Coordinating transfer pricing reports for income tax and customs: can an OECD report be tailored to satisfy both section 482 and customs purposes?

• Author: McClure, J. Harold
• Position: Organisation for Economic Co-operation and Development

Multinationals that produce goods abroad for importation to the United States have asked the U.S. Customs and Border Protection (CBP) whether the report prepared for income tax purposes is sufficient evidence for its intercompany pricing to be at "arm's length." A substantial amount of imports in the United States during 2007 were from related party transactions. Of total imports of $1942.86 billion, nonrelated party transactions amounted to $975.31 billion, or 50.2 percent, of this total, with the remaining $967.52 billion being from related party trade or nonreported party trade. (1)

Imports involving nonrelated party transactions should be recorded at their transactional value. When imported goods represent related party transactions, the importer must provide evidence that the declared value was consistent with the arm's-length value. The importer can satisfy this requirement with a "circumstances of sale" test that the relationship has not influenced the price or that the transaction value closely approximates test values pertaining to identical or similar goods exported at or about the same time as the goods in question.

CBP recently published Customs Guidance on Determining Transaction Value for Related-Party Transactions. If the multinational's report for income tax purposes was based on the Comparable Profits Method, CBP appears to be saying that an OECD report cannot be tailored to satisfy both section 482 and customs considerations. Several customs and transfer pricing practitioners have provided various commentaries on this issue. For example, Damon Pike strongly objected to the CBP ruling in HQ 548482 arguing that Comparable Profits Method should have been sufficient to establish arm's-length pricing for the issues in this case. (2)

The article explains that some of the CBP's concerns could have been alleviated if a CPM analysis had been recast in terms of the Deductive Value Method or its transfer pricing equivalent--the Resale Price Method. It presents a hypothetical example, however, that allows for two differences between a broad-based Comparable Profits Method approach and an appropriate application of the Deductive Value Method. One difference involves variations over time in the operating expense to sales ratio for the related party importer; the other difference occurs when the importer purchases more than one good from its related party supplier.

Other practitioners have analyzed in detail the differences between what income tax authorities and customs authorities expect in a transfer pricing analysis. For example, Pascal Luquet, Jerome Riorda, and Stephanie Thomas discuss how the French income tax authorities view transfer pricing as compared to how the French customs authorities view this issue. (3) Sean Foley, Todd R. Smith, and Vanessa Francisco have analyzed the U.S views of income tax transfer pricing versus customs enforcement, noting the following key customs considerations:

Customs has historically required that the price paid or payable be sufficient to cover the related seller's cost plus a profit that is equivalent to the firm's overall profit. Thus, to support a transfer price for Custom's purposes, any study would have to test the results of the related party foreign seller rather than the U.S. importer. (4) Finally, the article addresses a hypothetical situation where the consolidated profits of the related party foreign seller and U.S. importer are temporarily negative noting that a Comparable Profits Method approach where the importer is the tested party may lead to a lower transfer price for income tax purposes than the CBP approach noted by Foley, Smith, and Francisco. This discuss includes comments on the potential means for reconciling the seemingly divergent views of the IRS and the CBP in such situations.

Is the Comparable Profits Method Equivalent to the Deductive Value Method?

This section considers a hypothetical example of a U.S. distributor of fresh fruits and vegetables that are purchased from a related party foreign supplier. Assume the following:

* the distributor sells $200 million of products per year;

* the cost of producing this product is $160 million per year;

* the operating expenses incurred by the distribution are $20 million; and

* the intercompany pricing policy results in the distributor paying the foreign supplier $175 million per year.

Assume further: Operating expenses equal 10 percent of sales. The distributor receives a 12.5-percent gross profit margin and a 2.5-percent operating margin. Production costs equal 80 percent of sales and the related party supplier's intercompany revenue equals 87.5 percent of sales. Consolidated profits equal $20 million per year with the distributor receiving $5 million in profits and the supplier receiving $15 million in profits.

