Editor: Mary Van Leuven, J.D., LL.M.
The financial impact of the COVID-19 pandemic, coupled with former President Donald Trump's widespread use of sweeping tariffs and customs duties as a policy tool, has critically disrupted supply chains while also driving up import costs. One significant challenge for multinational enterprises has been how to mitigate the effects of the fluctuations in the prices of imported goods from a customs perspective. The global pandemic has forced multinational enterprises to reassess previous transfer-pricing policies and consider making compensating adjustments to bring their intercompany transfer price for goods into an acceptable arm's-length range, often retroactively. In most situations, these compensating adjustments must be reported to U.S. Customs and Border Protection (CBP).
An upward adjustment to price generally means increased customs duties
In the United States, customs duties are generally assessed on an ad valorem basis and applied to the "transaction value" of imported goods, defined as the "price actually paid or payable for the merchandise when sold for exportation to the United States" (19 U.S.C. §1401a(b)(1)). In many cases, the transaction value is the price listed on the commercial invoice. Thus, the higher the commercial invoice price, the greater the assessment of duties.
Often, particularly in sales of goods between related parties, the import price (or transfer price) declared to CBP at the time of importation is provisional and subject to change. Once the final price is determined, the parties may make an adjustment to "true-up" the provisional price. As a result of the adjustment, the price actually paid or payable for imported goods typically changes — either up or down. More specifically, if there is a corresponding increase to the product price that also adjusts the cost of goods sold, the importer would generally be required to tender additional duties to CBP.
Not all transfer-pricing adjustments trigger additional customs duty liability
While an upward price adjustment affecting cost of goods sold generally needs to be reported to CBP (e.g., a period 13 year-end adjustment),it is important to consider the specific nature of the adjustment to determine whether there will need to be a corresponding adjustment to the declared customs value. For example, if a transfer-pricing adjustment reported on a company's Schedule M is deemed a capital contribution or dividend, there would likely be no correlative adjustment to the multinational enterprise's financial accounts — unless the taxpayer elects treatment under Rev. Proc. 99-32, which would require both a correlative adjustment to the multinational enterprise's financial accounts and actual repatriation of the corrected transfer-pricing adjustment amount (e.g., by cash, note, or setoff). In essence, absent the election, the Schedule M adjustment operates merely to assess income taxes, but it is not necessarily booked to the multinational enterprise's financial accounts; i.e., the price actually paid or payable for previously imported goods has not changed.
As a result, a deemed capital contribution or deemed dividend adjustment may not be required to be reported to CBP. However, the need for a "deemed" adjustment from a tax perspective may also suggest other potential customs issues such as, for example, that the price that served as the basis for the originally declared import value was inadequate and may not satisfy customs arm's-length requirements, which differ from the arm's-length requirements for tax purposes. It behooves the taxpayer in such a situation to evaluate its transfer price from a customs arm's-length perspective to ensure there is no customs penalty exposure, even if the adjustment may not have triggered any additional customs duty liability.
Similarly, for a compensating adjustment to affect the value of the imported goods, it must affect the price actually paid or payable. For example, adjustments booked as "market support" payments that reduce the seller's or manufacturer's marketing expenses and do not alter the cost of goods sold of imported goods should be further examined as potentially excludable from the duty basis of those goods, as was the case in CBP Headquarters Ruling HQ H125118 (Sept. 12, 2014).
Downward adjustments may result in a duty refund
Retroactive transfer-pricing adjustments can sometimes mean good news for U.S. importers. In some situations, importers in related-party transactions may require compensating adjustments to bring their profits up to a level acceptable to local tax authorities. This may be done through a retroactive decrease to the price of previously imported goods, which in turn may result in a refund of customs duties because the U.S. importer, in theory, had initially overpaidduties. For U.S. importers to obtain such a refund, CBP requires an "objective formula" to be in place prior to importation of the goods, for purposes of determining the transaction value of the imported goods. The five factors CBP considers in determining that an objective formula exists are:
- A written "intercompany transfer pricing determination policy" is in place prior to importation, and the policy is prepared taking Sec. 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 for 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 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 (i.e., the adjusted price must be at arm's length, from a customs perspective).
The importer must satisfy all the formulaic factors to be considered eligible to use transaction value and to potentially receive a customs duty refund for the downward price adjustments. For many importers, factors 1 and 3 tend to present the biggest challenges.
For example, CBP found that the term "transfer pricing policy" in factor 1 can refer to advance-pricing agreements and legally binding intercompany agreements or memoranda (seeHQ H018314 (March 18, 2013)). In CBP Headquarters Ruling HQ H018314, CBP determined that the importer's distributor agreement was evidence of factor 1, since it provided that the related seller "shall charge to [importer] . . . arm's length prices for the products as determined in accordance with the global transfer pricing study." Similarly, the transfer-pricing study that applied to goods purchased from its related seller was evidence of factor 1 (seeHQ H018314 (March 18, 2013)).Furthermore, an agreement specifying that year-end compensating adjustments are contemplated between the buyer and seller to bring profit margins within an arm's-length range for tax purposes, supported by a study of comparable data based on uncontrolled transactions, would likely also be sufficient to satisfy factor 1 (seeHQ W548314 (May 16, 2012) and HQ H018314 (March 18, 2013)). However, an agreement merely providing that the parties will review and adjust prices "in accordance with arm's length pricing principles" is insufficient to satisfy factor 1 (seeHQ H157795 (June 29, 2015)).
