VAL OT:RR:CTF:VS H138203 HkP
Port Director
Port of Charlotte
U.S. Customs and Border Protection
2001 Beam Cross Drive
Charlotte, NC 28217-2856
RE: Internal Advice; Related Parties; Transfer Pricing; Discount; Circumstances of the Sale
Dear Port Director:
This is in response to the Request for Internal Advice, dated November 23, 2010, submitted through your port concerning the proper basis of appraisement of merchandise imported by Hauni Richmond Inc. from its parent company in Germany. In reaching our decision we have taken into account additional information submitted to this office on February 21, 2011.
FACTS:
The importer, Hauni Richmond Inc. (HR), is a wholly owned subsidiary of HauniMaschinenbau AG (HAG), which is in turn a wholly owned subsidiary of K?rber AG Group. HAG designs and manufactures equipment used in tobacco processing and in filter and cigarette manufacturing, and sells machinery and spare parts to subsidiaries, third party customers (factories), and third party distributors worldwide, who in turn sell to unrelated customers. HR rebuilds and services cigarette-producing equipment and imports spare parts into the United States for distribution to unrelated customers. HR is HAG’s exclusive sales and service center in the United States, although HR also sells parts bought from other related parties and third parties when parts are not available from related parties. As a general practice, HAG does not sell directly to unrelated parties in the United States.
HR states that a principal/agent relationship does not exist between itself and HAG, and that HR does not receive any commission payments from HAG related to the imported spare parts. In addition, HR buys spare parts for its own account at prices set according to HAG’s Intercompany Price Guideline between the Tobacco Division Companies. While HR generally sells the parts according to the prices published by HAG, it is free to sell to buyers on the terms it negotiates with them. HR imports parts to stock its own inventory and fulfills customer orders out of its own U.S. stock.
HAG manages spare part sales through its Spare Parts Center in Germany. Prices are set on a yearly basis following a two-step process. First, An Ex Works list price is established for each part based on HAG’s moving inventory cost of that part and is adjusted prospectively based on a combination of market factors such as lead times, sales volumes, and competitive advantages. Second, HAG negotiates discounts to the list price with specific customers. One of the discounts offered is an e-commerce discount that varies from two percent to four percent based on the technology used: two percent for the HauniWebshop ordering system; two-and-a-half percent for a fully integrated ordering system through ERP communication; and four percent for the Vendor Managed Inventory system. HAG’s pricing policy is set out in the Intercompany Price Guideline between the Tobacco Division Companies (discussed below).
HAG grants its decentralized sales entities, such as HR, a discount on the list price for spare parts purchased from the Spare Parts Center. According to the importer, the discount granted by HAG to HR and its affiliates is higher than the average discount given to unrelated multinational cigarette companies, though not by more than three percent. The importer explains that distributors, such as HR, receive a greater discount than an end customer to compensate for additional distributor costs, such as payroll and fringe benefits, shipping and receiving materials and supplies, and IT costs. Discounts are reviewed yearly for transfer pricing purposes. In 2009, the price for spare parts sold by HAG to HR was discounted 14 percent from the list price, which included a two percent e-commerce discount. In 2011, operational changes at HR resulted in the elimination of the e-commerce discount so that the current discount received by HR is 12 percent.
This decision is being issued subsequent to our review of the following documents:
Terms and Conditions of Sale (Export Orders) of HauniMaschinenbau AG (HAG), dated January 2004;
Intercompany Price Guideline between the Tobacco Division Companies, valid from January 1, 2004;
Hauni Richmond, Inc. Transfer Pricing Report, prepared for the Taxable Year ending December 31, 2003, by Ernst & Young; and
Focused Assessment Pre Assessment Survey Audit Report, U.S. Customs and Border Protection, Regulatory Audit Division (Charlotte), dated June 8, 2010.
The Terms and Conditions of Sale (Export Orders) provides in relevant part:
The delivery terms will be Ex Works (in conformity with the latest version of Incoterms)
Parts deliveries will be allowable.
If delivery is carried out in installments, or if we wholly or partly assume responsibility for or arrange other services, e.g. transportation costs and insurance, or installation, as per your order, the risk will pass to you no later than the time when each installment is dispatched.
Risk of damage or loss of the Goods shall pass finally to you in accordance with the agreed Incoterm Clause. From this point on, you are therefore obliged to insure the entire value of the contract against all risks until the final acceptance of the Goods….
