OT:RR:CTF:VS H065024 TNA
Port Director
U.S. Customs and Border Protection
Service Port of Boston
10 Causeway Street - Room 603 Boston, MA 02222
Re: Internal Advice Request; Related Parties; Transfer Pricing; Circumstances of Sale
Dear Port Director:
This is in response to your request for internal advice, initiated by counsel for [***] (“the parent company” or “the importer”) on May 12, 2009, regarding the acceptability of transaction value for certain products imported from its related foreign subsidiary. Our decision in this matter takes into account your submissions to the Port of Boston; a conference at our offices with members of my staff on June 8, 2011; and supplemental submissions dated April 7, 2011 and June 7, 2011. We regret the delay in responding.
[The importer] has asked that certain information submitted in connection with this internal advice be treated as confidential. Inasmuch as this request conforms to the requirements of 19 CFR §177.2(b)(7), the request for confidentiality is approved. The information contained within brackets and all attachments to the internal advice request, forwarded to our office, will not be released to the public and will be withheld from published versions of this ruling.
FACTS:
[The parent company] purchases and imports products from its subsidiary, [****] (“[***]”) (“the subsidiary”), located in [***]. These products fall into three categories of merchandise: chemistry products [(****)]; data products; and mass spectrometry instruments. [The subsidiary] is an indirect wholly owned subsidiary of [the parent company], who holds more than five percent of [the subsidiary]’s outstanding voting stock.
On December 4, 2008, the Port of Boston (“the Port”) initiated a Related Party Price Review inquiry regarding the applicability of transaction value to [the parent company]’s related party purchases from [the subsidiary]. [The parent company] responded with a written submission on January 20, 2009, in which it used the “circumstances of sale” (“COS”) test to conclude that the price between [the parent company] and [the subsidiary] was adequate to ensure recovery of all costs plus a profit that 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. This submission included invoices, purchase orders and entry summary worksheets to substantiate the company’s price claims on five different products, selected from four entries, that fell within the three product categories from which [the parent company] buys from [the subsidiary].
On January 23, 2009, because the Port had a conference with [the parent company] to discuss the issues, the company’s initial submission did not contain data regarding [the parent company]’s overall profit, and the Port requested additional information on January 26, 2009. On March 11, 2009, [the parent company] provided data to show that the [parent company’s] 2008 gross margin was [***]%. The data product center’s gross margin was [***]% in 2008, while the profit margins for the two data products at issue in [the parent company’s] prior submission, were [***]% and [***]%, respectively. The profit margin for the chemistry product center as a whole was [***]% in 2008, while the gross margins for the chemistry products at issue were [***]% and [***]%, respectively. Lastly, the mass spectrometer product center as a whole had a gross margin of [***]% in 2008, while the gross margin of the mass spectrometer at issue was [***]% in 2008. [The parent company] also included a marketing and distribution agreement between [the parent company] and [the subsidiary], which laid out the companies’ agreement with respect to such terms as price, terms of payment, and marketing. As per this distribution agreement, title passes to [the parent company] at the point of embarkation from [the subsidiary] (“FOB”). [The parent company] provided CBP with a transfer pricing study that determined that the pricing was compliant with the reasonableness requirements of the Internal Revenue Service (“IRS”) regulations.
Based on the conference and these submissions, the Port determined that [the parent company]’s method of setting the transfer price with respect to [the subsidiary]’s sale of mass spectrometers to [the parent company] met the circumstances of sales test, but that sales of chemistry and data products did not. The Port informed [the parent company] of this decision by letter on March 23, 2009. On April 8, 2009, [the parent company] held further discussions with CBP, which led to this request for internal advice.
[The parent company] submitted a number of supplemental documents in support of its position, including transfer pricing studies conducted for tax purposes by Ernst & Young. In 2010, Ernst & Young also conducted a transfer pricing study for CBP purposes to determine whether [the parent company’s] transactions with its subsidiaries would be acceptable for CBP’s purposes. This study was also included in [the parent company]’s submissions.
