The Interaction Between Transfer Pricing and Customs Value

By William H. Newton, III*
Bittingham v. Commissioner, 66 T.C. 373 (1976), afford., 598 F. 2d 1375 (5th Cir. 1979) held that an importer of ceramic tile from Mexico on its sale to an ostensible related person in the United States could adopt inconsistent vales for transfer pricing and customs purposes. This led to the United States Government’s being whipsawed in terms of the overall revenue collected, i.e., income otherwise subject to United States income taxation  was shifted abroad due to a higher transfer price with reduced customs duty.
To remedy this disparity in tax treatment, Congress adopted I.R.C. §1059A. The policy behind this provision is to place a ceiling on the basis of the imported inventory for transfer pricing in an amount equivalent to its value for customs purposes.
By way of overview, in a basic transfer pricing scenario the standard applied is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. At the outset, the focus is directed to the functions performed and the risks undertaken by the controlled taxpayer as compared with similar functions and risks of uncontrolled taxpayers. On identification of comparable taxpayers, the relevant financial data are then utilized in a manner which yields the most reliable arm’s length result.
In terms of the interaction of transfer pricing and customs duty, the often overlooked effect of I.R. C. §1059A should necessarily be duly taken into account. For this purpose, I.R.C. §1059A applies only to property imported into the United States in a transaction between persons who are related for transfer pricing purposes under I.R.C. §482. As the application of I.R.C. §1059A is itself based on customs duty, where the imported property is not subject to any customs duty or is subject to a free rate of duty, e.g., the General System Preferred Trade Agreement, etc., I.R.C. §1059A is inapplicable. In applying the ceiling on the basis of the imported inventory, the customs value of the imported property may be increased by amounts incurred and properly included in inventory costs for freight, insurance, and other miscellaneous expenses.

To avoid imposition of a transfer pricing penalty a report addressing pertinent transfer pricing considerations must be prepared, consistent with the criteria of the Internal Revenue Code and its underlying Treasury Regulations. The report must be duly finalized and in existence by the due date of the required income tax return for the relevant taxable year to which the transfer pricing report is directed.

Curiously, the Regulations do not address the substantive criteria of I.R.C. §1059A for purposes of the transfer pricing report. Even so, to claim the exception to imposition of the penalty for a reportable transaction understatement, the existence of reasonable cause and good faith must be established. A corresponding showing of compliance with the requirements of I.R.C. §1059A would be expected not only to enhance the position that such requirements have been satisfied but in addition that the I.R.C. §482 transfer prices as utilized are indeed arm’s length. The effect may likewise forestall or even conclude an otherwise ongoing I.R.S. audit.

As a result, it is recommended that the criteria of I.R.C. §1059A be duly addressed in conjunction with preparation of the transfer pricing report. The intended objective is not only to be fully prepared for the potential of an audit by the I.R.S. but most importantly to keep the client fully informed of the associated risks in the event of a divergence, especially a substantial one, between the basis of the imported inventory and its customs value.

*William H. Newton, III is author of the two volume treatise, International Income Tax and Estate Planning, published by Thomson Reuters, a practicing attorney in Miami, Florida, an adjunct professor of law in the Masters of Tax Program at the University of Miami School of Law for over 25 years, author of numerous articles regarding international tax and international estate planning, and a graduate of the Massachusetts Institute of Technology and Southern Methodist University.