Related Party Pricing - CBP v. IRS

May 15, 2007
By: Alan Goggins

                                              Related Party Pricing – CBP vs. IRS[1]


By:  Alan Goggins[2]

             U.S. Customs and Border Protection (“CBP”) recently issued a new Informed Compliance Publication What Every Member of the Trade Community Should Know About: Determining the Acceptability of Transaction Value for Related Party Transactions (April 2007) which can  be found here.   While this publication does not break any new ground, it is a signal that CBP may perhaps scrutinize related party valuation issues more closely in the near future. 

             Related party transactions typically arise whenever either the overseas exporter or the U.S. importer directly or indirectly owns or controls 5 percent or more of the voting stock of the other party, or if both directly or indirectly control, are controlled by, or are under common control of a third party.   The prices in such related party transactions are regulated in the U.S. both by CBP and the U.S. Internal Revenue Service (“IRS”), and may be regulated overseas as well by the exporting country’s version of the IRS. 

             The requirements imposed by CBP and IRS are similar in theory as both seek to establish that the related party prices are conducted at arm’s length, but these requirements are sometimes drastically different in the details of their application.  Under the valuation statute (19 U.S.C. § 1401a) administered by CBP, the value declared for imported merchandise is almost always determined under the transaction value standard because the statute requires that the secondary methods of appraisement (transaction value of identical or similar merchandise, deductive value or computed value) be used only after the primary transaction value method is rejected.  Transaction value is defined as “the price actually paid or payable for the merchandise when sold for exportation to the United States” plus certain additions.  If such prices are between unrelated parties, the inquiry ends.  If related parties are involved, however, CBP may inquiry as to whether such prices are acceptable for determining transaction value. 

             If the exporter and importer are related, one way to avoid CBP inquiry into the acceptability of the related party prices is first sale appraisement.  The possibility of first sale appraisement exists if the related exporter purchases the merchandise from an unrelated factory and such transactions otherwise qualify as sales for exportation to the United States.  The basic requirements here are that the factory knows the goods are destined for the United States and that the transactions be established as sales.  Once these requirements are met, CBP is faced with a transaction value based on prices in sales between unrelated parties, and the inquiry ends.  The advantages to this method are that the exporter’s mark-up is not included in the values declared to CBP, resulting in lower duties, and that the sometimes onerous documentation requirements discussed below for supporting related party prices can be avoided. 

             I.  CBP Related Party Pricing Tests

             Absent the availability of first sale appraisement, under the Customs laws, related party prices are acceptable for transaction value purposes if they meet either the circumstances of sales test or a test value.  While evidence sufficient to meet only one test is required, we do not recommend reliance on only one test. 

                         A.  Circumstances of Sales Test

             The circumstances of sales test is met if the analysis reveals that the relationship between the buyer and the seller did not influence the prices paid which can be demonstrated in three different ways.  Under Variation 1, the circumstances of sales test is met if the related party prices are settled in a manner consistent with the normal pricing practices in the industry.  An example occurs when the related party prices are tied to quoted public market prices such as for traded commodities. 

             Variation 2 is met if the related party prices are settled in a manner consistent with the way the seller settles prices in sales to unrelated buyers.  As an example, if the exporter sells the same merchandise to unrelated buyers in the U.S. or in other countries and uses the same pricing formulas or if the prices are comparable at the same level of trade, then the related party prices are acceptable for CBP purposes.  The documentation necessary to satisfy CBP here would include a comparative analysis of the related and unrelated prices converted into a common currency, along with sales invoices from the exporter demonstrating such prices.  CBP prefers a comparison using prices in sales to unrelated parties in the U.S., but will accept comparisons to prices in sales to unrelated parties outside the U.S. if such sales do not exist in the U.S. and an adequate explanation of such sales is provided. 

             The third variation of the circumstances of sales test is met if the related party price is adequate to ensure recovery of all the exporter’s costs plus a profit equal to its overall profit realized over a representative period of time such as a year in sales of merchandise of the same class or kind.  Anytime an analysis of the cost of production is undertaken, the amount of documentation necessary to satisfy CBP as to the accuracy of such costs is enormous, and Variation 3 is therefore only recommended as a back-up method or if Variations 1 and 2 do not apply. 

                         B.  Test Values

             The second method of establishing the acceptability of related party prices is to determine whether such prices closely approximate the appraised value of the merchandise if one of the secondary methods of appraisement were used.  Three variations again exist.  The first test value is the transaction value of identical or similar merchandise in sales to unrelated buyers in the United States.  This variation thus requires the exporter to sell to unrelated buyers in the U.S., or to have access to and documentation of its competitors’ prices in sales to unrelated buyers in the U.S.

             Deductive value is the second possible test value and starts with the U.S. importer’s resale prices to unrelated buyers in the U.S. and then backs out the duties and freight, the importer’s selling, general and administrative costs, and the profits in the U.S.  The last possible test value is computed value which looks at the exporter’s cost of production, general overhead and profits. 

