OT:RR:CTF:VS H176775 EE
Port Director
U.S. Customs and Border Protection
Area Port of Cleveland
6747 Engle Road Middleburg Heights, OH 44130
RE: Internal Advice Request; Related Party Transactions; Post-Importation Adjustments
Dear Port Director:
This is in response to your memorandum, dated July 13, 2011, forwarding a request for internal advice submitted by KPMG LLP, on behalf of Company B, concerning the appropriate method of appraisement of certain flash memory products imported by Company B from its foreign related party, Company A. The request for internal advice arose in connection with a focused assessment audit conducted by the San Francisco Field Office of the Regulatory Audit Division in 2010.
Company B has asked that certain information submitted in connection with this internal advice request be treated as confidential. Inasmuch as this request conforms to the requirements of 19 C.F.R. §177.2(b)(7), the request for confidentiality is approved. The information contained within brackets and all attachments to this 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:
Company B is a U.S. distributor, and part of a consolidated global group of entities which will be referred to in this internal advice as Company C. Company C is a publicly traded company with headquarters in the United States. Company C designs, develops, manufactures, and markets flash memory products used in a variety of electronic systems and digital devices. The card products are used in a range of consumer electronic devices such as mobile phones, digital cameras, gaming devices, and laptop computers. Company C provides high-speed and high-capacity storage solutions, known as solid-state drives (SSDs) that can be used in lieu of hard disk drives in a range of computing devices including personal computers and enterprise servers. Company C also produces universal serial bus (USB) drives, and moving picture experts group layer-3 audio (MP3) players, as well as embedded flash storage products that are used in a range of systems for the enterprise, industrial, military, and other markets.
Company B purchases flash memory devices and products incorporating flash memory devices from its related party supplier, Company A, for distribution in the U.S. pursuant to the terms of a Distribution Agreement, effective August 1, 2005. Company A is a contract manufacturer located in Country A that arranges for the production of Company B’s products from third party and related suppliers primarily located in Asia. For the purposes of this internal advice request, the merchandise imported by Company B from Company A have been categorized as follows (collectively referred to as “Intercompany Transactions”):
Intercompany Transaction 1: Referred to as “Sales Orders”, these orders are for goods which are sold from Company A to Company B, who in turn sells the same merchandise to unrelated U.S. customers;
Intercompany Transaction 2: Referred to as “Distribution Orders”, these orders are for goods procured for the purpose of replenishing Company B’s own inventories;
Intercompany Transaction 3: Referred to as “Consignment Orders”, these orders are for goods which are consigned by Company B to its U.S. customers. In such transactions, the merchandise is imported into the U.S. and stored in a warehouse. Company A retains title to the merchandise until Company B’s customers in the U.S. purchase the merchandise from Company B which then purchases the merchandise from Company A.
The three types of Intercompany Transactions differ based on how the order is initiated. However, the imported products do not vary, in that regardless of the Intercompany Transaction type, the imported products are flash memory devices and products incorporating flash memory devices purchased from Company A for resale in the U.S. by Company B.
According to Company B, for Intercompany Transaction 1, the value declared at the time of entry is based on the commercial invoice between Company B and its customer in the U.S. These values are flagged for reconciliation with U.S. Customs and Border Protection (“CBP”) on a quarterly or annual basis to adjust for the differences between the price used for importation and the price actually paid to Company A. For Intercompany Transaction 2, the value declared at the time of entry is based on the invoice between Company A and Company B which reflects the goods’ standard cost plus an “uplift” of X percent. Similar to Intercompany Transaction 1, these values are also quarterly or annually reconciled. Regardless of how the transactions are structured and the value declared at entry is determined, the reconciled values are calculated the same way for both Intercompany Transaction 1 and Intercompany Transaction 2.
Company A sells inventory to Company B, who in turn resells the same merchandise to unrelated U.S. customers. The negotiated intercompany price between Company A and Company B considers the U.S. customer’s negotiated price as well as Company A’s and Company B’s role in the transaction. From the price paid by the U.S. customer, Company B seeks to recover its costs as well as a reasonable net operating profit margin for its role as the U.S. distributor. As the party responsible for sourcing and purchasing the inventory, Company A seeks to recover its costs as well as an arm’s length net operating profit margin in the negotiated intercompany price. The total price paid or payable from Company B to Company A is calculated to allow Company B to earn a net operating margin of X percent referred to as the “Agreed Margin”. Based on Company B’s actual revenues and selling costs, transfer pricing adjustments are made on a monthly basis from Company B to Company A so that Company B’s net operating margin does not exceed the Agreed Margin. It is claimed that the Agreed Margin is consistent with the normal pricing practices of the industry.