In addressing factor 3, CBP stated that the transfer-pricing policy must be clear on "how adjustments will be made with regard to the prices for sales [of the goods] from the related supplier to the importer" (see HQ H157795 (June 29, 2015)). For example, CBP found that a transfer-pricing agreement sufficiently specified how the transfer price and any adjustments were determined, where the agreement specified that the transfer price would equal the "[s]ales price to the U.S. customer (net of cash customer discount and rebates) minus variable costs and a percentage of margin (profit)," further detailed how such variable costs were to be determined, and allowed only for adjustments to budgeted fixed costs. CBP reasoned that the importer was able to demonstrate through its agreement how true-ups were calculated and recomputed to give the importer its arm's-length return as a percentage of operating income if the actual fixed cost allocation should cause the importer's profit to fall outside the acceptable range (seeHQ W548314 (May 16, 2012)). While the formula in HQ W548314 was fairly detailed, CBP has also concluded that a transfer-pricing study submitted for IRS approval as part of an advance-pricing agreement application, which specified the selected transfer-pricing methodology and profit-level indicator, sufficiently satisfied factor 3 (seeHQ H219515 (Oct. 11, 2012)).
There is no magic bullet that satisfies CBP's five formulaic factors. Importers should consider their transfer-pricing arrangements in advance, based on the totality of the circumstances, to assess any potential refund of duties on adjusted prices to imported goods.
Unique circumstances may present unique savings or planning opportunities
Generally, CBP presumes that all payments made by the buyer to the seller or to a party related to the seller are part of the price actually paid or payable. When the buyer or importer makes a payment to the foreign seller for something other than the goods, the importer bears a high burden of establishing that these payments are unrelated to the imported goods and, thus, not dutiable. Otherwise, CBP will add these additional payments to the basis, or goods value, to assess customs duties. Thus, it is important to consider whether the payments are truly for the imported goods or for something else.
The COVID-19 disruption to global supply chains has required many U.S. companies to suspend or cancel product purchases from foreign suppliers, sometimes resulting in contractual damages. Payments made by the importer or buyer to the foreign manufacturer or seller for the importer's failure to purchase a contracted number of products, to allow the manufacturer to recover certain fixed costs related to production underutilization, may not be dutiable. The Court of International Trade concluded that these "shortfall" payments do not relate to the purchase of the imported goods but rather to goods not purchased (Chrysler Corp., 17 Ct. Int'l Trade 1049 (1993)).As a result, these payments are not subject to customs duties. Other examples of nondutiable payments include compensation for out-of-pocket expenses incurred due to the foreign seller's excess capacity caused by a reduction in customer purchases, compensation for maintenance costs incurred by the seller for reserved but underutilized production capacity, and payments for termination of supply contracts or cancellation of future purchase orders (see HQ 543882 (March 13, 1987), HQ 554999 (Jan. 5, 1989), HQ W545175 (Jan. 4, 1995), and HQ 543770 (Feb. 10, 1987)).
The primary consideration in determining the dutiability of these payments is whether they are for the imported goods or are paid as a result of goods not being produced by, or not being purchased from, the seller. These "shortfall" or "maintenance" payments that compensate the foreign seller for setting aside production capacity or investments anticipated to fulfill goods orders are generally established through written contracts, accounting records, and the actions of the parties, indicating the payments are a type of "penalty" for the goods not purchased; the dutiability of the payments is determined on a case-by-case basis.
These opportunities are important to keep in mind when there is a significant shortfall between anticipated and actual production quantities — for example, due to supply chain COVID-19 disruption.
While the challenges of 2020 and 2021 have undoubtedly disrupted traditional business practices, U.S. importers should be encouraged that opportunities exist to help blunt the increased duty and customs compliance costs, particularly in transactions with related parties. Multinational enterprises should proactively and prospectively make sure the language in transfer-pricing and intercompany agreements satisfies CBP's requirements and the costs or expenses are appropriately attributable and booked to the proper accounts. These steps can help ensure that the importer complies with customs rules when making upward transfer-pricing adjustments and avoids costly penalties. Moreover, these steps can position the importer to obtain refunds if and when downward transfer-pricing adjustments are made — and may avoid overpaying duties for additional payments to the seller that may be excludable from the duty basis of imported goods, such as market support, shortfall, or maintenance payments. During challenging economic times when cash is king, every potential cost-saving opportunity should be carefully considered.
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Contributors are members of or associated with KPMG LLP.
The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information 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. The articles represent the views of the author or authors only, and do not necessarily represent the views or professional advice of KPMG LLP.