Customs authorities use somewhat different methods from income tax authorities to value intercompany cross-border transactions in tangible goods. This difference can produce negative outcomes for a business if not considered in the context of total tax liability. This article summarises the relationship between customs valuation and transfer pricing and highlights specific areas for tax planning.
The widespread adoption of globally integrated supply chains and the ensuing growth of intercompany transactions warrant strategic thinking and planning to avoid potential negative scrutiny of the influence of affiliated parties’ relationship on the “conditions” of sales. Affiliated companies (which often share common management, officers, directors, ownership, etc.) must comply with separate direct and indirect tax requirements when structuring transactions.
While similarities exist between the methods used to value tangible goods, customs authorities and income tax authorities have different goals: Customs authorities are charged with ensuring that the value of imported goods accurately reflects all dutiable cost elements, while the goal of income tax authorities is to ensure that the value is not misstated (and accurately reflects income realised in the tax authorities’ jurisdiction). These differences give rise to competing tensions and goal incongruence that could negatively affect total tax liability outcomes in each jurisdiction where goods are imported and companies file income tax returns.
The issue has increased in importance because the growing trend of protectionist policies and use of supplemental tariffs have elevated the significance of customs duties as a percentage of the overall cost of goods.
The transaction value
The intercompany transfer price, or, in customs terms, the transaction value (TV), is the primary method used by customs authorities and multinational enterprises (MNEs) globally to value cross-border transactions involving tangible goods. According to the World Customs Organisation (WCO) Guide to Customs Valuation and Transfer Pricing (2018 Edition), the TV is used in 90% to 95% of all imports in most countries.
Businesses must ensure that the TV declared for customs duty assessment purposes reflects certain arm’s-length principles set forth in the World Trade Organization (WTO) Agreement on Implementation of Article VII of the General Agreement on Tariffs and Trade 1994 (the “WTO Agreement,” based on the 1979 GATT Valuation Agreement). The arm’s-length principle requires that the circumstances of the sale denote that the price is arm’s-length and that the relationship between affiliated parties does not affect the price. These global concepts are implemented in the customs rules in each WTO member country with few differences.
In contrast, the income tax authorities are responsible for ensuring that taxpayers accurately report income in each jurisdiction where they operate so that they pay the appropriate amount of income tax. For companies trading tangible goods across borders, the declared value of imports (cost of goods) marks the key driver in calculating the correct income tax reflected in the annual tax return for each jurisdiction. This relationship can be viewed more clearly by its effects: As the TV of tangible goods increases, duty liability increases, and profit of the buyer recognised for income tax purposes decreases. These characteristics can lead to tensions in assessing the value of sale transactions between related parties, in particular when the income tax and customs authorities are housed together and have ready access to customs and tax return data.
Moreover, although customs value and duty liability relate to tangible goods, certain intangible elements may also be reportable as part of the TV, including royalties and licensing fees paid by the buyer as a condition of sale and subsequent proceeds that accrue to the seller. The customs rules also require adjustments for certain cost elements that form the basis of the cost of imported goods, including selling commissions and the value of goods and services or “assists” (materials, parts, tools, and certain intangibles, such as foreign design and development activities) provided by the buyer free of charge or at a reduced cost in connection with the production of imported goods. In general, any payment from a related buyer to the seller (direct or indirectly) is presumed to be dutiable, and the burden remains with the importer to demonstrate otherwise.
The WTO Agreement establishes TV as the primary method of valuing imported goods (in a listed hierarchy of alternative methods), as long as the parties can demonstrate that their relationship did not influence the price. All WTO member countries are required to apply this method, and some non-WTO members have chosen to adopt it as well. As such, importers should consider how they will establish that the price is the same as, or the equivalent of, a “freely negotiated” price between unrelated parties for similar products, all other facts being equal. This can be particularly challenging where limited public data exists to support such conclusions.
Differences in applicable standards
Important differences also exist in the principles of the WTO Agreement versus the arm’s-length standard principle used by the Organisation for Economic Co-operation and Development (OECD) member nations for transfer-pricing purposes. The focus of the OECD framework on functions and risks of parties to an intercompany transaction does not necessarily reflect the requirements of the WTO Agreement, which is more concerned with examining comparable products and merchandise of the tested party (ie, economic analyses applied in tax transfer-pricing reports should include companies that produce or distribute similar “classes or kinds” of merchandise to those of the tested party in the same markets to support TV under the customs rules).
This distinction is rooted in the reality that duties are assessed at the product level, whereas income taxes are assessed at the enterprise level. Notably, this is one of many factors businesses should consider when reviewing income tax transfer-pricing documentation to bridge the gap between direct and indirect tax rules, in addition to substance for the method applied to the intercompany pricing formula (that supports TV under the customs rules).