Packing will be appropriate for the method of dispatch and will be invoiced by us at cost price. Packaging is not returnable.
….
Our prices will apply to delivery unpacked Ex Works….
….
Any additional costs incurred at home and abroad which are not covered by the
agreed Incoterm clause (Incoterms 2000), such as inspection costs, consulate and certification fees incurred in connection with the delivery are to be borne by you.
The Intercompany Price Guideline states that its assessment basis is “the principle of third-party comparison, and thus the market price. This indicates that pricing is to be undertaken as for Group independent third parties; for this reason this guideline envisages that, on a matter of principle, any resell is based on the list price ….” The Guideline also states that the basis for the intercompany price is the respective Spare Parts Centre price list for sales to third parties, and that decentralized distribution sites are granted a discount of 12 percent. Email correspondence between unidentified parties in February 2006 indicates that the discount was increased to 14 percent in 2006. However, as previously mentioned, the current discount is 12 percent. Decentralized Spare Parts Centre distribution sites, such as HR, are responsible for the distribution function of the Spare Parts Centre for each respective allocated distribution region.
The stated aim of the Transfer Pricing Report drafted by Ernst & Young is to determine if HR’s purchase of finished industrial equipment and spare parts manufactured by HAG for resale to third parties was conducted at arm’s length from a U.S. transfer pricing perspective. For purposes of the Report, Ernst & Young defines an arm’s length result as “the operating margin that should be earned by Hauni Richmond, the buyer and reseller in the controlled transaction, under the Comparable Profits Method (CPM) provided by [Treasury Regulations].” The CPM method “evaluates whether the amount charged in a controlled transaction is arm’s length based on objective measures of profitability (profit level indicators) derived from uncontrolled taxpayers (comparable parties) that engage in similar business activities under similar circumstances. Application of the CPM method requires selection of a tested party, which is the participant in the controlled transaction whose operating profit attributable to the controlled transaction can be validated using the most reliable data, requiring the fewest and most reliable adjustments. Ernst &Young selected HR as the tested party.
In its search for comparable companies, Ernst & Young identified public companies on the Standard & Poor’s Compustat, Moody’s, and Disclosure databases (the latter two databases only provide business descriptions and not financial information) categorized under the following U.S. SIC Codes: (1) 5072 – Establishments primarily engaged in the wholesale distribution of cutlery and general hardware, including handsaws, saw blades, brads, staples, and tacks; and, bolts, nuts, rivets, and screws; (2) 5084 - Establishments primarily engaged in the wholesale distribution of industrial machinery and equipment, not elsewhere classified; and, (3) 5085 – Establishments primarily engaged in the wholesale distribution of industrial supplies, not elsewhere classified. The general U.S. SIC code search identified 175 potentially comparable companies.
To further refine its search, Ernst & Young applied the following financial screening criteria:
(1) Net Sales must be greater than $0 for at least one year in the 2000 to 2002 time period. (2) Companies performing unrelated business activities, functions or services were eliminated. For example, companies that design and/or manufacture industrial products, chemical or building products were eliminated. Also, companies primarily providing services were eliminated.
(3) Companies distributing non-comparable products were eliminated, such as gas and oil, office supplies or large equipment, or the company is primarily engaged in direct sales to retail customers.
(4) Companies with three consecutive years of financial losses, who were acquired, or were no longer active were eliminated.
(5) Companies with significant international operations were eliminated.
(6) Companies under financial distress were eliminated.
(7) Companies that sold to a different level of the market were eliminated. For example, distributors that sell to retailers or to home-improvement warehouses were eliminated.
(8) Companies that provided services to related parties were eliminated.
After reviewing the short business descriptions and 10-Ks of screened companies, Ernst & Young determined that eight companies were comparable to the tested party (HR). The companies are described as industrial equipment and parts distributors. The types of parts/products sold by these companies are:
(1) Bearings and seals, linear motion products, power transmission products, fluid power products, industrial rubber products, general maintenance products, and related specialty items;
(2) Maintenance, repair and operating products for fluid handling equipment, bearing, power transmission equipment, general mill, and safety supply and electrical products;
(3) Facilities maintenance products;
(4) Construction and industrial materials, equipment, and supplies, for commercial construction, residential construction, industrial and public infrastructure markets;
(5) Cutting tools, abrasives, hand and power tools, coolants, lubricants, adhesives, safety products, and machine tools;
(6) Fasteners, fittings and related parts, industrial supplies such as hoses, lubricants, cleansers, files, shop supplies, and drills, and automotive and equipment maintenance parts for automotive, appliance, aerospace, construction, and transportation industries;
(7) Cutting tools, abrasives, measuring instruments, machine tool accessories, safety equipment, fasteners, welding supplies, and electrical supplies; and
(8) Plumbing, air conditioning and electrical/industrial supplies.