Company B engaged an independent accounting firm, KPMG, to evaluate the arm’s length nature of the payments between Company B and its direct and indirect subsidiaries. KPMG prepared two transfer pricing studies. The initial transfer pricing study is for the tax year ending December 28, 2008. The second transfer pricing study is for the tax year ending January 3, 2010. The transfer pricing studies were conducted in compliance with Section 482 of the Internal Revenue Code (“IRC”). Section 482 of the IRC (26 U.S.C. §482) requires that the arm’s length result of a controlled transaction be determined under the method that, given the facts and circumstances, provides the most reliable measure of an arm’s length result. The application of the best method establishes an arm’s length range of prices or financial returns with which to test controlled transactions. As stated in the Company B’s transfer pricing studies, the Comparable Profits Method (“CPM”) was determined by KPMG to be the best method to evaluate the intercompany tangible transactions between Company B and Company A. The CPM examines whether the amount charged in a controlled transaction is an arm’s length price for tax purposes by comparing the profitability of the tested party to that of comparable companies. The tested party under the CPM transfer pricing analysis is the entity that performs the least complex functions and faces the least amount of risk. Company B was chosen as the tested party since reliable segmented financial statements of Company B were readily available. Additionally, it was determined that Company B is less complex than Company A with respect to the transaction at issue. KPMG compared the profit level indicators (“PLI”) of Company B during the most recent three historical years (2006 to 2008 for the taxable year ending December 28, 2008; 2007 to 2009 for the taxable year ending January 3, 2010) to the PLIs achieved by the selected independent companies during the same period. KPMG stated that it relied upon multi-year data to mitigate the impact of individual year fluctuations in operating profit that are unrelated to transfer pricing. The PLI selected was the operating margin. Operating margin is calculated as follows: operating profit divided by net sales.
In selecting comparables for its analysis of the Company B’s distribution activities, KPMG used its Interpreter® transfer pricing software to access the Standard & Poor’s Compustat (“Compustat”) database of North American companies and focused on companies under the following Standard Industrial Classification (“SIC”) codes: 5000-5099 (wholesale trade: durable goods) and 5100-5199 (wholesale trade: non-durable goods). For the period 2006 through 2008, the search generated two hundred and ninety (290) potentially comparable companies. For the period 2007 through 2009, the search generated three hundred and twenty-one (321) potentially comparable companies. In order to limit the search, KPMG excluded companies that: had sales and operating profit data available for less than three years; did not have three-year average positive operating profit; had R&D expenses greater than or equal to three percent of sales; inventories more than ten percent of sales; and, operating profit more than $1 billion. Additionally, KPMG refined the list to those that classify themselves as “distributors”; sell consumer electronics, computer hardware, software, peripherals and/or related components to third parties without adding significant value in the process; and own few or no intangible assets. This search and selection yielded eight (8) comparable companies. The financial data for the comparable companies identified were adjusted for differences in levels of accounts receivable, inventory, and accounts payable between tested parties and each comparable company. We note that the comparable companies identified do not necessarily distribute products of the same class or kind as Company B.
For the period 2006 through 2008, the interquartile range of comparable North American distributors period-weighted average operating margins ranged from 0.6 percent at the 25th percentile level to 2.7 percent at the 75th percentile level, with a median of 1.6 percent. Company B’s period-weighted average operating margin was X percent for its distribution of products purchased from Company A during the same period. For the period 2007 through 2009, the interquartile range of comparable North American distributors period-weighted average operating margins ranged from 0.6 percent at the 25th percentile level to 2.5 percent at the 75th percentile level, with a median of 1.7 percent. Company B’s period-weighted average operating margin was X percent for its distribution of products purchased from Company A during the same period. Based on this analysis, KPMG concluded that Company B’s operating margin was within the arm’s length range of operating margins earned by comparable companies during taxable year ending December 28, 2008 and the taxable year ending January 3, 2010.
