Intra-company transfers of goods and services account for a substantial portion of international trade and it has long been recognized that the prices negotiated in such transfers (transfer prices) may be influenced by a variety of non-market factors, including the desire to export profits to lower tax jurisdictions. For decades, national tax authorities have scrutinized transfer pricing policies to ensure that the taxing jurisdiction receives its fair share of profits and collects its fair share of taxes. While the income tax authorities in Canada and the U.S. have spent the last twenty years developing, refining and explaining their policies for testing transfer pricing decisions, the customs authorities in those countries have been slower to come to grips with the issue.
That has now changed and the customs authorities in Canada and the U.S. have begun to look more carefully at transfer pricing. As a result of that scrutiny, two things have become clear. First, a transfer price that may be acceptable to the income tax authorities may not be acceptable to the customs authorities. Second, a transfer price study that confirms the acceptability of transfer prices for income tax purposes is, in most cases, irrelevant for the purposes of customs valuation.
Getting the customs value wrong can be enormously expensive, not simply in terms of additional duty liabilities and penalties, but in the administrative expense of being forced to determine value on a transaction by transaction basis using an alternative method in the future.
The Customs Value Of Imported Goods
Importers must establish and declare the value of imported goods on an entry-by-entry basis and there are detailed legislative rules for establishing that value.1 The Canadian and U.S. rules for establishing customs value are based on the methodology set out in the Customs Valuation Code.2 As a result, there are broad similarities in the valuation provisions in both countries.3 Legislation in both countries provide for a hierarchy of several different methods for establishing the value for duty of goods: the transaction value of the goods imported; the transaction value of identical goods; the transaction value of similar goods; the deductive value; the computed value and a residual method when all else fails. The vast majority of imports are valued on the basis of the transaction value of the imported goods which is the price paid or payable for the goods in a sale for export4, adjusted in accordance with required additions and deductions.
The Customs Valuation Rules For Related Party Transactions
Under Canadian and U.S. law, the transaction value between related parties is only conditionally acceptable. In the U.S. a related party transaction value is acceptable if it meets a 'circumstances of sale' test or if the value 'closely approximates' certain test values.5 In a recent Informed Compliance publication on the establishment of customs value in related party transactions, U.S. Customs explained the circumstances of sales test as follows:
Under the "circumstances of sale" test, the transaction value between a related buyer and seller is acceptable if an examination of the circumstances of the sale of the imported merchandise indicates that the relationship between the buyer and the seller did not influence the price actually paid or payable.6
The thrust of Canadian legislation is the same; a related party transaction is acceptable providing (i) that the relationship did not influence the price paid or payable for the goods; or (ii) the importer demonstrates that the transaction value of the goods closely approximates certain test values.7 The test values are either the price in an arms-length transaction or the deductive or computed value of the goods.8
Thus, in both countries, related party prices are only acceptable if the parties' relationship did not influence the price or the price meets specific test values. The importer's dilemma is to demonstrate the absence of influence or that the price meets a particular test value. Most companies with significant intra-company trade spend time developing a transfer price policy that is acceptable to the tax authorities and often have transfer price studies that support their pricing decisions. Many will have entered into Advance Pricing Agreements (APA) with the relevant tax authorities. Little thought is given to transfer pricing from a customs perspective. The assumption is that if transfer prices are acceptable to one agency they will be acceptable to others. That assumption is wrong.
Both the U.S. and Canadian customs authorities have made it clear that transfer price studies for income tax purposes, or even APAs, are not determinative of the acceptability of transfer prices for customs purposes.
In its Informed Compliance publication on related party transactions, U.S. Customs states:
Importers sometimes claim that a related party transaction value is acceptable because it satisfies the Section 482 arm's length principle as determined using the best transfer pricing method. Sometimes, a copy of an APA or transfer pricing study is submitted along with the claim. In various rulings addressing this issue, CBP has determined that an APA or transfer pricing study by itself is not sufficient to show that a related party transaction value is an acceptable transaction value. CBP has noted that although the broad goal of both the relevant provisions of the customs and the tax law is the same, i.e., to ensure that related party transactions are at arm's length, there are substantial differences in the legal requirements.9
In a similar vein, the Canada Revenue Agency highlighted the difference between what is acceptable for tax purposes and what is acceptable for customs purposes in Information Circular IC06-1, International Transfer Pricing and Customs Valuation:.