The intercompany pricing policy may be scrutinized by three tax authorities. While the Internal Revenue Service will ask the U.S. distributor why this $175 million payment should not be reduced, the foreign income tax authority will ask the foreign supplier why this $175 million payment should not be increased. And CBP will ask why the $175 million payment for imported goods should not be increased. The importer can address the CBP question with a "circumstances of sale" test that the relationship has not influenced the price or that the transaction value closely approximates test values pertaining to identical or similar goods exported at or about the same time as the goods in question. CBP considers the following three approaches for evaluating the test value:

* the transaction value of identical merchandise, or of similar merchandise, in sales to unrelated U.S. buyers;

* the deductive value; or

* the computed value.

Each of these methods has parallels in section 1.482-3 of the U.S. transfer pricing regulations. The transactional value is similar to the Comparable Uncontrolled Price method. The Deductive Value Method evaluates the gross profit margin received by the importer and is similar to the Resale Price Method. And the Computed Value Method is similar to the Cost Plus Method, which evaluates the intercompany price by examining the supplier's cost and profitability. The methods listed in section 1.482-3 are also included in chapter 2 of the OECD Transfer Pricing Guidelines. Which method is the most reliable means for evaluating whether an intercompany pricing policy is consistent with the arm's-length standard depends on the particular facts.

A. Evaluating the Applicability of Different Methods

The Comparable Uncontrolled Price method and the Transactional Value Approach are often seen as a reliable means for evaluating commodity prices. While fresh fruits and vegetables are commodity goods, the transfer pricing for two North American cases involving such products was evaluated by determining the gross profit margin received by the related party distributor. GAC Produce v. Commissioner addressed whether the gross profit margin received by a U.S. importer of tomatoes supplied by the Canelos growers was consistent with arm's-length standard. (5) The Canelos growers also owned GAC Produce. While GAC Produce received gross profits that were less than 7 percent of sales, the IRS argued that the gross profit margin should be 11 percent. The expert witnesses for the IRS and for GAC Produce evaluated the gross profit margins received by third-party distributors of Canelos products as well as the gross profit margins received by GAC Produce as a distributor of products supplied by third parties. The functions performed by the third-party distributors that sold Canelos were considered to be materially fewer than the functions performed by GAC Produce.

The Tax Court agreed with the IRS expert's opinion that the only reasonably comparable agreement was the agreement between the Otros growers and GAC Produce. While the gross profit margin in this agreement was 10 percent, the IRS argued that the gross profit margin in the controlled transaction should be higher because of terms-of-credit differences between the uncontrolled and controlled transactions.

Another dispute involved a Canadian blueberry farming operation known as Bridges Brothers Limited that utilized a related party sales agent known as Bridges Wild Blueberry Company to distribute products to a third-party U.S. processor. Bridges Wild Blueberry Company paid Bridges Brothers Limited what it received from the processor minus a fee for packaging and transporting the blueberries to the processor. While the Canadian Revenue Agency argued that the fee should have been substantially lower, this taxpayer was able to convince the Canadian Tax Court that the arm's-length fee, which represented a gross margin for its activity, should be reduced only slightly.

This focus on gross profit margins for the sales entity with respect to the distribution of blueberries and tomatoes may be seen as addressing the circumstances of sales test for customs purposes. The test considers facts such as whether the intercompany price was settled in a manner consistent with the normal pricing practices of the industry in question or settled in a manner consistent with the way the seller settles prices for sales to buyers who are not related to its company. The taxpayer's expert in the GAC Produce litigation discussed the range of commission rates received by distributors of fresh produce imported from Mexico. (6) If the transfer pricing policy can be reliably evaluated by an application of the Resale Price Method, then one can argue that the transfer pricing is consistent with the Deductive Value Method.

The U.S. transfer pricing regulations also list two other methodologies for evaluating intercompany prices: the Profit...