Additionally, KPMG prepared a supplemental economic analysis for each tax year using information from the respective transfer pricing study to determine whether Company B and Company A settled prices in a manner consistent with the normal pricing practices of the industry. The economic analysis report examined whether Company B’s profits from the resale of flash memory devices and products incorporating flash memory devices are in line with similarly situated distributors in the flash memory industry. KPMG concluded that the operating margins earned by Company C and Company B’s distribution segment were consistent with what unrelated parties acting at arm’s length would have earned during taxable year ending December 28, 2008 and the taxable year ending January 3, 2010.
Company B claims that its transfer pricing policy constitutes an objective formula for purposes of applying transaction value and claiming post-importation adjustments. In support of its position, Company B submitted the following documents: (1) Memorandum from KPMG, addressing the five factors, dated February 8, 2012, and a supplementary submission dated December 19, 2013; (2) Excerpts from the Distribution Agreement between Company B and Company A, dated August 1, 2005, which set out the terms of the transfer pricing policy, and the amendment to the Agreement, dated October 10, 2006; (3) Excerpts from Company B’s Transfer Pricing Studies for Taxable Years Ended December 28, 2008 and January 3, 2010 which tested the transfer pricing policy; and (4) Company B’s financial and tax documents (for calendar year 2008) to demonstrate that the adjusted cost of goods sold (“COGS”) was used to prepare its tax returns and was reported to the IRS.
Finally, Company B submitted sample documents to substantiate a bona fide sale between Company B and Company A. The documents for Intercompany Transaction 1 include: entry summary, commercial invoice issued by Company B to its unrelated US buyer, Company D, and corresponding purchase order and packing list; airway bill; Company B’s accounts payable history; payment records for payments from Company D to Company B; intercompany advice issued from Company A to Company B; Company A’s accounts payable history; payment records from Company B to Company A; and inventory movement reports. The documentation for Intercompany Transaction 2 include: entry summary, commercial invoice issued by Company A to Company B and corresponding packing list, airway bill, payment records from Company B to Company A, and inventory movement reports. Company B also submitted the Distributor Agreement between Company B and Company A reflecting the terms of sale and payment terms for the imported merchandise.
ISSUES:
Do Intercompany Transaction 1 and 2 between the Company B and Company A constitute bona fide sales?
Do the circumstances of sale establish that the price actually paid or payable by Company B to Company A is not influenced by the relationship of the parties and is acceptable for purposes of transaction value?
Is it acceptable to take post-importation price adjustments (upward and downward) into account in determining transaction value?
Is the alternative basis of appraisement utilized for Intercompany Transaction 3 appropriate?
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 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). When transaction value cannot be applied, then the appraised value is determined based on the other valuation methods in the order specified in 19 U.S.C. § 1401a(a).
Do transactions between Company A and the Company B constitute bona fide sales?
In order for transaction value to be used as a method of appraisement, there must exist a bona fide sale between the buyer and the seller. In VWP of America, Inc. v. United States, 175 F.3d 1327 (Fed. Cir. 1999), the Court of Appeals for the Federal Circuit found that the term “sold” for purposes of 19 U.S.C. § 1401a(b)(1) means a transfer of title from one party to another for consideration, (citing J.L. Wood v. United States, 62 C.C.P.A. 25, 33, C.A.D. 1139, 505 F.2d 1400, 1406 (1974)).
No single factor is decisive in determining whether a bona fide sale has occurred. See HQ 548239, dated June 5, 2003. U.S. Customs and Border Protection (“CBP”) will consider such factors as to whether the purported buyer assumed the risk of loss for, and acquired title to, the imported merchandise. Evidence to establish that consideration has passed includes payment by check, bank transfer, or payment by any other commercially acceptable means. Payment must be made for the imported merchandise at issue; a general transfer of money from one corporate entity to another, which cannot be linked to a specific import transaction, does not demonstrate passage of consideration. See HQ 545705, dated January 27, 1995. In addition, CBP may examine whether the purported buyer paid for the goods, and whether, in general, the roles of the parties and the circumstances of the transaction indicate that the parties are functioning as buyer and seller. See HQ 547197, dated August 22, 2000; and HQ 546602, dated January 29, 1997.
Finally, pursuant to the CBP’s Informed Compliance Publication, entitled “Bona Fide Sales and Sales for Exportation,” CBP will consider whether the buyer provided or could provide instructions to the seller, was free to sell the transferred item at any price he or she desired, selected or could select its own downstream customers without consulting with the seller, and could order the imported merchandise and have it delivered for its own inventory.
