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How to Bridge the Gap Between Transfer Pricing and Customs Valuation by Beomjune Kim Reprinted from Tax Notes Int’l, September 9, 2013, p. 1031 Volume 71, Number 11 September 9, 2013 (C) Tax Analysts 2013. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

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Page 1: How to Bridge the Gap Between Transfer Pricing and ... to Bridge the Gap Between Transfer Pricing and Customs Valuation by Beomjune Kim I n May 2006, two international bodies, the

How to Bridge the Gap BetweenTransfer Pricing and CustomsValuation

by Beomjune Kim

Reprinted from Tax Notes Int’l, September 9, 2013, p. 1031

Volume 71, Number 11 September 9, 2013

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TaxA

nalysts2013.A

llrightsreserved.

TaxA

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notclaim

copyrightin

anypublic

domain

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partycontent.

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How to Bridge the Gap Between Transfer Pricing andCustoms Valuationby Beomjune Kim

In May 2006, two international bodies, the OECDand the World Customs Organization (WCO), held

a joint conference with experts from the private sector.This joint conference was followed by a second confer-ence in May 2007. The issue they address is how toreconcile transfer pricing with customs valuation.Transfer pricing and customs valuation are regarded asthe backbones of tax administration and customs ad-ministration. However, essential differences betweenthe two systems often create contradictory results thatare undermining consistency and certainty.

The goal of this article is to describe and analyzethese inconsistencies. Specifically, this article explainsthe essential differences between transfer pricing andcustoms valuation (Section I), reviews typical chal-lenges arising from such differences by examining tworecent cases (Section II), explores the recent develop-ments in bridging the gap between transfer pricing andcustoms valuation (Section III), examines how to revisethe OECD and WCO rules or commentaries (SectionIV), and analyzes a few current coordination systemsfor reducing the inconsistency risks (Section V).

I. Two Arm’s-Length PrinciplesA multinational enterprise manufactures and sells

goods through its global supply chain. For example,company X in Nigeria exports raw materials to its par-ent company Y in the United States. Then, Y manufac-tures and supplies finished goods to Y’s subsidiarycompany Z in Korea that sells them in Korea. Thissupply chain is controlled by Y.

For income tax purposes, every transaction in thissupply chain is subject to transfer pricing rules, becauseX, Y, and Z are related parties. According to theOECD’s Transfer Pricing Guidelines for MultinationalEnterprises and Tax Administrations (OECD guide-lines), the objective of transfer pricing rules is to ensurethat each enterprise reflects income attributable to con-trolled transactions and to prevent tax avoidance byallocating profits of transactions between related par-ties.1 Thus, the tax authorities of Nigeria, the UnitedStates, and Korea may make adjustments to transferprices and income, unless raw materials or finishedgoods are at an arm’s-length price. Section 482 of theU.S. Internal Revenue Code grants the IRS the author-ity to allocate profit arising from related-party transac-tions. The OECD guidelines suggest the comparableuncontrolled price method, the resale price method, thecost plus method, the transactional net marginmethod,2 and the transactional profit split method as

1OECD, Transfer Pricing Guidelines for Multinational Enter-prises and Tax Administrations, para. 1.6 (July 2010), available athttp://www.oecd-ilibrary.org/taxation/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-2010_tpg-2010-en.

2The transactional net margin method of the OECD guide-lines is similar to the comparable profit method of Treas. reg.section 1.482-5(a). Marc M. Levey and Steven C. Wrappe, Trans-fer Pricing: Rules, Compliance and Controversy, para. 1420.03, at 386(3rd ed. 2010).

Beomjune Kim is a graduate of the International Tax Program at New York University School of Law in2013 and an associate with Yulchon LLC in its tax group in Seoul.

This article was prepared as part of a directed research project under the supervision of professor H.David Rosenbloom. The author is grateful to professor Rosenbloom for his comments and guidance. Theresponsibility for the content of this article rests solely with the author.

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measures to determine an arm’s-length price.3 AnMNE or a tax authority should choose the bestmethod among them in accordance with the circum-stances of each case.4

Besides transfer pricing, MNEs have another arm’s-length standard issue to consider in related-party trans-actions — customs valuation. The sales of goodswithin an MNE group should be at an arm’s-lengthprice for customs purposes. The arm’s-length principleof customs valuation is stated in the Agreement onImplementation of Article VII of the General Agree-ment on Tariffs and Trade 1994 (the agreement) of theWTO. In principle, the customs value of all importedmerchandise means the actual price paid or payable forthe goods. This approach is usually known as thetransaction value method.5 However, there is a possibil-ity that transfer prices of raw materials or finishedgoods are influenced by the relationship between Xand Y, or Y and Z. In general, in determining whetherthe relationship has affected the prices, customs au-thorities use the ‘‘circumstances of sale’’ test.6 Thetransaction value method will not apply if the circum-stances of sale test shows that the prices are influencedby any relationship between the parties. Instead of thetransaction value method, other appraisement methodswill apply in the following order: the transaction valueof identical or similar goods method, the deductivevalue method, the computed value method, and thefallback method.7

Although transfer pricing and customs valuation arepursuing the same goal (that is, the arm’s-length price),they are different in many respects. The main differ-ences may be summarized in four basic items. First,transfer pricing adopts the best method principle, whilecustoms valuation is based on a strict hierarchy.