Adjustments to transfer prices
In addition, businesses planning to make ex-post transfer-pricing adjustments necessary to bring realised profit margins in line with the targeted arm’s-length benchmark range have unique planning considerations for customs duty purposes, particularly for downward adjustments (where duties have been overpaid). The principle affecting repayment of overcharged customs duties is established in the Revised Kyoto Convention of 2006, which sets a standard for repayment when duties and taxes have been erroneously overcharged.
In practice, the local treatment of transfer-pricing adjustments is inconsistent around the world, with some regimes considering both upwards and downwards price adjustments to the cost of goods (collective import values for the fiscal year) to arrive at a proper profit margin as part of the TV, and others considering only upwards adjustments — meaning that customs will accept duties that are owed (but will not issue duty refunds).
In either case, many jurisdictions require advance notice of the existence of transfer-pricing policies with price review clauses to consider the effects of the contractual structure when evaluating the substance and acceptability of such adjustments and to reach an agreement on how the adjustments will be dealt with. Self-initiated or government-imposed adjustments made for tax purposes only (absent an invoice price adjustment) could be construed as indicia of price influence, an issue that frequently comes up during customs audits.
Adjustments also should be considered within the context of the importer’s responsibility to accurately report customs values at the time of entry and to pay any finally determined duties owed. Notably, in instances where value adjustments do not affect duty liability (such as for duty-free goods), importers should assess local procedures and requirements to disclose price adjustments to customs. Regulators globally use customs data to collect and report trade statistics. In the event of a customs audit, undisclosed adjustments, where required, may be viewed as a compliance gap or failure that can trigger fines and penalties (which are typically much higher than those imposed on dutiable goods). Accordingly, these risks should be managed appropriately and proactively. In many countries, such as the US, a formal mechanism exists to reconcile (or finalise) declared customs values in due course and to pay additional duties owed or claim refunds, as applicable.
The role of transfer pricing in many MNEs’ decision-making processes reflects widespread adoption of transfer-pricing legislation globally, as well as the trending increased audit capacity of income tax authorities. Additionally, customs and tax authorities have established bilateral lines of communication (especially, as noted earlier, where the two are housed in a single agency, such as HMRC in the UK) and exchange information and data. Tax authorities also often share and compare data with their counterparts in other jurisdictions.
With respect to adjustments, it is important to maintain transfer-pricing policy documentation detailing the criteria (or, in customs parlance, the “formula”) that will be applied to establish the final transfer price of imported goods. This documentation should be in place before the import transaction in order to be covered by any ex-post adjustments.
Some businesses have successfully established and concluded advance-pricing arrangements (APAs) with the tax authorities as a proactive measure, but, as with transfer-pricing studies, standing alone, these types of documents are not sufficient to support the use of the TV. Full customs documentation is required to “translate” these tax-focused documents into the language of the WTO Agreement for a customs audience, ie, a customs auditor.
Finally, the combined effects of the coronavirus pandemic on production and suppressed global demand could severely affect the overall profitability of MNEs, which may now need to review their supply chains. Additionally, the increasing use of tariff measures by customs authorities to counteract unfair and discriminatory trade practices (such as the US Section 301, Section 201, and Section 232 tariff measures) is noteworthy in the context of how transfer-pricing adjustments should be viewed and managed. Because many countries do not permit post-importation adjustments to reduce the customs value declared, importers may be unable to substantiate such claims or recover overpaid duties on downwards value adjustments. Moreover, the existence of supporting documentation and proactive communication with the customs authorities will be essential to a successful recovery effort.
Customs valuation planning considerations
Businesses may wish to review the following areas to better understand the interdependencies of international income tax, transfer-pricing, and customs value rules to achieve positive outcomes:
- Use a multidisciplinary approach to assess current transfer-pricing models to manage total tax liability and required adjustment processes, particularly for customs duties and other indirect taxes;
- Evaluate policy and contract documentation from a customs duty perspective to ensure they reflect customs requirements;
- Consider the effect of local procedure requirements on adjustment processes;
- Consider using APAs or other available transfer-pricing dispute avoidance tools; and
- Formally prepare contemporaneous documentation that fully covers the formula-pricing approach of the customs rules and comports with the economic analysis in any transfer-pricing studies or APAs.
— Anna Zajac, MBA, is a licensed customs broker at BDO Tax in Chicago. To comment on this article or suggest an idea for another article, contact Dave Strausfeld, an FM magazine senior editor, at David.Strausfeld@aicpa-cima.com.