As noted in the FACTS section of this internal advice, Company B provided numerous sample documentation for Intercompany Transaction 1 and Intercompany Transaction 2 to substantiate its claim that there was a bona fide sale between Company A and Company B. For Intercompany Transaction 1, the intercompany invoice (referred to as “intercompany advice”) from Company A to Company B lists “ex works” term of sale. “Ex works” is a term of sale which means that the seller fulfills his obligation to deliver when he has made the goods available at his premises to the buyer. See Incoterms 2000, International Chamber of Commerce, 27 (1999). Consequently, the buyer assumes all risk of loss or damage involved in taking the goods from the seller’s premises. Id. The air waybill indicates that the merchandise is shipped “freight collect”, which typically means that the receiver of the goods pays the transportation costs. This is consistent with the “ex works” term of sale. The payment records indicate that a wire transfer payment, which references the intercompany advice from Company A to Company B, was made by Company B to Company A. This payment was for the exact amount invoiced on the intercompany advice. Company B acquires title to the imported merchandise in accordance with Section 4.2 of the Distribution Agreement which provides that “except as otherwise agreed upon between Supplier (Company A) and Distributor (Company B) from time to time, all sales by Supplier to Distributor shall be ex works (Incoterms 2000), and title and risk of loss shall pass to Distributor at Supplier’s (or its contract manufacturer’s or logistics provider’s) facility.” Accordingly, based on the description of Company B’s sales process, substantiated by the sample documents submitted, we find that Company B sufficiently proved the existence of a bona fide sale between Company B and Company A under Intercompany Transaction 1. Additionally, there was a sale for exportation to the U.S. since the air waybill lists the airport of departure as Hong Kong and the airport of destination as New York.
For Intercompany Transaction 2, the commercial invoice from Company A to Company B lists “ex works” term of sale. This is supported by Section 4.2 of the Distribution Agreement as previously noted. The payment records indicate that a wire transfer payment, which references the commercial invoice from Company A to Company B, was made by Company B to Company A. This payment was for the exact amount invoiced on the intercompany advice. Accordingly, we find that there is a bona fide sale between Company B and Company A. under Intercompany Transaction 2. Additionally, there was a sale for exportation to the U.S. since the air waybill indicates that the merchandise was shipped from Country B to the U.S.
Do the circumstances of sale establish that the price actually paid or payable by Company B to Company A is not influenced by the relationship of the parties and is acceptable for purposes of transaction value?
In HQ W548314, we determined that the importer needed to show that the relationship of the parties did not influence the adjusted prices. Thus, having established that the Company B’s transfer pricing policy constitutes a formula and that there is a bona fide sale for exportation to the U.S. in this case, we must determine whether the imported merchandise may be appraised under transaction value. There are special rules that apply when the buyer and seller are related parties, as defined in 19 U.S.C. §1401a(g). Specifically, 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). In this case, Company B provided information regarding the circumstances of the sale.
The CBP Regulations specified in 19 C.F.R. 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, 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). Nonetheless, these are examples to illustrate that the relationship has not influenced the price, but other factors may be relevant as well. See 19 C.F.R. §152.103(I); see also HQ H037375, dated December 11, 2009; HQ H029658, dated December 8, 2009; and, HQ H032883, dated March 31, 2010.
In this case, Company B contends that Company B and Company A organize their commercial relations and arrive at prices in a way that demonstrates that their relationship does not influence the price of the imported merchandise. In support of this position, Company B claims that Company B and Company A operate as separate and distinct legal entities with separate financial statement reporting, budgets, performance and operating profit goals. As such, when Company B purchases merchandise from Company A, the commercial relationship is in many respects similar to how Company B would deal with purchases from unrelated sellers.
Company B provided a detailed description of the structure and flow of the transactions between Company B and Company A. Company B claims that it negotiates the transfer of title and risk of loss, the discount to selling price, the payment terms and other relevant commercial terms with Company A, documented in the Distribution Agreement, similar to how it would transact with unrelated suppliers. Company B provided supporting documentation including purchase orders, invoices, proof of payment which are consistent with the Distribution Agreement. The Agreement provides that the negotiated intercompany price between Company A and Company B is based on a discount that allows Company B to earn a net operating margin of X percent. Company B purchases products from Company A at standard costs and based on Company B’s actual revenues and selling costs, books monthly journal entries to adjust the transfer price so that Company B’s net operating margin does not exceed X percent for the applicable accounting period. Additionally, the Distribution Agreement establishes that Company A has the right to refuse Company B’s order, in whole or in part.
