OT:RR:CTF:VS H284014 CMR
Port Director
U.S. Customs & Border Protection
40 South Gay Street
Baltimore, MD 21202
RE: Internal advice request; Related Parties; Valuation; 19 U.S.C. § 1401a
Dear Port Director:
This is in response to a memorandum, dated March 1, 2017, forwarding a request for internal advice, dated February 6, 2017, submitted by Mayer Brown, LLP, on behalf of their client, i.e., the importer. The internal advice request is the result of a disagreement between the importer and the Office of Regulatory Audit (“Audit”) regarding the proper valuation method for appraisement of certain products entered by the importer at the Ports of Houston and Baltimore. The issue arose as the consequence of a Focused Assessment conducted by the Philadelphia Regulatory Audit Field Office which examined Fiscal Year 2014. Audit was not satisfied that the importer had provided sufficient information to show that the all costs plus a profit test was met with regard to the examined walkthrough entry, which included five (5) products, to satisfy the circumstances of the sale test with regard to related party transactions.
FACTS:
The U.S. importer purchases products from a related manufacturer (the parent company of the importer’s parent company). The U.S. subsidiary acts as the sole distributor of the imported products to customers in North America, i.e., the United States, Canada and Mexico, who use the imported products as inputs in the production of various other products.
The importer submits purchase orders for products well in advance of the month in which it expects to receive the products at its U.S. warehouses. The importer monitors its inventory levels and adjusts it purchases weekly based on its anticipated need. The importer places the imported merchandise into its warehouse inventory and sells products to U.S. customers from this inventory. The distribution agreement between the importer and the related manufacturer indicates that all sales of products from the manufacturer to the importer are CIF (Cost, Insurance and Freight). Further, the agreement provides that the “[b]uyer shall have the sole authority to determine the price at which it resells the Products to its customers in the Territory.” The agreement indicates that to the extent the manufacturer may ever suggest resale prices, they should be considered “Suggested Resale Prices” only and the importer is in no way obligated or required to adopt such prices. The importer negotiates sales contracts with its U.S. customers for products, which usually allow for periodic price adjustments, and also sells to customers through “spot sales.”
The distribution agreement further indicates the following with regard to transfer of title, at paragraph 10 of the agreement:
Delivery of the Products to the carrier over the rail or truck of an ocean vessel in a [port of export] shall constitute delivery to Buyer. Title to the Products, under CIF (Cost, Insurance and Freight), shall pass to Buyer upon delivery over the rail of the ocean vessel at the [port of export]. Risk of loss shall remain with [the manufacturer] until delivery to Buyer at the named port of destination specified by Buyer.
The manufacturer arranges and pays for the international freight, which is provided by an unrelated third party and is itemized on the intercompany invoice to the importer. The importer reimburses the manufacturer for the international freight costs.
Counsel for the importer submits that the intercompany prices are set based on market conditions, that is, the price at which the importer is able to sell products to customers. The products are not openly traded on any exchanges, and therefore, there are no published market prices. The related parties determine the transfer prices through discussions of the prices at which the importer can sell products to third-party customers in North America; the appropriateness of the profit margin to be earned by the importer; and quarterly sales meetings at which final prices are established based upon market conditions. The importer relies upon the all costs plus a profit method of meeting the circumstances of the sale to support that the sales between the related parties qualify as arm’s length sales. As the manufacturer/seller is the parent company, the importer has submitted documentation to show that the manufacturer’s selling price to the U.S. importer is sufficient to cover all costs plus a profit equivalent to the manufacturer’s profit in sales of the same products globally.
The importer submitted customs and transaction-specific documentation related to the transaction selected by Audit for its walkthrough on valuation issues at the Entrance Conference. The materials submitted included documentation for each of the five (5) line items on the entry summary. The manufacturer invoiced each line item separately and the documentation provided for each invoice traces the invoice into the importer’s accounts payable and inventory.
As the manufacturer’s financial statement reflects the manufacturer’s worldwide revenue, costs and expenses associated with its sales of the various products, the manufacturer used its accounting system in which it tracks the product costs to provide financial information, by product, to show Customs and Border Protection (CBP) that each product individually qualifies under the all costs plus a profit test. The manufacturer was able to tie the financial statements by product back to its audited financial statement. Extensive documentation taken from the manufacturer’s accounting system and general ledger were submitted to CBP and the manufacturer was able to explain and trace the submitted financial information for each product. The manufacturer created quarterly income statements by product to identify actual costs for the quarter in which the merchandise in the walkthrough entry was produced. In preparing the analysis comparing the profit of the manufacturer in the sales of products to the importer in the walkthrough entry to the profit of the manufacturer in all sales of the same products, the related parties used the net profit margin as the profit level indicator.