Ernst & Young made certain adjustments to the data of the allegedly comparable companies in order to improve consistency and achieve greater similarity between the comparable parties and the tested party. The adjustments accounted for LIFO (last in first out) inventory accounting, asset intensity for accounts receivable (to achieve the same receivables-to-sales ratio as HR), inventories, and accounts payable. Ernst & Young then analyzed HR’s operating margin according to two scenarios. Under the first scenario, commission income for sales of new equipment was included in the calculation of HR’s operating margin as an offset to operating expenses. The three-year (2001 -2003) average operating margin was 7.31 percent. Under the second scenario, Ernst & Young grossed-up HR’s net sales to reflect the total amount of net sales by assuming that the commission rate on new equipment sales was 10 percent and divided the amount of the commission income in each year by 10 percent. The three year average operating margin was 4.68 percent. Ernst & Young conducted an analysis of the comparable companies over the same three year period and found that the interquartile range of the average operating margins for the comparable companies was from 2.83 percent to 8.02 percent, with a median of 3.99 percent. Based on this analysis, Ernst & Young concluded that HR’s intercompany transactions are arm’s-length and that no transfer pricing adjustment is required.
In CBP’s Focused Assessment Pre-Assessment Survey of the importer, consisting of a line item walkthrough for a particular entry, Regulatory Audit determined that during calendar year 2009, HR received a 14 percent discount on parts purchased from HAG. After deducting the discount from the invoiced amount, HAG added to the discounted amount 2.8 percent of the total for shipping charges and 1 percent of the total for packing costs. HR deducted the 14 percent discount from the entered value as a non-dutiable charge and added the amounts for shipping and packing to the price declared to CBP. Based on the invoice reviewed, imported parts include spur wheels, axles, relays, temperature sensors, valves, and support rails. The contract term stated on the invoice was CPT (Carriage Paid To) Richmond, which means that the seller/exporter arranges for the goods to be delivered to the named port of destination and bears all costs incurred until delivery, but the seller’s risk ends the moment the goods have been delivered to the carrier.
ISSUE:
What is the proper method of appraisement of the imported merchandise under 19 U.S.C. § 1401a(b)?
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 (19 U.S.C. § 1401a; TAA). The preferred method of appraisement of imported merchandise for customs purposes is transaction value. Transaction value is the price actually paid or payable for the merchandise when sold for export to the United States, plus certain enumerated additions to the extent not otherwise included in the price actually paid or payable. 19 U.S.C. § 1401a(b)(1). The term “price actually paid or payable” means the total payment (whether direct or indirect, and exclusive of any costs, charges, or expenses incurred for transportation, insurance, and related services incidental to the international shipment of the merchandise from the country of exportation to the place of importation in the United States) made, or to be made, for imported merchandise by the buyer to, or for the benefit of the seller. 19 U.S.C. § 1401a(b)(4)(A).
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 C.F.R. § 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 CBP 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. Headquarters Ruling Letter (“HQ”) 543568, dated May 30, 1986. In this instance, no information regarding test values has been submitted or is available; consequently, the circumstances of the sale must be examined in order to determine the acceptability of transaction value.
Under the circumstances of sale 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 CBP Regulations specified in 19 C.F.R. Part 152 provide illustrative examples of how to determine if the relationship between the buyer and the seller influences the price. In this respect, CBP 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 C.F.R. §152.103(l)(1)(i)-(ii). In addition, CBP 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 C.F.R. §152.103(l)(1)(iii). These are examples that illustrate that the relationship has not influenced the price, but other factors may be relevant as well.
The importer argues that the price at which HAG sells spare parts to HR is in accordance with the Intercompany Price Guideline, and that the circumstances of the sale indicate that the parties transact business at arm’s length because the price is settled in a manner consistent with the normal pricing practices in the industry. The Intercompany Price Guideline provides that the price for spare parts is based upon the price lists for sales to third parties in the U.S., and that decentralized distributors related to HAG are entitled to a 14 percent discount off the list prices. The discounted price is determined by the resale minus method, under which the resale price to unrelated buyers is reduced by a set margin. This allows HR to achieve a profit level that is consistent with other companies that distribute industrial machinery and equipment, as identified in the Transfer Pricing Report.