While the description and commercial documents show how the transactions between Company B and Company A are structured, this alone is not sufficient for us to conclude that Company A settles prices as it does with unrelated buyers. Company B also argues that the intercompany prices are settled in a manner consistent with the normal pricing practices of the industry. In support of this, Company B submitted transfer pricing studies for the tax year ending December 28, 2008 and the tax year ending January 3, 2010 as well as a supplemental economic analysis for each tax year prepared by KPMG. Company B also submitted a range of information as to how it does business, from its transfer pricing studies to the way it establishes prices with Company A.
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 H029658, dated December 8, 2009; HQ 547672, dated May 21, 2002; HQ 548482, dated July 23, 2004; and, HQ 542261, dated March 11, 1981 (TAA. No. 19) (stating 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).
However, in HQ H029658, while the information presented was not entirely objective, based on the totality of the information considered, CBP held that the importer showed that the sales price was not influenced by the relationship for purposes of the circumstances of the sale test, and, as a result, transaction value was the proper method of appraisement for the related-party import transaction. In HQ H029658, the importer provided various evidence to show that the prices were at arm’s length, including: (1) a detailed description of its sales process and price negotiations; (2) a bilateral APA that was approved by the IRS (the importer was a tested party under the APA, with CPM chosen as the best method to evaluate intercompany transactions); and, (3) a paper, prepared by their accountants, which provided details with respect to the pricing practices in the automotive industry. The evidence presented by the importer did not fall strictly within a single illustrative example, specified in 19 C.F.R. §152.103(l)(1)(i)-(iii), such as the normal pricing practices of the industry. Nevertheless, taken together, the documents provided by the Importer assisted CBP in reaching its conclusion that the relationship of the parties did not influence the price.
As previously noted, in order to show that the circumstances of the sale did not influence the price, Company B submitted two transfer pricing studies for our review and consideration. 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; and HQ 546979, dated August 30, 2000. However, information provided to CBP in a transfer pricing study may be relevant in examining the 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; and HQ 548482, dated July 23, 2004. A significant factor, by way of example, is whether the transfer pricing study has been reviewed and approved by the IRS. See HQ H037375; and 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; and 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 Company B’s transfer pricing studies by themselves are not sufficient to show that a related party transaction value is acceptable for Customs purposes, the underlying facts and the conclusions reached in Company B’s transfer pricing studies may contain relevant information in examining the circumstances of the sale.
In this case, the IRS reviewed Company B’s transfer pricing methodology as set out in the two transfer pricing studies. The CPM performed in the transfer pricing studies compare the operating margins of functionally comparable companies that perform functions, serve markets, and bear risks similar to those of the tested party – Company B. If the transfer pricing results indicate that the operating margins of Company B are within the interquartile range established on the basis of operating margins of comparable companies, the prices charged are viewed as acceptable for income tax purposes. If the operating margins are outside the interquartile range of comparable companies, an adjustment to the price would be made. We note that CPM is the least relevant method for customs purposes. 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. See HQ H219015.
Although KPMG searched for companies that perform functions, serve markets, and bear risks similar to those of Company B, the final set of comparable companies distribute consumer electronics, computer hardware, software, peripherals and/or related components but not necessarily products of the same class or kind as Company B. Under these circumstances, the comparison between Company B and these other companies cannot be considered consistent with the market as a whole. However, even though the Company B’s transfer pricing studies by themselves are not sufficient to show that a related party transaction value is acceptable for Customs purposes, the underlying facts and the conclusions reached in these transfer pricing studies contain relevant information in examining the circumstances of the sale, since these transfer pricing studies confirm the operating profit margins of Company B.
Further, as previously noted, KPMG prepared supplemental economic analyses for FY 08 and FY 09 to determine whether Company B and Company A settled prices in a manner consistent with the normal pricing practices of the industry. These economic analyses were created to demonstrate that the results of the existing transfer pricing studies were similar to the arm’s length results of similarly situated distributors in the flash memory industry.
