that on the basis of the documentation submitted, the transfer price between the related supplier and the Company for the same wall rack, during the approximate same period of 2011 was also $[*] (identical). However, Counsel explains that the standard cost values that are used to develop the transfer price to the Company are changed each year as actual costs change. Thus, because the sales price to the unrelated party [***] remained constant, in years other than the first year, in which the sales price to the unrelated party [***] was based not only on the same elements as those used for the transfer price to the Company but also on the same standard cost values, differences could occur between the sales to the unrelated party and transfer prices. In other words, the related supplier in [***] made a business decision to keep the price to the unrelated party in the United States the same in order to continue business in the unrelated market in the United States. The second factor is that in subsequent years, the unrelated party requested special printed material (e.g., packaging) be added to the units it ordered. Initially, the related supplier used an identical bill of materials for units to be sold to the Company and units to be sold to the unrelated party. With the unrelated party’s [***] request for special printed material, new items were added to its [***] bill of materials. These different costs did not change the price at which the related supplier sold to the unrelated party [***]; however, for the same business reasons, the sales price remained constant despite other changes. We find the Company’s explanation for the differences in prices to the related and unrelated parties in the United States to be reasonable. We note once again that the Company’s transfer pricing study, which belongs to another business unit in the country of exportation, does not show that the transfer prices are at arm’s length; however, the Company is able to establish by other means that the prices are not influenced by the relationship. In view of the information submitted by the Company concerning the prices of the wall racks sold by the related supplier to the unrelated and related parties in the United States (even though utilizing the profitability levels in the transfer pricing study), CBP finds that the Company sufficiently explained the differences in prices between the related and unrelated parties and provided the necessary evidence to show how the prices were established in both situations. Thus, the Company has satisfied the circumstances of the sale test. Accordingly, the transaction value is an acceptable method of appraisement in the instant case. HOLDING: In conformity with the foregoing, transaction value is the appropriate method of appraisement for sales between the Company and its related supplier. This decision should be mailed by your office to the party requesting internal advice no later than sixty days from the date of this letter. Sixty days from the date of the decision, the Office of Trade, Regulations and Rulings will make the decision available to CBP personnel, and to the public on the Customs Rulings Online Search System (“CROSS”) at https://rulings.cbp.gov/, which can be found on the U.S. Customs and Border Protection website at http://www.cbp.gov  and other methods of public distribution. Please do not hesitate to contact us at (202) 325-0042 if you have any questions or concerns. Sincerely, Monika R. Brenner, Chief Valuation and Special Programs Branch