             Unfortunately, CBP has a policy of not accepting any test values unless one of the secondary appraisement methods was actually used in a previous importation and accepted by CBP.  This policy effectively rewrites the statute and eliminates test values.  If the valuation statute requires an importer to use transaction value unless such method is rejected, then an importer would not have had the opportunity to use a secondary method of appraisement until after CBP questioned the acceptability of the related party prices.  According to CBP, by then it is too late. 

             Only a few court cases have addressed related party pricing under the Customs laws.  Although this “policy” has been raised in those cases, the court decisions have not discussed it.  BR&C recommends reliance on test values only as a back-up method. 

             II.  IRS Transfer Pricing Tests

             Unlike CBP which only has the option of accepting or rejecting related party prices for transaction value appraisement purposes, the IRS can adjust transfer prices for tax purposes if such prices do not meet one of the IRS tests.  The IRS has several profit-based methods and three transaction-based methods for reviewing transfer prices.  In addition to using one of these methods, the IRS also requires a taxpayer to demonstrate that the method used provides the best and most reliable measure of the arm’s length nature of the transfer prices. 

                         A.  Profit-Based Methods

             The profit-based methods include the comparable profits, comparable profit split and residual profit split methods, all of which focus on overall profits and not on specific transactions.  Profit comparisons are made either between the related parties or between the related parties and competitors.  Because a customs value must be ascertained for each imported article, these IRS methods will generally not establish the acceptability of such related party prices for CBP purposes.

                         B.  Transaction-Based Methods

             The IRS’s transaction-based methods include the comparable uncontrolled price or CUP method, the resale price method and the cost plus method.  The CUP test compares the related party transfer prices to the prices in sales to unrelated parties.  This method is thus very similar to CBP’s circumstances of sales test Variation 2 and could possibly be met by the same type of documentation – an analysis comparing such related and unrelated prices and the sales invoices demonstrating such prices. 

             The IRS’s resale price method compares the gross margin earned in related party sales to the gross margin earned in sales to unrelated parties.  This method is typically used for a reseller.  The IRS’s cost plus method is ordinarily used in the context of a manufacturer and again compares the gross margins earned in related and unrelated party sales.  The resale price method is thus somewhat similar to CBP’s deductive test value and the cost plus method is somewhat similar to CBP’s circumstances of sales test Variation 3 or the computed test value, but both of these IRS methods would have to undergo significant adjustments before they were acceptable to CBP.

             III.  CBP vs. IRS

             Proactive U.S. taxpayers can obtain an advanced pricing agreement (“APA”) with either the IRS or with the IRS and the overseas taxing authorities.  Absent an APA, many multinational companies prepare their own transfer pricing studies based on the IRS methods to support their transfer prices.  In the Informed Compliance Publication, CBP has served notice that the existence of an APA or a transfer pricing study by itself will not satisfy their inquiries into the acceptability of related party prices for transaction value appraisement purposes.  Rather, the importer must demonstrate how the IRS transfer pricing method used also satisfies one of the CBP tests.  Similar in effect to an APA, a proactive importer can apply for a CBP ruling approving its related party pricing. 

             The only IRS method that would appear to readily satisfy a CBP test as well is the CUP test.  Information found in the other IRS transaction-based methods may help support one or more CBP tests, but significant adjustments would have to be made. 

             One other aspect of the interplay between the IRS and CBP with regard to related parties deserves mention.  Under 26 U.S.C. § 1059A, the inventory costs of imported merchandise taken into account by a related party importer for IRS purposes shall not exceed the value declared to CBP.  This statute does not apply to first sale appraisements but applies a double penalty when, for example, a related party importer does not declare an assist[3], one of the required additions to the price paid or payable.   Not only is the importer subject to CBP penalties for undervaluing its imported merchandise, but the IRA can disallow the tax deduction for the cost of that assist. 


             Many companies devote a significant amount of time and resources preparing for the day the IRS knocks on the door and questions the transfer prices.  Companies typically do not, however, devote a comparable amount of time and resources preparing for the day CBP questions the acceptability of the related party prices for purposes of transaction value appraisement.  BR&C has a practice devoted to Customs and International Trade and can help you prepare for CBP’s inquiries or apply for a CBP ruling.  The recent Informed Compliance Publication serves notice that the day CBP knocks on your door is probably sooner rather than later. 

[1]  Copyright 2007 Barnes, Richardson & Colburn.

[2]   Mr. Goggins is a partner in the New York office of Barnes, Richardson & Colburn (“BR&C”) where his practice includes customs and international trade law.  Mr. Goggins is also a CPA. 

[3]   Common assists include materials, components, tools, dies or molds supplied free of charge or at a reduced cost by the buyer of imported merchandise to the overseas parties.