KPMG indicated that in the flash memory industry, competitors tend to be vertically integrated in a manner that is more akin to Company C’s global operations, rather than to just Company B’s purchase of goods from Company A. Therefore, KPMG evaluated the profits earned by Company B under its distribution segment as well as Company C as a whole. Both segments of profitability were evaluated since Company B distribution segment captured the narrowest level of activity as it relates to the intercompany distribution transaction, and the profitability for Company C as a whole captured the vertical supply chain structure that is evident in Company C’s other key competitors.
KPMG relied on the competitors listed in Company B’s SEC Form 10-K for the respective year of the analysis. KPMG identified two pools of comparable firms performing similar activities to Company C and Company B’s distribution segment in terms of functions performed, risks assumed, and market conditions. The companies identified were those that operate in flash memory semiconductor manufacturing since these companies tend to be vertically integrated in a manner that is more akin to Company C’s operations. KPMG also identified flash memory card and USB manufacturing companies since this business segment represents the majority of Company B’s revenues.
KPMG utilized the CPM method to evaluate whether the operating margins of Company C, and Company B for the distribution of products from Company A, were at arm’s length during FY 08 and FY 09. To implement this analysis, KPMG compared Company C’s and Company B’s distribution segments’ three year and five year period-weighted average operating margins to the range of period-weighted average operating margins achieved by the selected comparable semiconductor manufacturing companies and comparable flash memory and USB companies. KPMG found that Company C and Company B’s distribution segment were both within the three year and five year ranges of companies. Even though the economic analyses were not presented to the IRS, the qualitative data serves as additional evidence that Company B’s operating margins are consistent with the arm’s length range of operating margins earned by companies that distribute goods of the same class or kind (flash memory devices and products incorporating flash memory devices).
Accordingly, even though none of the information provided strictly falls under the three illustrative examples under 19 C.F.R. §152.103(l)(1)(i)-(iii), we find that the sales price will not be considered influenced by the relationship for purposes of the circumstances of the sale test, based on the totality of the information considered and our review and examination of all relevant aspects of the transaction, including the way in which Company B and Company A organize their commercial relations and the way in which the price in question was arrived at. As a result, we determine that transaction value is the proper method of appraisement for the related-party import transactions.
Is it acceptable to take post-importation price adjustments (upward and downward) into account in determining transaction value?
On May 30, 2012, CBP published a notice concerning the treatment of post-import adjustments made pursuant to a formal transfer pricing policy. See Customs Bulletin, Vol. 46, No. 23, dated May 30, 2012. Prior to the Customs Bulletin notice, effective date of July 30, 2012, CBP allowed adjustments, but not under the transaction value basis of appraisement. CBP consistently held that transaction value in the transfer pricing context did not apply because the price was not fixed or determinable pursuant to an objective formula prior to importation. See HQ 547654, dated November 8, 2001 (revoked by HQ W548314, dated May 16, 2012). Nevertheless, sometimes these adjustments were allowed under the “fallback” method of appraisement. In other instances, CBP disallowed the adjustments completely because they were considered to be a post-importation rebate or decrease under 19 U.S.C. §1401a(b)(4)(B).
In HRL W548314, CBP reviewed this matter and proposed a broader interpretation of what is permitted under transaction value to allow a transfer pricing policy/Advance Pricing Agreement ("APA") to be considered a “formula” in the transfer pricing context provided certain criteria are met. HQ W548314 specifically referred to the adjustments made pursuant to a company’s formal transfer pricing policy or APA. In order to claim the post-importation adjustments (upward and downward), all of the following factors must be met:
A written transfer pricing policy is in place prior to importation and the policy is prepared taking IRS code section 482 into account;
The U.S. taxpayer uses its transfer pricing policy in filing its income tax return, and any adjustments resulting from the transfer pricing policy are reported or used by the taxpayer in filing its income tax return;
The company’s transfer pricing policy specifies how the transfer price and any adjustments are determined with respect to all products covered by the transfer pricing policy for which the value is to be adjusted;
The company maintains and provides accounting details from its books and/or financial statements to support the claimed adjustments in the United States; and,
No other conditions exist that may affect the acceptance of the transfer price by CBP.
Therefore, if the importer meets the above referenced factors, CBP will accept the adjusted values, provided these adjusted values meet the circumstances of the sale (or test values) test, because the prices would be established pursuant to a “formula,” even though the prices were not fixed at the time of the importation. In this case, Company B provided detailed information to satisfy the above-referenced criteria.
