A significant amount of work has been done over the last 15 years on “convergence” of income tax transfer pricing (TP) and Customs valuation. Both income tax and Customs rules seek the same result, ensuring that prices between related parties are “at arm’s length,” set as if the parties were unrelated. But the rules are different. Income tax TP rules in the majority of countries are based on guidelines established by the Organisation for Economic Co-operation and Development, OECD. Customs valuation principles are established in the WTO Valuation Agreement (Agreement). Moreover, the revenue collection focal points of tax and Customs administrations are different: a high transfer price generally results in a high duty, but low income tax; a low transfer price results in lower duties and higher income taxes.

The objectives of convergence are to provide more certainty for a business that the approach it takes in establishing prices will satisfy both tax and Customs administrations, and more certainty for governments that there is consistency in approach leading to appropriate pricing, and tax collections, of both income tax and Customs duties. Global convergence efforts began with two conferences jointly sponsored by the WCO and the OECD in 2006 and 2007, followed by the establishment of a Focus Group including both public and private sector members to identify specific problems and suggest possible solutions. The Focus Group provided recommendations to the Technical Committee on Customs Valuation (TCCV)[1], which has issued several instruments providing guidance on using income tax TP materials to evaluate prices for Customs,[2] and continues to work on further guidance with input from the OECD and the International Chamber of Commerce. In 2015 the WCO issued the WCO Guide to Customs Valuation and Transfer Pricing, which was updated in 2018.

These convergence efforts have resulted in better appreciation of both disciplines by tax and Customs administrations and private sector professionals. There remains an information gap, however. Multinationals continue to set intercompany prices following OECD TP guidelines, and develop supporting material to meet income tax requirements. These materials can be helpful to Customs, but are often quite voluminous and are missing some important information to conclude a Customs assessment. This article reviews the most common approach for setting transfer prices, and the information that is often needed by Customs to close the gap.

Multinationals commonly establish a separate distribution entity in each country in which goods are sold. This distributor is the importer for goods sold in that market, and will be referred to as the Importer. Even when a multinational conducts multiple operations in a single country, for example, manufacturing, distribution, and R&D, the operations are generally segmented for accounting purposes, and TP is separately determined for each operation.

OECD Guidelines set forth five transfer pricing methods, and direct the taxpayer to look at each of them and assess which best fits the situation. In practice, the OECD method which best fits the import of products for distribution is the Transactional Net Margin Method, or TNMM.[3] Under this method, an evaluation is made of the business profile of the Importer, with a focus on the functions undertaken, business risks assumed, and assets deployed.[4] Then, a search is conducted to find financial data on independent companies (those which conduct business with unrelated parties) which match the business profile of the Importer. Databases of publicly available information, for example from securities filings, are available on a subscription basis and are used by accounting firms which conduct TP studies.[5] Database searches are generally conducted based on the Standard Industrial Classification (SIC) of the Importer, and results are further refined by reviewing the data compiled.

From these results a set of benchmarks is assembled representing the profits that are earned by these business profile “comparable” companies. If the Importer’s profits are within the range of the benchmarked profits, the Importer is considered to be conducting business with a related party at arm’s length – the Importer’s profits are the same as those of other parties who do conduct business at arm’s length with unrelated parties. If, however, the Importer’s profits are outside the benchmarked range, the Importer is required to adjust the price paid for imported goods to bring overall profits into the benchmarked range. So, if the Importer’s profits are too high – above the range – the Importer must make a supplemental payment to the related seller to reduce the profit to a point within the range. If the Importer’s profits are too low – below the range – the seller refunds money to the Importer, reducing the price paid by the Importer and thus increasing profit. Of course, the profits of the Importer and the comparable companies must be computed the same way; in TP this is referred to as the Profit Level Indicator, or PLI. For the Transactional Net Margin Method, the most frequent PLI is operating margin, the ratio of operating profits (profits before interest and taxes) to gross receipts, expressed as a percentage.

Customs valuation rules are set forth in the Agreement, which serves as the basis for valuation in all WTO countries. While there are some language differences in local legislation, and interpretative differences among Customs administrations, the fundamental rules are the same.

Although the Agreement and the OECD TP Guidelines were developed at about the same time, they were developed separately. The Agreement establishes transaction value (TV), the price paid or payable for an imported good, as the preferred method for establishing Customs value. The transaction value is acceptable for related party sales provided that the price was not influenced by the relationship of the parties. This may be established by a review of the circumstances surrounding the sale (COS), or by the importer providing evidence of test values. In practice, other than in some commodity sales, test values rarely exist. Consequently, in order for an importer to use a single approach for TP and Customs purposes, it becomes necessary for the importer to demonstrate that setting the price based on the TP approach meets the “circumstances surrounding the sale” test.