It is the Port’s position that it advised [the parent company] of the option of using either the circumstances of sales approach or the test values approach to satisfy transaction value. The Port believes that because [the parent company] chose to use the circumstances of sale approach, the company had to show that the price being paid to [the subsidiary] for each of the five products it chose to review was adequate to ensure that [the subsidiary] recovered all costs plus a profit equivalent to [the parent company]’s own profit realized over a representative period of time in sales of merchandise of the same class or kind. It is the Port’s position that this test is met only with respect to the mass spectrometer, and not with respect to the data and chemistry products at issue.
ISSUE:
Whether transaction value is the appropriate basis of appraisement of the imported merchandise.
LAW AND ANALYSIS:
Merchandise imported into the United States is appraised for customs purposes 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 primary method of appraisement is transaction value, which is defined as “the price actually paid or payable for the merchandise when sold for exportation to the United States,” plus amounts for certain statutorily enumerated additions to the extent not otherwise included in the price actually paid or payable. See 19 U.S.C. §1401a(b)(1). Transaction value is an acceptable basis of appraisement only if, inter alia, the buyer and seller are not related, or if related, an examination of the circumstances of the sale indicates that the relationship did not influence the price actually paid or payable, or the transaction value of the merchandise closely approximates certain “test values.” 19 U.S.C. §1401a(b)(2)(B); 19 CFR §152.103(l). While the fact that the buyer and seller are related is not in itself grounds for regarding transaction value as unacceptable, where Customs has doubts about the acceptability of the price and is unable to accept transaction value without further inquiry, the parties will be given the opportunity to supply such further detailed information as may be necessary to support the use of transaction value pursuant to the methods outlined above.
“Test values” refer to values previously determined pursuant to actual appraisements of imported merchandise. Thus, for example, a deductive value calculation can only serve as a test value if it represents an actual appraisement of merchandise under section 402(d) of the TAA. See Headquarters Ruling Letter (“HRL”) 543568, dated May 30, 1986. In this case, no information regarding test values has been submitted or is available. Consequently, the circumstances of the sale approach must be used in order to determine the acceptability of transaction value.
Under this approach, the transaction value between a related buyer and seller is acceptable if an examination of the circumstances of the sale indicates that although related, their relationship did not influence the price actually paid or payable. The Customs Regulations specified in 19 CFR Part 152 set forth illustrative examples of how to determine if the relationship between the buyer and the seller influences the price. In this respect, Customs will examine the manner in which the buyer and seller organize their commercial relations and the way in which the price in question was derived in order to determine whether the relationship influenced the price. If it can be shown that the price was settled in a manner consistent with the normal pricing practices of the industry in question, or with the way in which the seller settles prices with unrelated buyers, this will demonstrate that the price has not been influenced by the relationship. See 19 CFR §152.103(l)(1)(i)-(ii). In addition, Customs will consider the price not to have been influenced if the price was adequate to ensure recovery of all costs plus a profit equivalent to the firm’s overall profit realized over a representative period of time. 19 CFR §152.103(l)(1)(iii). These are examples to illustrate that the relationship has not influenced the price, but other factors may be relevant as well. See 19 CFR §152.103(I); see also HQ H037375, dated December 11, 2009; and HQ H032883, dated March 31, 2010.
In the present case, [the parent company] argues for a general approach that takes into account every aspect of the transactions at hand to determine whether transaction value is adequate. On the one hand, the company submitted information regarding its own profitability versus that of its competitors, information that speaks to the Comparable Profits Method (CPM), an IRS test laid out in Section 482 of the Internal Revenue Code (26 U.S.C. § 482). The CPM examines whether the amount charged in a controlled transaction is an arm’s length price by comparing the profitability of the tested party to that of comparable companies. The information provided in this regard is intended to demonstrate that the importer earns a profit on its sales of the imported merchandise that is consistent with normal industry practices. [The parent company] also submitted a range of information as to how it does business, from its transfer pricing studies to the way it establishes prices with its subsidiaries. These factors speak to the circumstances of sale. [The parent company] argues that all of these factors should be taken into consideration in CBP’s determination. While CBP agrees that there is no single factor that determines the adequacy of transfer pricing, [the parent company’s] approach is so general that it does not adhere to any of the regulatory tests for determining the adequacy of its transfer pricing. Nonetheless, we address each of [the parent company’s] arguments in turn.
