Editor: Mary Van Leuven, J.D., LL.M.
A taxpayer’s basis in imported goods may depend on customs valuation determinations made by U.S. Customs and Border Protection (CBP). Customs valuation often involves issues that may be unfamiliar to a tax practitioner. Yet failure to recognize this tax-customs intersection may result in unexpected additional tax (nonduty) costs. This item explains the concern and highlights certain procedures designed to coordinate tax and customs valuation.
Sec. 1059A Limitation
Sec. 1059A generally limits taxable basis or inventory cost for imported dutiable merchandise purchased from a related party to the “customs value” of the merchandise declared by the importer of record—often the taxpayer—to CBP (the Sec. 1059A limitation). Normally, full customs value must be reported on the Entry Summary document, Customs Form 7501, which is the customs equivalent of a tax return for a single import transaction. If the taxpayer inadvertently or intentionally undervalues imported merchandise subject to ad valorem customs duties, the IRS may decrease the cost basis, resulting in partial disallowance of the property’s tax basis or increased taxable income.
Customs law values imported merchandise based on specified costs or value elements enumerated in the statute (19 U.S.C. Section 1401a). For instance, the statutorily preferred and most commonly used method of customs valuation—transaction value—includes, in addition to the “price actually paid or payable” for the imported merchandise:
- Packing costs;
- Selling commissions;
- Assists (i.e., production items supplied free or at reduced cost by the buyer);
- Royalty or license fees that are a condition of sale; and
- Proceeds of subsequent resale or use that accrue to the seller.
There is also a legal presumption that all payments made by the buyer of imported merchandise to the foreign seller, or to a party related to the seller, are included in customs transaction value (e.g., research and development cost-sharing payments). See Generra Sportswear Co., 905 F.2d 377 (Fed. Cir. 1990). However, these costs, payments, or value elements are often initially incorrect or omitted from Customs Form 7501 because in the normal course of business the items are not generally reflected (nor expected to be reflected) in the commercial invoices accompanying the import transaction. This in turn caps the inventory tax basis at a lower than expected amount by operation of the Sec. 1059A limitation.
For example, see the following field advice memoranda issued by the IRS:
- Royalties: In Field Service Advice (FSA)200036015, the IRS concluded that the taxpayer did not timely report certain royalties to CBP. Thus, the Sec. 1059A limitation prevented the taxpayer from deducting the royalties from income. In an FSA dated April 11, 1996 (available at 1996 FSA LEXIS 62), the IRS similarly concluded that the taxpayer’s tax deduction for royalties may be disallowed under Sec. 1059A.
- Additional payments and assists: In an FSA dated January 31, 1997 (available at 1997 FSA LEXIS 83), the foreign manufacturer invoiced the taxpayer separately from the imported merchandise for tooling used to produce the merchandise. Because the taxpayer did not declare tooling costs to CBP, the IRS used the Sec. 1059A limitation to make an upward adjustment to taxable income.
- Exchange rate: In an FSA dated July 9, 1997 (available at 1997 FSA LEXIS 45), the foreign exchange rate used by the taxpayer for actual payment resulted in a higher dollar amount than that quoted on the import invoice. The IRS made an adjustment because the amount actually paid for the merchandise, claimed as the tax basis, exceeded the value reported to CBP.
Sec. 482 Transfer Price Increases
Adjustments triggered by the transfer pricing rules can further complicate the situation. Specifically, Sec. 1059A exposures are prominent when transfer prices are retroactively increased after year end with an additional payment made to the related seller under Sec. 482 to bring the taxpayer within an arm’slength range. From a customs transaction value perspective, the retroactive increase may be part of the total payment for previously imported merchandise. From a tax perspective, the taxpayer would normally expect the retroactive increase to increase the inventory cost basis; however, the Sec. 1059A limitation may disallow an increase not included in the declared customs value. The exhibit provides a financial illustration of the potential adverse tax consequence of this scenario.
The Sec. 482 adjustment may be initiated by the taxpayer or by the IRS (e.g., the IRS may initiate an adjustment via competent authority or when the IRS is a party to an advance pricing agreement). The regulations arguably support a taxpayer’s position that the Sec. 1059A limitation should be increased to allow a full deduction for the cost of imported property when the retroactive transfer price increase is initiated by the IRS under Sec. 482. Regs. Sec. 1.1059A-1(c)(7) provides that Sec. 1059A does not limit the IRS’s authority to adjust the claimed basis of inventory cost under Sec. 482.
Timing of Adjustments
The risk of a Sec. 1059A violation is increased if a customs value element is unknown or is undeclared when Customs Form 7501 is initially filed upon importation. However, customs law may mitigate this risk by providing taxpayers additional—albeit limited—opportunities to increase the customs value, and the Sec. 1059A limitation, post entry.
