RELATED PARTY PRICING / TRANSFER PRICING: Customs vs. IRS

1. RELATED PARTY PRICING / TRANSFER PRICING:Customs vs. IRS Presented to the NYSSCPA International Taxation Committee June 17, 2008

2. Barnes, Richardson & Colburn475 Park Avenue South New York, NY 10016 212-725-0200 Ext 118 agoggins@barnesrichardson.com Alan Goggins

3. Both Customs (or CBP) and the IRS can scrutinize related party prices to determine if such prices are “arm’s length” The tests are similar in theory but drastically different in the details

4. Why is this important? • Any sale from an overseas exporter to a related U.S. importer implicates both the CBP and the IRS. • An overseas version of the IRS in the country of exportation may also be involved

5. Why is this important? • CBP has recently announced its intention to step up enforcement in this area • Having an APA in place is no longer sufficient to convince CBP

6. Goals for today • Compare methods employed by CBP and IRS • Determine what types of documentation can satisfy both

7. Relationship Test • Control – 5% of voting stock threshold • Parent – subsidiary and subsidiaries of subsidiaries • Sister companies under common control of a parent company

8. CBP Valuation Issues • Value for CBP purposes is almost always determined under the transaction value method – 19 U.S.C. § 1401a • Statute requires use of transaction value if applicable • Transaction value = price paid or payable when sold for export to the U.S.

9. If parties are related, CBP can question acceptability of prices • Circumstances of sales test – 3 variations • Test values test – 3 variations • Only need 1 to pass, and any 1 will do • Pass / Fail – unlike IRS, CBP cannot adjust prices – must accept or reject • If rejected – must use alternative valuation method

10. First Sale Appraisement • Method of avoiding CBP inquiry (and saving duty) • If unrelated factory sells to exporter, may be able to use factory or first sale prices instead of prices from exporter to related importer • No duty paid on exporter’s margin

11. First Sale Appraisement • Transaction between factory and exporter must be a sale • Must be for exportation to the U.S. – factory must know the goods are destined to the U.S. • Labeling, shipping instructions, separate P.O. for U.S. market goods

12. Circumstances of Sale Test • The analysis reveals that the relationship between the buyer and the seller did not influence the prices paid

13. Circumstance of Sales Test – Variation 1 • Related party prices settled in a manner consistent with the normal prices practices in the industry • Example – commodities prices tied to public market quotations • Documentation – public market quotes

14. Circumstance of Sales Test – Variation 2 • Related party prices settled consistent with the way the seller settles prices to unrelated buyers • Example – exporter sells same merchandise to unrelated buyers in U.S. (preferred) or in third countries at similar prices • Same pricing formula - related & unrelated

15. Circumstance of Sales Test – Variation 2 (Continued) • Same level of trade • compare sales to related and unrelated distributors • OR related and unrelated wholesalers • OR related and unrelated retailers • Otherwise, make a level of trade adjustment • Documentation – Comparative analysis converting prices to a common currency plus the invoices

16. Circumstance of Sales Test – Variation 3 • Related party price adequate to ensure recovery of all the exporter’s costs plus a profit = overall profit in sales of the same class or kind of merchandise • Cost of production analysis • Business segment or product line profit rather than overall profit

17. Circumstance of Sales Test – Variation 3 (Continued) • Cost of production analysis required for every product imported • Documentation – a mountain of paper required – invoices, ledgers, journals, cost accounting records, etc.

18. Test Values • Related party prices are acceptable to CBP if such prices closely approximate a test value or an appraised value if one of the secondary bases of valuation were used • Transaction value of identical or similar merchandise, deductive value, computed value

19. Test Values – Transaction Value Identical or Similar Goods • Transaction value identical goods = same exporter sells same goods to unrelated buyers in U.S. (? – how is this different from COS Variation 2?) • Transaction value similar goods = ask your competitor what he pays for imported goods and ask for his customs entries (do not hold your breath)

20. Test Values – Deductive Value • Start with importer’s most common U.S. resale price and work your way back to a proxy for the purchase (import) price • Deduct NDC’s • Deduct importer’s SG&A • Deduct importer’s profits in U.S. • Try to narrow focus to product line costs

21. Test Values – Computed Value • This is also an exporter’s cost of production analysis • ? How is this different from COS Variation 3?

22. Test Values Roadblock • CBP policy – will not accept any test values unless the secondary appraisement method was actually used in a previous importation

23. Test Values Roadblock • Statute requires use of transaction value first – only get to secondary methods if transaction value rejected • By then, per CBP, too late to use test values • CBP policy erases test values from the statute

24. IRS Transfer Pricing Tests • Unlike CBP, IRS can propose adjustments to prices • IRS also requires taxpayer to establish that the method used provides best and most reliable measure • Profit-based methods • Transaction-based methods

25. IRS Transfer Pricing Tests Profit-Based Methods • Comparable profits • Comparable profit split • Residual profit split • Profit comparisons between related parties or between related parties and competitors • None acceptable to CBP because must have a customs value for each imported article

26. IRS Transfer Pricing Tests Transaction-Based Methods • Comparable uncontrolled price (“CUP”) • Compares related party prices to prices in sales to unrelated parties • Similar to COS Variation 2 and can be met with the same type of documentation (comparative analysis with invoices and prices converted to a common currency) • Here, CBP would likely accept the APA if given an explanation

27. IRS Transfer Pricing Tests Transaction-Based Methods • Resale price method – used for a reseller • Compares gross margin in related party sales to gross margin in unrelated party sales • Exporter must have sales to related and unrelated parties • Would need substantial explanation to demonstrate an APA here also meets CBP – possibly COS Variation 2

28. IRS Transfer Pricing Tests Transaction-Based Methods • Cost plus method – used for a manufacturer and compares gross margins in sales to related and unrelated parties • Somewhat similar to COS variation 3 or computed value – mountain of documents • Would again require substantial explanation to demonstrate APA here also met CBP

29. CBP vs. IRS • APA or transfer pricing study alone will not satisfy CBP • Must also demonstrate how a CBP method is met • Like an APA, importer can apply for a CBP ruling in advance

30. CBP vs. IRS • The only method that appears to readily satisfy both CBP and IRS is Circumstances of Sales Variation 2 / CUP test

31. CBP vs. IRS • 26 U.S.C. § 1059A • Inventory costs of imported merchandise for a related party importer taken into account for IRS purposes must not exceed value declared to CBP • Does not apply to first sale method • Example: failure to declare an assist results in double penalty – CBP underpaid duty and IRS disallows expense deduction

32. Concluding Thoughts • Companies spend significant time and resources preparing for the day the IRS knocks on the door • Comparable effort not made in preparing for the day CBP questions related prices • CBP has served notice – be prepared!

33. Questions? Alan Goggins, Esq. Barnes, Richardson & Colburn 475 Park Avenue South New York, NY 10016 212-725-0200 Ext 118 agoggins@barnesrichardson.com