There is no prescribed approach to meet the “circumstances surrounding the sale” test. Interpretative Notes to the Agreement provide three illustrative examples of ways in which an importer may establish that the relationship of the parties did not influence the price:

(1) if it can be shown that prices are settled in a manner consistent with the normal pricing practices of the industry;

(2) if it can be shown that prices are settled in the same way the seller settles prices for sales to unrelated buyers; or

(3) if it can be shown that the prices are adequate to ensure recovery of all costs plus a profit which 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.[6]

Practically speaking, looking at the big picture, a Customs administration which is evaluating the TP of an Importer, determined by the Transactional Net Margin Method, is generally in a position in which dutiable value is high. As a distributor, the Importer is normally taking only the risk of reselling products in the market. Most of the “entrepreneurial risk” of the enterprise – manufacturing, R&D, and supply chain – is borne by others in the related group. As a result, the Importer is only entitled to a modest profit for its activity, as would be the case for other distributors who meet the business profile of the Importer. It is not uncommon, for example, to see a range of distributor profits in a TP benchmark study to be between 2 and 6 percent. This means that the import value must be high enough to allow this small profit – if the profit were any higher the Importer would be required to make a supplemental payment to the seller to reduce the profit. Practically, the import price is about as high as it can get without requiring the Importer to resell the products at a loss, which is clearly not a sales price that would be agreed between unrelated parties.

In general, Customs should see a satisfactory result from an Importer which uses the Transactional Net Margin Method. But, in order to properly examine the circumstances surrounding the sale to determine that the relationship of the parties did not influence the price, and the TP results in transaction value, the Importer must provide some information in addition to the TP supporting documentation. Four questions commonly arise. Prudent Importers will be prepared to answer these questions, and Customs should be prepared to review the responsive information. The four questions are:

• What is the basis for Customs to accept a transaction value which is not firmly established at the point of import?
• How can Customs link a TP method to a “circumstances surrounding the sale” evaluation?
• How can Customs confirm that the parties are actually following the Transactional Net Margin Method, and that the method results in transaction value?
• How can the Importer report TP adjustments made to bring profits back into the range?

One of the early TCCV instruments is Commentary 4.1- Price review clauses. Commentary 4.1 deals with situations in which prices are provisional at the time of import, and may be finally determined after import by variables which are not known at import. Commentary 4.1 concludes that because the Agreement prefers transaction value, and as Article 13 provides that final value determination may be delayed with goods released to the importer by providing a bond or other security for payment, imports subject to a price determined after import can qualify for transaction value.

In effect, an Importer which sets prices using the Transactional Net Margin Method is importing pursuant to a formula which is established at the time of import, but with variables – the actual operating expenses of the Importer – unknown until the accounting period is complete.[7] Only when the variables are known can the cost of goods purchased from related parties be calculated. The proper cost is that which would have had to be paid to the related seller in order for the Importer’s profits to be within the benchmarked range of comparable company profits.

Many countries have been generally accepting of this approach, but it should be noted that a 2017 European Court of Justice Decision in Hamamatsu raises questions of how price review clauses should be evaluated in the EU. The Court stated:

“Articles 28 and 31 of the Customs Code, in the version in force, must be interpreted as meaning that they do not permit an agreed transaction value, composed of an amount initially invoiced and declared and a flat-rate adjustment made after the end of the accounting period, to form the basis for the Customs value, without it being possible to know at the end of the accounting period whether that adjustment would be made up or down.”[8]

Currently, EU Customs administrations do not have a common view of the impact of Hamamatsu on Transactional Net Margin Method pricing. Both business and Customs would benefit from additional guidance.

As noted in the report of the Focus Group to the TCCV, and acknowledged in TCCV Commentary 23.1, the “circumstances surrounding the sale” framework is quite broad, and can include a review of TP documentation as support that the price is not influenced by the relationship of the parties. As noted above, the Interpretative Notes provide non-exclusive examples of ways in which an importer may meet the “circumstances surrounding the sale” test; two of these are particularly relevant for the Transactional Net Margin Method:

(1) if it can be shown that prices are settled in a manner consistent with the normal pricing practices of the industry; or

(2) if it can be shown that the prices are adequate to ensure recovery of all costs plus a profit which 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.

While these are non-exclusive examples, because they have been in place since the adoption of the Agreement they often serve as a frame of reference for Customs administrations. TCCV Case Study 14.1 uses the first example as a frame of reference for examining the circumstances surrounding the sale. It reviews a Transactional Net Margin Method TP study in which the benchmarked comparable companies are in the same industry as the importer, and concludes that the import price was settled in accord with normal industry practices.

The WCO Guide on Customs Valuation and Transfer Pricing contains a discussion of how Transactional Net Margin Method transfer pricing may be used to demonstrate the second example.[9] While noting that this example refers to the seller’s profit, the Guide states: “information derived from the importer’s profit can potentially give Customs assurance that the exporter/seller’s profit is acceptable.” The Guide goes on to illustrate the point with data.

As the “circumstances surrounding the sale” examples are non-exclusive, it may also be possible to review the Importer’s financial data through the lens of another Customs valuation methodology. An Importer which sets prices under the Transactional Net Margin Method will be receiving a profit that is commensurate with that of other distributors possessing similar attributes. With the Importer earning a normal profit, the annual financial results can be rearranged in a format that aligns with deductive value as set forth in Article 5. While not an actual application of deductive value, which is applied to each importation individually, this type of review can establish a “notional deductive value” for all products sold during the year. Using an Article 5 deductive value framework to evaluate the circumstances surrounding the sale is another way for Customs to use TP data.