The importer also provided CBP with, among other things, the manufacturer’s income statement by product for 2014, purchase orders, invoices, a copy of the distribution agreement between the manufacturer and the importer, packing lists, bills of lading, and certificates of cargo insurance for the manufacturer. In addition, copies of the related manufacturer’s complete financial statement with notes and the importer’s financial statement with notes covering the year 2014 were submitted.
An accounting company conducts an annual transfer pricing study of the importer to ensure that the profit margin earned by the importer satisfies U.S. tax law regarding related party transactions. A copy of the transfer pricing study for the year 2014 was submitted for CBP’s review. The submitted transfer pricing study utilized the comparable profits method with the importer as the tested party. The profit level indicator selected was the Berry ratio (gross profit divided by operating expenses). Six companies were selected as functionally comparable companies and their 6-year weighted-average adjusted Berry ratio results during a 6-year period were determined. The report stated that the importer’s weighted-average Berry ratio was “a result that is not below the arm’s length interquartile range demonstrated by the comparables over the same period.”
In this case, Audit was not convinced that the importer satisfied the all costs plus a profit method for meeting the circumstances of the sale. Audit views the methodology used by the related parties to determine prices, relying upon the price at which the importer could sell products to customers in the U.S. as a starting point for their price analysis with adjustments to account for the importer’s operating costs and profits, as indicative that the deductive value method would be a more appropriate basis of appraisement. Further, Audit believes the importer’s failure to provide information that the selling prices for the line items included in the selected walkthrough entry included a profit percentage equivalent to the overall profit of the parent, precluded the use of transaction value between the parties.
On May 31, 2018, counsel and his client’s representatives met with CBP personnel to discuss this matter and go over the extensive documentation provided to support the importer’s position. There is no issue with regard to whether there is a sale between the manufacturer and its related U.S. distributor who imports the products. The issue for CBP is the acceptability of the transfer price under transaction value and whether the parties have presented sufficient information to support the claim that the transfer price meets the arm’s length standard by application of the all costs plus a profit test of the circumstances of the sale examination.
ISSUE:
Whether the related parties may use transaction value utilizing the transfer price paid by the U.S. importer to its parent company.
LAW AND ANALYSIS:
Merchandise imported into the United States is appraised 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 preferred method of appraisement is transaction value, which is defined as the "price actually paid or payable for merchandise when sold for exportation to the United States," plus five statutorily enumerated additions. 19 U.S.C. § 1401a(b)(1). In order for transaction value to be applicable for appraisement purposes, there must be a bona fide sale of merchandise for export to the United States.
The transactions at issue involve related parties as defined in section 402(g) of the Tariff Act of 1930, as amended by the TAA, codified at 19 U.S.C. 1401a. With regard to related transactions, the statute provides, in part, under 19 U.S.C. § 1401a(b)(2)(A)(iv), that the transaction value between a related buyer and seller is acceptable if an examination of the circumstances of the sale of the imported merchandise indicates that the relationship between such buyer and seller did not influence the price actually paid or payable. See also 19 CFR § 152.103(j)(2)(i). The CBP Regulations provide guidance at 19 CFR § 152.103(l) through “Interpretative Notes” as to methods to examine whether the relationship of the parties influenced the price actually paid or payable. One method, relied upon by the importer in this case, is commonly referred to as the all costs plus a profit method. “Interpretative Note 3”, at 19 CFR § 152.103(l)(iii) states:
If it is shown that the price is 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 (e.g., on an annual basis), in sales of merchandise of the same class or kind, this would demonstrate that the price has not been influenced.
In applying the all costs plus a profit test, CBP normally considers the “firm’s” overall profit to be the profit of the parent company. See HQ H065015, dated April 14, 2011; HQ 546998, dated January 19, 2000; and, HQ 542792, dated March 25, 1983. CBP regulations do not give us the definition of “equivalent” profit; however, if the profit of the seller is equal to or higher on the U.S. imports than the firm's overall profit, the purchase price would not be artificially low for CBP’s purposes. See HQ H106603, dated July 25, 2011; HQ H065015, dated April 14, 2011; and, HQ H065024, dated July 28, 2011. Finally, CBP Regulations do not define what profit we are to consider. However, CBP is of the view that the operating profit margin is a more accurate measure of a company's real profitability because it reveals what the company actually earns on its sales once all associated expenses have been paid. Nevertheless, in certain circumstances, gross profit can be considered. See HQ H037375, dated December 11, 2009.