It is not disputed that [the parent company] and [the subsidiary] are related parties. As a result, the COS test must be satisfied in order for transaction value to be applicable. [The parent company] has submitted data for five different products across three groups of products: chemistry products, data products, and mass spectrometry products, and has elected to use the all cost plus profit method to show that the relationship between the buyer and seller did not influence the prices paid. The data show that the profit margin for the chemistry product center as a whole was [***]% in 2008, while the gross margins for the chemistry products at issue were [***]% and [***]%, respectively. The data product center gross margin was [***]% in 2008, while the profit margins for the two data products at issue were [***]% and [***]%, respectively. Lastly, the mass spectrometry product center as a whole had a gross margin of [***]% in 2008, while the gross margin of the product at issue was [***]% in 2008. The company argues that [the subsidiary]’s profit margins are comparable to the margins of the company as a whole when a proper representative group of transactions is taken into account.
With respect to the comparison between profit margins for the time in question, while 19 CFR 152.103 does not set out a fixed percentage as to what difference in profit margin is acceptable, prior CBP rulings have established a general outline, while following the general rule that the seller’s profit must be equal to or exceed the parent company’s profit. HQ W563326, dated November 3, 2006, for example, addressed the transaction value where a United States-based manufacturing company obtained its parts from a foreign company that wholly owned the parent company of which the United States company was a subsidiary. There, analyzing the circumstances of sale, CBP ruled that the subsidiary’s 2.0% profit, as compared to the foreign parent’s 2.5% profit margin, showed that the price paid by the U.S. Manufacturer was sufficient to ensure recovery of all costs plus a profit that was equivalent to the foreign company’s overall profit realized over a representative period of time in sales of merchandise of the same class or kind. By contrast, HQ H016585, dated December 30, 2008, addressed imported textile luggage bought by an importer from an unrelated wholesaler, who in turn bought the luggage from related parent company. The subsidiary showed a net profit of 0.95% and 0.84% for the years in question, while the parent corporation realized an operating profit ranging from 5.4% to 6.3% for the same period. There, CBP held that because the subsidiary did not realize an operating profit equivalent to the parent firms’ profit over the same period of time, the transaction failed the circumstances of sale test.
The present case shows a significant difference between the profits of the parent company and its subsidiaries. [The subsidiary]’s profit margins for the data and chemistry products at issue are significantly lower than [the parent company]’s profits for its data and chemistry centers. [The subsidiary]’s profit margin for the chemistry products at issue differ from [the parent company]’s profit by 19.8% and 4.8%, respectively. Under the framework of HQ H016585, [the subsidiary] has not recovered all costs plus a profit that is comparable to [the parent company]. [The subsidiary]’s profit margin for the data products at issue differ from [the parent company’s] profit by 9.2% and 3.2%, respectively. These differences also show that [the subsidiary] has not recovered all costs plus a profit that is comparable to [the parent company]. By contrast, [the subsidiary]’s profit margin with respect to the mass spectrometer at issue was higher than [the parent company]’s profit by 0.2%. This situation is comparable to HQ W563326. As a result, we find that for the mass spectrometer, [the subsidiary] has recovered all of its costs plus a profit that is equivalent to [the parent company]. Thus, it is the only product out of the five products submitted for which [the parent company]’s transaction value is acceptable.