A written transfer pricing policy is in place prior to importation and the policy is prepared taking IRS code section 482 into account
In the instant case, a written transfer pricing policy is set out in the Distribution Agreement between Company B and Company A. The Distribution Agreement is dated August 1, 2005 which is prior to the dates of the earliest importations under Intercompany Transaction 1 and 2. Under the terms of the transfer pricing policy, Company B earns a net operating margin of X percent with respect to its distribution activities, with periodic, post-importation payments between the parties in order to reach the targeted margins. The transfer pricing policy was tested by conducting formal transfer pricing studies for the taxable years ending December 28, 2008 and January 3, 2010 prepared in accordance with section 482 of the IRC. The transfer pricing studies confirmed that Company B’s operating margin earned in its distribution of products purchased from Company A fell within the interquartile range of operating margins reported by a set of comparable North American distributors.
The U.S. taxpayer uses its transfer pricing policy in filing its income tax return, and any adjustments resulting from the transfer pricing policy are reported or used by the taxpayer in filing its income tax return
Company B states that it filed its income tax returns and reported adjustments based on the methodology presented in its transfer pricing policy. Company B provided financial and tax documents for tax year 2008 to demonstrate that the adjusted COGS are used to prepare its tax returns. The following documents were provided: (1) the first page of the 2008 Income Tax Return Form 1120; (2) Schedule M-3 of the 2008 Income Tax Return Form 1120; (3) 2008 IRS Schedule M Form 5471 (a supplemental IRS form that is part of the tax return and is required to report intercompany transfers); (4) 2008 IRS Schedule M Worksheet; and, (5) Company B’s intercompany product sales account balance detail reports which reflect the amounts recorded for purchases of inventory and transfer pricing adjustments in 2008 as reported on Company B’s IRS Schedule M Form 5471. Upon review of the documents submitted by Company B, we find that there is a link between the adjusted COGS and the tax returns, Company B indeed uses its transfer pricing policy in filing its income tax returns, and the adjustments are reported to the IRS and used by Company B in filing its income tax return.
The company’s transfer pricing policy specifies how the transfer price and any adjustments are determined with respect to all products covered by the transfer pricing policy for which the value is to be adjusted
In this case, the related party price and the adjustments to the price are determined pursuant to Company B’s transfer pricing policy as set out in the Distribution Agreement between Company B and Company A. Paragraph 1(x) of the Distributor Agreement defines “transfer price adjustment” as: “(i) Net Sales minus (ii) Net Sales multiplied by the Agreed Margin minus (iii) COGS minus (iv) Selling Costs.” Appendix B of the Distributor Agreement specifies how the transfer price adjustments are calculated:
Within fifteen days from the last day of each month, or at such other times as the Parties may agree, Distributor (Company B) shall provide Supplier (Company A) with a detailed summary of its actual revenues and Selling Costs for such period. The Parties shall compute the Transfer Price Adjustment so that Distributor’s actual net operating margin is the Agreed Margin for the applicable accounting period. The resulting Transfer Price Adjustment shall increase or decrease COGS in order to for Distributor to achieve the Agreed Margin.
Additionally, section 3.1.1 of the two Transfer Pricing Studies confirm that Company B sets its transfer price in accordance with the Distribution Agreement with Company A. The Transfer Pricing Studies specify the Intercompany Transactions as Company B’s purchase of “products from Company A for resale in the North and South American Markets.” Accordingly, the Transfer Pricing Studies assess the arm’s length nature of all the covered products.
The company maintains and provides accounting details from its books and/or financial statements to support the claimed adjustments in the United States
Company B provided numerous financial and accounting records to support the claimed adjustments. In order to calculate the transfer pricing adjustment amount that must be made each month, Company B determines actual revenues and selling costs for goods purchased from Company A. It then determines the amount of adjustment needed to achieve an operating margin of X percent on those sales. This process is repeated monthly, and summarized on a quarterly basis. Company B provided calculations for the first quarter of 2008 (consolidating the monthly journal entries for January – March).