While international transfer pricing rules require related parties to establish supportable transfer pricing procedures for income tax purposes, the value for duty for customs purposes may be different. Information Circular 87-2 states:
The methods for determining value for duty under the current provisions of the Customs Act resemble those outlined in this circular. However, differences do remain. The Department is not obliged to accept the value reported for duty when considering the income tax implications of a non-arm's length importation.10
The customs agencies in both countries have sought to explain why acceptable transfer prices for income tax purposes may not be acceptable for customs valuation purposes.11 The reasons are varied but boil down to the fact that the requirements in the income tax area are different to those in the customs area and a study demonstrating the acceptability of a method in one area will not do the same for the other. For example, customs values must be determined on a transaction by transaction basis whereas income tax rules allow for aggregation and bundling of transactions and prices to determine the proper level of income. Similarly, the establishment of a customs value goes beyond the invoice price for the goods and requires the addition of certain payments (assists, some royalty payments, subsequent proceeds etc.) and the deduction of others (transport cost, fees for post-import services etc.). Those legislated additions and deductions will form part of the customs value on a all-in/all-out basis, without any consideration of the 'reasonableness' of the amount sometimes considered in the income tax context. As another example, while customs and income tax legislation looks to test transfer prices against prices in arms-length transactions, under customs rules, those comparable transactions are limited to those involving identical or similar goods and, in certain circumstances goods of the same class or kind. Generally, for income tax purposes, a wider range of comparable transactions are available. Any study that does not involve the same limitations on the group of comparable transaction is of limited value.
The publication of its Informed Compliance publication on related party transactions in April 2007 is a clear signal from U.S. customs that transfer prices are now on its agenda. That publication puts all importers on notice that they cannot rely on transfer price studies made in an income tax context and that APAs will not necessarily be acceptable for customs purposes. From now on, U.S. customs will consider the failure to examine transfer pricing from a customs valuation perspective, and to document decisions made and conclusions reached, will be considered a lack of reasonable care, exposing the importer to penalties:
The exercise of reasonable care includes an analysis of whether there is sufficient information and documentation to establish that the related party transaction value satisfies the circumstances of sale or test value method, as set forth in 19 U.S.C. §1401a, 19 CFR Part 152, CBP rulings and this Informed Compliance Publication. An importer that relies solely on an APA or transfer pricing study to conclude that transaction value is acceptable would not be exercising reasonable care. 12
Canadian customs authorities have not issued any recently revised policy statement on transfer pricing but have given a strong indication that the issue is one that they are eager to tackle. In a recently revised Audit Manual designed to be used by its field auditors, the Valuations and Origin Division of the Canada Border Services Agency has ordered its auditors to consult with the Valuation Policy Unit "in all cases where it is suspected that the price paid or payable is influenced by relationship"13.
The two agencies have also made it clear that it is the importer's obligation to provide evidence supporting his declaration of value.
It is, therefore, recommended that all importers that declare the value for duty of imported goods on the basis of transfer prices conduct a separate transfer price study to substantiate their value declarations and document that study with supporting data. Such a study can be stand alone or as an annex to the income tax transfer price study. While it is not uncommon for companies to complete tax transfer price studies on an ex post facto basis that practice is not to be recommended for customs. Customs requires an accurate, transaction by transaction declaration of the value for duty of the imported good and, while there are provisions to make post-importation adjustments to customs value in certain circumstances, there is no provision that permits a customs valuation declaration based on estimates or projections.
* This article was first published in North American Free Trade and Investment Report, Vol. 18, No. 2, January 31, 2008.
1. In the U.S., the rules are found in section 402 of the Tariff Act of 1930 as amended by the Trade Agreements Act of 1979, 19 U.S.C. §1401a and the regulations made thereunder (19 CFR Part 152). In Canada, the rules are contained in sections 44 to 56 of the Customs Act, 1985 c.1 (2d Supp.) and the regulations made thereunder.
2. Agreement on Implementation of Article VII of the General Agreement on Tariffs and Trade (Tokyo Round Customs Valuation Code), done at Geneva on November 1, 1979.
3. While there are broad similarities between the legislation in both countries, there can be significant differences in interpretation and administration.
4. In Canada the 'sale for export' must be a 'sale for export to a purchaser in Canada' (Customs Act, op-cite, subsection 48(1)).
5. 19 U.S.C. §1401a(b)(2)(B).
6. Determining the Acceptability of Transaction Value for Related Party Transactions, April 2007, U.S. CBP Publications at p. 6. [http://www.cbp.gov/xp/cgov/toolbox/legal/informed_compliance_pubs/]
7. Customs Act, 1985, c-1, S. 48(1)(d).
8. The deductive value of the goods starts with the first arms-length sale in Canada and arrives at a border price by certain prescribed deductions. The computed value provides a value for duty at the border by certain prescribed additions to the cost of the goods (either acquisition cost or the cost of production).
9. Op. cite. fn. 5 at p.14
10. Income tax Transfer Pricing and Customs Valuation, Canada Revenue Agency, IC06-1, October 2006 at para. 6.
11. Op. cite. fn. 5, especially at pages 12 to 16; Income Tax Transfer Pricing and Customs Valuation, Canada Revenue Agency, IC06-1, [http://www.cra-arc.gc.ca/E/pub/tp/ic06-1/ic06-1-e.html].
12. Op. cite. fn 5, at pg. 7.
13. Trade Verification Manual, Canada Border Services Agency, Version 1.3, February 28, 2007, at 3.5 Exhibit R.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.