[The parent company] also submitted two different types of transfer pricing studies in support of its argument that its transfer pricing is acceptable; one type was for IRS purposes, and the second was done separately and examined whether [the parent company]’s transfer pricing was acceptable from a CBP standpoint. In these studies, [the parent company] uses the CPM method to argue that its transfer pricing was acceptable. We note that the existence of a transfer pricing study does not, by itself, obviate the need for CBP to examine the circumstances of sale in order to determine whether a related party price is acceptable. See HQ H037375, dated December 11, 2009; HQ 546979, dated August 30, 2000. However, information provided to CBP in a transfer pricing study may be relevant in examining circumstances of the sale, but the weight to be given this information will vary depending on the details set forth in the study. See HQ H037375; HQ 548482, dated July 23, 2004. A significant factor, by the way of example, is whether the transfer pricing study has been reviewed and approved by the IRS. See HQ H037375; HQ 546979, dated August 30, 2000. Whether products covered by the study are comparable to the imported products at issue is another important consideration. See HQ H037375; HQ 547672, dated May 21, 2002. The methodology selected for use in a transfer pricing study is also relevant. See HQ 548482, dated July 23, 2004. Thus, even though [the parent company]’s transfer pricing study by itself is not sufficient to show that a related party transaction value is acceptable for Customs purposes, the underlying facts and the conclusions reached in Custom’s transfer pricing study may contain relevant information in examining the circumstances of the sale.
As indicated above, if it can be shown that the price in question was settled in a manner consistent with the normal pricing practice of the industry in question, this will demonstrate that the price has not been influenced by the relationship. CBP has noted that the Importer must have objective evidence of how prices are set in the relevant industry in order to establish the “normal pricing practices of the industry” in question, and present evidence that the transfer price was settled in accordance with these industry pricing practices. See HQ 542261, dated March 11, 1981 (CBP determined that the transfer price was defined with reference to prices published in a trade journal (the posted price) and other buyers and sellers commonly used the posted price as the basis of contract prices). The pricing practices must relate to the industry in question, which generally includes the industry that produces goods of the same class or kind as the imported merchandise. See HQ 546998, dated January 19, 2000; and HQ 548095, dated September 19, 2002. CBP does not consider the industry in question to consist of other functionally equivalent companies if those companies do not sell goods of the same class or kind. See HQ 548482, dated July 23, 2004.
In the present case, in the June 8 conference, [the parent company] explained how its sets its prices, also called the “U.S. list price,” which is the customer selling price for a product. This price is set by Product Marketing Managers based on their research of market conditions, trends, reports, competing quotes from competitors provided by third parties, and what the market will bear. Prices are re-evaluated annually and adjusted based on a product’s life-cycle, technical specifications, demand, and competitive pressure. The price that a customer ultimately pays is a discount from the U.S. list price that is negotiated by sales teams with customers. Overall, [the parent company]’s transfer prices are targeted to ensure [the parent company] meets local standards of reasonable profitability in each jurisdiction. Globally, transfer prices are managed via [the parent company]’s Transfer Price Matrix as a percentage of the US List Price by country by product center, or a percentage of the actual customer selling price. The percentage of the U.S. list price selected is based on estimated average discounts within a particular Product Center that will provide entities with sufficient gross margin to allow recovery of all costs plus a reasonable margin for a limited risk distributor for particular market. [The parent company] is also the exclusive distributor for all products in the U.S., as the subsidiaries do not sell directly to any non-[parent company] entities.
With respect to the pricing practices of the entire industry, the burden of proof lies with the importer to establish that its pricing is consistent with that of the industry. In prior cases where we have accepted the way in which the importer sets its prices, the importer has submitted evidence that its prices and methodology are in accordance with that of the industry. See, e.g., HQ H029658; HQ H037375. In HQ H029658, for example, the importer submitted a paper, prepared by their accountants, that detailed pricing practices in the automotive industry. See HQ H029658. In the present case, by contrast, [the parent company] has not submitted any comparable evidence to establish that its pricing methodology is consistent with that of the industry as a whole. As a result, we have no way to determine whether the manner in which [the parent company] sets its prices is in line with what the methodology of rest of the industry. Furthermore, [the parent company]’s transfer pricing study does not indicate whether it has been reviewed and approved by the IRS.