Regs. Sec. 1.1059A-1(d) binds the taxpayer to the “finally-determined customs value” as determined under the customs laws. Under the customs law, customs value becomes final upon liquidation (19 U.S.C. Section 1503), which generally occurs 314 days post entry. However, post-entry adjustments (PEAs) must be filed 20 days prior to liquidation, effectively reducing the adjustment period to 294 days post entry. Recognizing that these deadlines may not coincide with the timing of retroactive Sec. 482 transfer price adjustments or provide adequate planning certainty, CBP also offers taxpayers an opportunity to make adjustments up to 21 months post entry if the taxpayer applies and is preapproved for CBP’s Reconciliation Program.
Importers may file an administrative protest with CBP to challenge liquidated customs value within 180 days from liquidation, generally extending “finality” a total of 494 days post entry (19 U.S.C. Section 1514). Although the protest period would generally be sufficient to adjust all customs entries filed during the tax year for Sec. 482 adjustments, CBP has determined that it does not have the authority to allow protests for a resulting increase in value, only for a refund or remittance of customs duty. See CBP Headquarters Ruling Letters 228838 (2002), 222982 (1991), 222981 (1991), and 220678 (1989).
CBP’s interpretation appears to be at odds with Regs. Sec. 1.1059A-1(d), which provides that liquidation is considered final 90 days following liquidation, “unless a protest is filed.” Because an increase to the Sec. 1059A limitation requires an increase to the customs value, the regulation implies that the taxpayer may protest an entry to increase customs value. In FSA 200036015, the IRS acknowledged that the taxpayer’s deficiency stemmed from failure to protest the entries to timely report the undeclared royalties. Thus, there appears to be an administrative gap that should be bridged between the two agencies—or reconsidered by CBP—to give taxpayers additional time to make yearend upward adjustments.
Enforcement and Interagency Cooperation
The IRS raises Sec. 1059A challenges primarily upon examination or audit of the taxpayer’s income tax return, with CBP’s cooperation and information. See, for example, the above-referenced field service advice and Shabahang Persian Carpets, Ltd., 22 C.I.T. 1028 (1998). In addition, under Regs. Sec. 1.6038A-2(b) (5), certain reporting corporations must also complete Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. On the form, they must declare whether the inventory basis of the imported goods is valued greater than the customs value and explain any differences.
In the past two decades, the IRS and CBP have made frequent efforts to improve cooperation in related-party matters. In 1993, Sec. 6103(l)(14) was enacted to allow the IRS to release to the Customs Service (now CBP) information necessary to ascertain whether customs entries were correctly reported. In 1994, the IRS and CBP entered into a “Working Arrangement for Mutual Assistance and Exchange of Information Regarding International Compliance,” facilitating the sharing of information, including copies of Customs Form 7501, with the IRS for Sec. 482 purposes (see 94 TNT 184-68 (9/19/94)).
This increased cooperation has been recently evidenced by CBP’s participation in advance pricing agreements and negotiations and the issuance of an informed compliance publication, Determining the Acceptability of Transaction Value for Related Party Transactions (2007), identifying differences between Sec. 482 and customs related-party requirements. This publication signals heightened attention by CBP to related-party matters.
Conclusion and Recommendations
The incongruities between customs valuation requirements and taxable basis could go unrecognized if tax departments do not coordinate with their company’s customs function. Consequently, the potential adverse tax exposure of Sec. 1059A may be unappreciated, particularly in the context of Sec. 482 transfer price adjustments.
A reasonable understanding of CBP’s regulations, valuation methods, and administrative proceedings is necessary to timely reconcile adjustments with CBP (and to properly complete Form 5472). Taxpayers should also develop internal procedures between their tax and customs functions to ensure that additional payments or other customs value issues are properly coordinated. Given the time constraints for revising customs value, absent participation in CBP’s Reconciliation Program, a good practice may include instituting a periodic comparison of inventory basis to declared customs value before the end of the tax year. For instance, taxpayers could leverage current processes for calculating quarterly tax provisions and/or estimated federal income tax liabilities.
While analyzing other “book to tax” differences, the taxpayer could also look for any differences between inventory costs in the general ledger accounts and the customs value declared to CBP. If differences are identified, the taxpayer should immediately notify its internal customs department to determine whether customs value adjustments are required and to take the necessary steps to timely report the adjustments to CBP before the PEA period expires for goods imported earlier in the tax year (i.e., for customs entries less than 294 days old). If potential customs or tax liabilities exist, taxpayers must also give careful consideration to Statement of Financial Accounting Standards No. 5, Accounting for Contingen cies, concerning financial accounting and reporting obligations for loss contingencies (i.e., for probable and reasonably estimated liabilities).
As the IRS and CBP move toward more vigorous enforcement of related-party requirements, it potentially becomes more likely that valuation errors will be discovered. The failure to internally coordinate these issues can result in a partial disallowance of tax basis for the imported property, or increased tax liability, and potential IRS and CBP penalties.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
This article represents the views of the author or authors only, and does not necessarily rep-resent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
© 2009 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or firstname.lastname@example.org.