Company B filed an audited consolidated financial statement as part of its 10K filing with the U.S. Securities and Exchange Commission (“SEC”). Company B did not file segmented reports that would show income earned by Company B specifically on the resale of products purchased from Company A. However, Company B provided segmented financials it maintained for internal reporting purposes, and described how those segmented financials are reconciled with the consolidated financials. The total sales, COGS, and income values listed on the quarterly profit and loss (P&L) reports for Company B (inclusive of transfer pricing adjustments) match the values on the segmented financials for 2008. Therefore, it is possible to trace the claimed adjustments, as reflected in the quarterly P&L’s to the segmented financials, which then reconcile to the consolidated financial statements filed with the SEC for 2008. Company B’s audited consolidated financial statement shows a 2008 total net loss of X which is consistent with Schedule M-3 of Company B’s tax return for 2008.
No other conditions exist that may affect the acceptance of the transfer price by CBP
Pursuant to our review of the documents submitted, we find that there are no other conditions that may affect the acceptance of the transfer price by CBP. As long as Company B maintains and provides accounting details from its books and/or financial statements to support the post-importation adjustments upon making a claim with CBP, Company B may claim downward and upward post-importation adjustments. Accordingly, post-importation adjustments (both upward and downward), to the extent they occur, may be taken into account in determining the transaction value under 19 U.S.C. §1401a(b).
Is the alternative basis of appraisement utilized for Intercompany Transaction 3 appropriate?
Company B states that for Intercompany Transaction 3, Company A retains title to the merchandise until Company B’s customers in the U.S. are ready to purchase it from Company B. Once requested by the U.S. customers, Company B purchases the merchandise from Company A and sells to the U.S. customers based on the contracted rates.
In order to use transaction value as the basis for appraisement, there must be a bona fide sale. If there is no sale, as in the case of merchandise imported under consignment, then appraisement must be based on another method set forth in 19 U.S.C. § 1401a, the valuation statute, taken in sequential order.
The second appraisement method in order of statutory preference is transaction value of identical and similar merchandise under 19 U.S.C. §1401a(c). This method refers to a previously accepted transaction value of identical or similar merchandise that was exported at or about the same time as the merchandise being valued. Treasury Decision (T.D.) 91-15, dated March 29, 1991. The term “identical merchandise” is defined in 19 U.S.C. §1401a(h)(2) as:
merchandise that is identical in all respects to, and was produced in the same country and by the same person as, the merchandise being appraised; or,
if merchandise meeting the requirements under subparagraph (A) cannot be found..., merchandise that is identical in all respects to, and was produced in the same country as, but not produced by the same person as, the merchandise being appraised.
The term “similar merchandise” is defined in 19 U.S.C. §1401a(h)(4) as:
merchandise that – (i) was produced in the same country and by the same person as the merchandise being appraised, (ii) is like the merchandise being appraised in characteristics and component material, and (iii) is commercially interchangeable with the merchandise being appraised; or
if merchandise meeting the requirements of subparagraph (A) cannot be found..., merchandise that – (i) was produced in the same country as, but not produced by the same person as, the merchandise being appraised, and (ii) meets the requirement set forth in subparagraph (A) (ii) and (iii).
Company B states that the merchandise is identical in all respects to and is sourced by Company A from the same suppliers as is other merchandise purchased from Company A; the transaction value is based on sales at the same commercial level and in substantially the same quantity; and the consignment merchandise is exported to the U.S. about the same time as other merchandise from Company A. Based on the information presented, we find that the merchandise imported under Intercompany Transaction 3 can be appraised pursuant to 19 U.S.C. §1401a(h)(2) using previously accepted transaction values.
HOLDING:
In conformity with the foregoing, transactions between Company B and Company A under Intercompany Transaction 1 and Intercompany Transaction 2 constitute bona fide sales. We also determine that transaction value is the appropriate method of appraisement for these transactions. Finally, we find that Company B may take into account downward and upward post-importation adjustments to the provisional values of the imported merchandise declared to CBP.
Under Intercompany Transaction 3, the importer merchandise must be appraised pursuant to 19 U.S.C. §1401a(h)(2) using previously accepted transaction values.
This decision should be mailed to the internal advice applicant no later than sixty days from the date of this letter. On that date, Regulations and Rulings of the Office of International Trade will make the decision available to CBP personnel and to the public via the CBP Home Page on the World Wide Web at www.cbp.gov, through the Freedom of Information Act, and by other methods of public distribution.
Sincerely,
Monika R. Brenner
Chief
Valuation & Special Programs Branch