As for the transfer study’s methodology, the study examined seven of [the parent company]’s intercompany transactions for seven different product groups, including the three at issue here. For each of the products at issue, [the parent company] was the tested party and Gross Margin (“GM”) was selected as the appropriate profit level indicator (“PLI”). A set of five U.S. distributors were identified as being comparable to [the parent company], and that set was used to benchmark [the parent company]’s profitability as related to its distribution of [the subsidiary]’s products. To select these five companies, Ernst and Young, who performed the study, searched three databases for information on publicly traded companies according to US Standard Industrial Codes (“SIC”): Standard and Poor’s Compustat, Moody’s U.S. Public Companies, and Disclosure. The SIC system is structured on an industry basis and is used to promote the comparability of data describing various industries in the U.S. economy. Companies with certain SIC codes were selected to identify companies engaged in similar service activities as [the parent company], and Ernest Young further narrowed the set of potentially comparable companies by performing a series of financial screens against the remaining companies. These screenings eliminated companies that are bankrupt or no longer in business and reviewed the companies’ short business description and disregarded companies it considered dissimilar based on the following criteria: companies that developed or provided unrelated products such as software or services; companies that performed dissimilar activities such as manufacturing or designing in addition to marketing; and companies that were rejected for other reasons such as bankruptcy, acquisitions, or a change in business activity. As a whole, this process eliminated 291 companies from comparison. After this initial screening, Ernest Young reviewed public SEC filings, and rejected an additional 32 companies based on the criteria listed above, yielding a total of eight comparable companies. This method was originally performed in 2003, and every year since then, Ernest Young has updated the list by comparing the yearly financials of each company to [the parent company]’s financials. This updating has caused three additional comparable companies to be rejected over the years, leaving the five U.S. distributors to which [the parent company] was compared in this study.
We reviewed the comparable companies selected by [the parent company]’s transfer pricing study and conclude that the products sold by the comparable companies are not of the same class or kind as the imported merchandise. The comparable companies distribute a range of goods, from medical and products and supplies to office supplies such as paper and desks. Under these circumstances, the comparison between [the parent company] and these other companies cannot be considered consistent with the market as a whole. Furthermore, the transfer pricing study for CBP purposes stated that the study:
does not include companies that import and distribute product of the same class or kind as [the parent company] in its set of comparable companies. We obtained from [the parent company] a list of companies viewed as direct competitors. As anticipated, these companies were not appropriate to review as benchmarks for the profit of [the parent company] as a distributor of products, as the competitors, similar to [the parent company], manufacture for sale to their own US distributions companies. Competitor information could, however, be evaluated to determine if reported gross margins are similar to [the parent company].
In excluding this information, the study omitted exactly the kind of comparables for which CBP is looking. Companies that import and distribute products of the same class or kind are the type of companies most likely to yield profit information that is most relevant to whether a company’s transfer pricing is acceptable. Furthermore, this study eliminated companies that were deemed to be too similar, structurally speaking, to [the parent company]. Once again, this similarity would have proved instructive with respect to comparing profits. Lastly, comparing competitors’ gross margins without regard to the factors that makes the companies similar limits the usefulness of such a comparison. As a result, this transfer pricing study does little to establish the efficacy of the profits compared therein.
We also note that [the parent company] used gross margin rather than operating profit, which is the usual standard by which companies measure their profits in this situation. At the June 8 conference, [the parent company] explained that the company calculates all of its numbers using the gross margin rather than operating profit, and stated this is the way the company does business because it is more efficient for them to do so. The company further asserted that it does not calculate operating profit. We respond by noting that publicly traded companies such as [the parent company] generally choose to calculate operating profit, and that operating profit is the standard by which profits are compared in the CPM. Not having an operating profit with which to work in the present case complicates our assessment.