In this particular case, the importer relies upon a comparison of the net profit margin to show that the manufacturer’s sales of products to the importer resulted in a profit equivalent to, or greater than, the manufacturer’s sales of products worldwide. The net profit margin equals the net profits after taxes divided by sales. According to Investopedia.com:
Net profit margins are those generated from all phases of a business, including taxes. In other words, this ratio compares net income with sales.
The reason provided for using the net profit margin for comparison purposes is that the net profit margin is a financial ratio which minimizes inconsistencies in accounting principles related to the classification of direct and indirect expenses and returns for companies. For this reason, the importer indicated that the net profit margin is the most reliable profit level indicator for comparison purposes. The net profit margin differs from the operating profit margin, which is normally considered by CBP in the context of the all costs plus a profit test, in that the net profit margin calculation utilizes profit after taxes, and the operating profit margin calculation utilizes profit before deductions for interest and taxes paid. However, in this case, as the manufacturer/seller is the parent and extensive documentation has been submitted to explain the derivation of the submitted figures, we agree that the use of the net profit margin is acceptable.
Sales of four out of the five products included in the walkthrough entry provided the manufacturer with a larger net profit margin than the manufacturer’s overall net profit margin in sales of those products in the same quarter. One item did have a much smaller net profit margin in the sale to the importer than in the manufacturer’s overall sales. However, the importer explained that this result was due to very low sales volume during the quarter and that when considered over the entire year, the price and cost plus profit equalized.
Audit is concerned with the manner in which the related parties arrive at their transfer price. The methodology by which the related parties arrive at their transfer price does not preclude the use of the transfer price under transaction value provided the parties can show that the transfer price is considered arm’s length under, in this case, the circumstances of the sale test. Audit referred to HQ H260036, dated February 24, 2015 and the World Customs Organization (WCO) Case Study 14.1, “Use of Transfer Pricing Documentation When Examining Related Party Transactions under Article 1.2(a) of the Agreement” as supportive of their determination that the related parties’ transactions did not meet the circumstances of the sale test. As counsel for the importer points out, the related parties rely upon the all costs plus a profit test for meeting the circumstances of the sale test. The related parties did not rely upon any transfer pricing studies, and thus, the WCO Case Study is not applicable here. However, CBP did receive, upon request, a copy of the importer’s transfer pricing study for the year 2014. The study reflected a conclusion by the accounting company which conducted the study that the importer’s transfer pricing method provided the most reliable measure of an arm’s length result for fiscal year 2014 from a U.S. tax perspective. While the parties did not, and need not, utilize the transfer pricing study in asserting the transfer price should be considered arm’s length under the circumstances of the sale test, the transfer pricing study provides additional support to the related parties position.
As for HQ H260036, it is distinguishable from the situation herein. In HQ H260036, CBP found that the importer/buyer did not satisfy the all costs plus a profit test, or any other measure for meeting the arm’s length requirement of using related parties’ prices under transaction value. In the decision, CBP states that the importer/buyer “has not submitted any documents . . . to collaborate its assertions.” In this case, the parent is the seller and the test relied upon is the all costs plus a profit test. Extensive documentation has been submitted to show that the prices charged by the manufacturer for the products in the walkthrough entry, with the exception of one, ensured recovery of all costs plus a profit equivalent to, or greater than, “the firm’s overall profit,” i.e., the parent’s, in sales of merchandise of the same class or kind, during a representative period of time, which in this case was the quarter in which the products were produced. With regard to the one product for which the net profit margin on the sale to the importer did not reflect a net profit margin equivalent to or greater than the manufacturer’s net profit margin for the quarter, we accept the explanation provided. If Audit believes it is necessary, it could request additional information from the importer to verify the annual net profit margin for sales of that product to the importer compared to the net profit margin of the manufacturer in its sales of that product for the year 2014.
HOLDING:
While limited to an examination of the walkthrough entry, the importer has satisfied this office that the related parties’ transfer prices should be considered arm’s length prices and the use of transaction value is appropriate for the appraisement of merchandise sold by the manufacturer to the importer.
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.
Sincerely,
Monika R. Brenner, Chief
Valuation and Special Programs Branch