TP studies tend to follow a common organization, some of which is relevant to a Customs assessment of the circumstances surrounding the sale, and some of which is not. Since TCCV TP instruments and the WCO Guide were issued, it has become more common for Importers to prepare a supplement to the TP study which explains how the TP documentation may be used by Customs in a “circumstances surrounding the sale” assessment.

Importantly, the Importer must also provide information that is not needed under income tax rules which will allow Customs to verify that the result will be transaction value. Following is commonly needed additional information:

1. Were all imports covered by the transfer pricing policy?

Only imports that are subject to the TP methodology can utilize the TP documentation as supportive of transaction value.

2. Did the adjustment impact the Importer’s cost of goods sold (COGS)?

The TP adjustment must change the price paid for goods to impact transaction value. This means that the adjustment must be booked by the Importer in a manner that directly impacts COGS in the financial statements. An adjustment that is made to a different account, or one that is made “for tax purposes only” and never impacts price paid cannot result in transaction value.[10] Of course, as Case Study 14.2 makes clear, a required TP adjustment must actually be made in order for transaction value to result.

3. Was the TP adjustment applied to all imports consistently for tax and Customs purposes?

TP only seeks to result in an arm’s length aggregate profit margin for the year. Because Customs duty rates vary by product, however, it would not be appropriate for an Importer to selectively decide which import prices to adjust. An Importer could manipulate the system by reducing the prices of high duty rate items and increasing the prices of low duty rate items, but still have an aggregate profit margin within an arm’s length range.

There is no single approach to testing Importer profits against the benchmarked range for TP, however. Some Importers, for example, will separate products into categories and test each category to be sure each category’s profits are in the range. Importers with multiple brands often test each brand separately. There is no single right or wrong way to do this. The important thing from a Customs standpoint is that the adjustment which results from whatever category of products is being tested for TP (e.g., all products, a product family, or a brand) is allocated equally across all products in that category. That way, there can be no inappropriate manipulation of profits for duties.

A clear implication of TCCV Case Studies 14.1 and 14.2 is that the price as adjusted is transaction value – the adjusted price is actually paid for the merchandise. While the Agreement contemplates release of goods before a final determination of value, it does not provide a process for reporting price adjustments. That is left to national legislation. Some countries have formal processes for reporting adjustments, while others have developed informal approaches to declare provisional values and provide final values later.[11] The WCO Guide notes several national initiatives,[12] and the TCCV has reviewed a number of separate national approaches.

Anecdotally, businesses report that their ability to properly report adjustments is greater in countries which have formalized rules. Countries which adopt formal processes for reporting may well benefit from greater compliance and greater duty collections compared with those that do not. Further work in this area by the WCO and the TCCV would benefit both business and Customs.

TP on its own is complex, and using TP to support Customs valuation adds another layer to the complexity. But as Customs better understands the most common TP approach for imported goods, and Importers better understand the additional information required for Customs to properly conclude a “circumstances surrounding the sale” assessment, the real benefits of convergence will positively impact both.

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william.methenitis@ey.com

[1] The TCCV is established by Article 18 of the Agreement and is charged with providing guidance on uniform interpretation and application of the Agreement.

[2] Commentary 23.1, and Case Studies 14.1 and 14.2 are discussed later in this article. Each is available at available at: http://www.wcoomd.org/en/topics/valuation/instruments-and-tools.aspx

[3] OECD TP Guidelines at Chapter II Part III B. The equivalent US method is the Comparable Profits Method, or CPM.

[4] OECD Guidelines instruct that business profiles of both the buyer and the seller be reviewed to determine which party is less functionally complex, and therefore may be tested in the most reliable manner. This is almost always the Importer, and that is assumed here.

[5] Databases include Amadeus, Orbis, Thomson-Reuters, Standard & Poor’s Compustat, and Oriana.

[6] Interpretative Note 3 to Article 1, paragraph 2.

[7] The accounting period is generally the Importer’s fiscal year, but could be more frequent. For example, some Importers make adjustments monthly or quarterly.

[8] Hamamatsu Photonics Deutschland GmbH v. Hauptzollamt München, Case C‑529/16, December 20, 2017 (available at: http://curia.europa.eu/juris/document/document.jsf;jsessionid=865FF6223E45A78A70EE274A8E2250E7 ?text=&docid=198053&pageIndex=0&doclang=EN&mode=lst&dir=&occ=first&part=1&cid=7482699).

[9] Section 5.2.2, pp 65-67.

[10] Some tax authorities allow, as an option, a taxpayer to make a transfer pricing adjustment directly to taxable income on a tax return without any actual transfer of cash. This “tax only” adjustment does not change the price paid or payable, and consequently is not taken into account for TV.

[11] Countries with formal processes include Australia, Canada, Mexico and the United States. Counties with informal processes include the Netherlands, Singapore, and the United Kingdom.

[12] Annex I, pp 75-80.