Furthermore, even if we considered [the parent company] to be comparable to the companies at issue in the transfer pricing study, not all of [the parent company]’s profits are comparable to the profits of these companies. For the chemistry products at issue, the transfer pricing study determined that the comparable company’s lower quartile gross margin in the single year interquartile range was 26.3%, and the comparable company’s lower quartile for the three-year interquartile range was 25.5%. By contrast, [the parent company]’s results for the single year were 11.0%, and its results for the three-year were 12.6%. With respect to the data products at issue, the transfer pricing study determined that the comparable company’s upper quartile gross margin in the single year interquartile range was 29.2%, and the comparable company’s upper quartile for the three-year interquartile range was 28.9%. By contrast, [the parent company]’s results for the single year were 39.9%, and its results for the three-year were 38.6%. With respect to the mass spectrometer at issue, the transfer pricing study determined that the comparable company’s upper quartile gross margin in the single year interquartile range was 29.2%, and the comparable company’s upper quartile for the three-year interquartile range was 28.9%. [The parent company]’s results for these products for the single year were 34.6%, and its results for the three-year were 30.9%. As a result, the transfer pricing study indicates that [the parent company]’s gross margin is only comparable to the distributors chosen for the mass spectrometer at issue. This supports our conclusion that [the parent company]’s transfer price is acceptable for the mass spectrometer, but not for the data products or chemistry products at issue.
In the June 8 conference, [the parent company] argued that the company sells a unique mix of products that is different from its competitors. [The parent company] also asserted that it sells high-end products, and that these factors account for the differences in profit margins between the company and its competitors. In response, we note that its transfer pricing study for CBP purposes disregarded companies that were considered direct competitors because they imported merchandise of the same class or kind as [the parent company]. Companies that manufacture for sale to their own U.S. distribution companies were also disregarded from this study. This seems to acknowledge that there is in fact a list of companies that [the parent company] feels are comparable in terms of the products they sell and are therefore direct competitors.
Lastly, [the parent company] compares its situation to HQ H029658 and HQ H037375. HQ H029658 dealt with the importation of motor vehicles by an importer who acted as an exclusive distributor for its parent company. HQ H037375 dealt with transfer pricing between a U.S. company that was the parent company of a group of companies abroad that did business in healthcare and medical products. In both these cases, CBP found the importer’s transfer pricing to be acceptable, and [the parent company] argues that a number of similar factors are present here as well. [The parent company] argues that here, as in HQ H029658 and HQ H037375, there is a consistency in the company’s gross margins, a consistency in its profits, a consistent discount given to the company’s U.S. customer list, and the company presented such documents as a transfer pricing study prepared by its accountants. Furthermore, [the parent company] argues that it presented evidence to explain how it sets its prices, how its transactions are arms-length, and the differences in profits between it and its competitors. The company has also furnished CBP with documents it presented to the IRS to substantiate its claims of an arms-length transaction.
While we acknowledge that there are similarities between these rulings and the present case, these rulings can be distinguished in ways that affect the outcome here. In HQ H037375, Cardinal Health was able to establish that it had direct competitors that sold the same or similar products, and that its profits were similar to their competitors. Not only did this speak in favor of the company’s transfer pricing being accepted via the CPM, CBP also accepted the way in which Cardinal Health set its prices because this factor helped prove that the company’s prices were set in accordance with industry standards. None of that is true in the present case. With respect to HQ H029658, while we acknowledge that [the parent company] goes through a similar process to set its own prices, the difference is that it, as discussed above, has not presented evidence showing that this process is consistent with industry standards. [The parent company] also has not presented evidence of a bilateral pricing agreements, as the importer did in HQ H029658. Furthermore, with the exception of [the parent company]’s [***] group, [the parent company] shows profits that are quite different from its competitors, and is quite different between the subsidiary and the parent company.
HOLDING:
The acceptability of transaction value based on the related party sale between [the parent company] and [the subsidiary] has not been demonstrated with respect to the two chemistry products and the two data products at issue. The acceptability of transaction value has been demonstrated with respect to the mass spectrometers at issue.
Please do not hesitate to contact us at (202) 325-0036 if you have any questions or concerns.
Sincerely,
Monika R. Brenner, Chief
Valuation and Special Programs Branch