We note that the existence of a transfer pricing report 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. HQ 546979 (Aug. 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 548482 (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 546979 (Aug. 30, 2000). Whether products covered by the study are comparable to the imported products at issue is another important consideration. See HQ 547672 (May 21, 2002). The methodology selected for use in a transfer pricing study is also relevant. HQ 548482 (July 23, 2004). Thus, even though HR’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 HR’s transfer pricing study may contain relevant information in examining the circumstances of the sale.
CBP has found that an 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 the industry pricing practices. See HQ 542261 (Mar. 11, 1981), in which Customs determined that where the transfer price was defined with reference to prices published in a trade journal (the posted price), and the posted price was commonly used by other buyers and sellers as the basis of contract prices, the transfer price was acceptable. In such instances, the determination could be made that the transfer price was settled in a manner consistent with the normal pricing practice in the industry. See also HQ H037375 (Dec. 11, 2009), and HQ 548482 (July 23, 2004). 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 (July 23, 2004).
Ernst & Young’s transfer pricing report does not discuss normal pricing practices in the cigarette manufacturing machinery spare parts industry. In addition, the method used by the companies claimed to be comparable to HR to price their products is not addressed in the report. Moreover, we note that the report focuses on the commissions earned by HR for services they provide. However, HR does not earn commissions on its sales of spare parts. The value of spare parts, not services, is the focus of the instant enquiry. Thus, the fact that HR may earn operating profits comparable to companies identified in the transfer pricing report is not persuasive. Furthermore, in order the determine whether the transaction in issue is conducted at arm’s length, CBP Regulations (19 C.F.R. 152.103(l)(1)(1)(iii) interpretive note 3) examine whether the seller received a price that enabled the recovery of all costs, plus a reasonable profit as described in the interpretive note. The focus of interpretive note 3 is the seller’s cost and profit. However, the “tested party” in the transfer pricing report is the buyer/importer. As a result, we find that the study does not provide CBP with the information necessary to conclude that the relationship between the related buyer and seller did not influence the price.
We also note that none of the companies claimed to be comparable to HR are in the tobacco manufacturing industry and, therefore, are not competitors of HR. Through simple research we found several competitor companies in the U.S. that distribute spare parts for cigarette manufacturing machinery that could have been used for a more accurate comparison. We also reviewed the products sold by the companies used in the transfer pricing report and conclude that they are not of the same class or kind as the imported merchandise. The companies in the report distribute products and systems, detailed in the FACTS section above, for the automotive, appliance, aerospace, construction and transportation industries. The parts imported by HR, however, are specific to cigarette producing machinery.
For all these reasons, we find that the transfer pricing study while perhaps conclusive for tax purposes, is not acceptable evidence that sales between HAG and HR are settled in a manner consistent with the normal pricing practices of the tobacco machinery industry for purposes of Customs valuation. Likewise, we find that the Intercompany Price Guideline is not persuasive evidence that the intercompany price is consistent with pricing between unrelated entities because it does not address how the industry sets its prices. Neither the transfer pricing report nor the Price Guideline persuades us that the price for the imported merchandise is not influenced by the relationship between the buyer and the seller.
Finally, we note that the importer freely admits that the relationship between itself and HAG affects the price actually paid or payable for the imported parts. According to the importer, HAG adjusts its prices on a yearly basis so that HR achieves a profit margin that is on par with the companies identified in the transfer pricing study. This consideration is not extended to distributors that are not related to HAG. Accordingly, transaction value is not the appropriate method of appraisement for sales between HAG and HR.
HOLDING:
Based on the information submitted, transaction value is not the appropriate method of appraisement for sales between HR and its parent, HAG.
This decision should be mailed by your office to the party requesting Internal Advice no later than 60 days from the date of this letter. On that date, Regulations and Rulings, Office of International Trade, will make the decision available to CBP personnel and the public on the CBP Home Page at www.cbp.gov, by means of the Freedom of Information Act and other methods of public distribution.
Sincerely,
Monika R. Brenner, Chief
Valuation and Special Programs Branch