Second, customs valuation has no valuation methodsimilar to the transactional net margin method or thecomparable profit method,8 which is often chosen asthe best method in an advance pricing agreement or atransfer pricing policy.9 Third, the functions or risks ofeach enterprise are important factors in applying trans-fer pricing rules.10 For instance, the expected return ofa distributor with marketing responsibilities is usuallyhigher than that of an agent without such responsibili-ties.11 On the other hand, the key point of customsvaluation is not the functions of an importer, but theobjective value of each product itself.12 Therefore, cus-toms valuation puts an emphasis on product similar-ity.13 Fourth, the aggregation of transactions is a usefulconcept for determining whether related-party transac-tions are consistent with transfer pricing rules.14 Forexample, a subsidiary imports printers at a low priceand toner cartridges at a high price from its foreignparent company. Although each item is sold at a pricethat is not an arm’s-length price, the total profit at thetime of filing the tax return may be consistent with thearm’s-length principle,15 because the objective of trans-fer pricing is allocating profits or income between re-lated parties. However, customs duty is imposed on theobjective value of goods themselves. Thus, wheneverthe subsidiary imports printers and toner cartridges,

3OECD, supra note 1, at para. 2.1.4Id. at para. 2.2.5Article 1.1 of the agreement.6Article 1.2(a) of the agreement. In addition to the circum-

stances of sale test, article 1.2(b) of the agreement suggests an-other approach for determining the influence of the relationshipon the price, namely, the test value method. According to article1.2(c) of the agreement, however, the test value method is animporter-initiated approach and can be used only for compari-son. Thus, the test value method is rarely used in practice. SeeLiu Ping and Caroline Silberztein, ‘‘Transfer Pricing, CustomsDuties and VAT Rules: Can We Bridge the Gap?’’ 1 World Com-merce Rev. 36, 37 (2007), available at http://www.oecd.org/ctp/transfer-pricing/39265412.pdf; Mayra O. Lucas Mas, ‘‘Section1059A: An Obstacle to Achieving Consistent Legislation?’’ Int’lTransfer Pricing J. 3, 3 (Jan./Feb. 2008); William M. Methenitisand Steven C. Wrappe, ‘‘The Growing Need for Harmonizationof Transfer Pricing and Customs Valuation,’’ 17 Tax Mgmt. Trans-fer Pricing Rep. S-3, S-13 (Aug. 28, 2008). For these reasons, thisarticle will focus on the circumstances of sale test.

7Articles 3-7 of the agreement.

8U.S. Customs and Border Protection, ‘‘What Every Memberof the Trade Community Should Know About: Determining theAcceptability of Transaction Value for Related Party Transac-tions,’’ 15 (Apr. 2007), available at http://www.cbp.gov/linkhandler/cgov/trade/legal/informed_compliance_pubs/icp089.ctt/icp089.pdf; Caroline Silberztein, ‘‘Transfer Pricing,OECD Policy Framework,’’ in: Anuschka Bakker and BelemaObuoforibo, eds., Transfer Pricing and Customs Valuation: TwoWorlds to Tax as One, 33, 46 (2009).

9IRS, Announcement and Report Concerning AdvancePricing Agreements, 11 (Mar. 25, 2013), available at http://www.irs.gov/pub/irs-drop/a-13-17.pdf (indicating that the transac-tional net margin method/CPM accounted for 75 percent of thetransfer pricing methods used for APAs executed in the U.S. in2012 regarding tangible and intangible property).

10OECD, supra note 1, at para. 1.42; U.S. Customs andBorder Protection, supra note 8, at 15; Sheri Rosennow andBrian J. O’Shea, A Handbook on the WTO Customs Valuation Agree-ment, 85 (2010).

11OECD, supra note 1, at para. 1.47.12U.S. Customs and Border Protection, supra note 8, at 14;

Levey and Wrappe, supra note 2, at para. 1510.04, at 400.13Articles 2 and 3 of the agreement; Rosennow and O’Shea,

supra note 10, at 85; U.S. Customs and Border Protection, supranote 8, at 15.

14U.S. Customs and Border Protection, supra note 8, at 14;Levey and Wrappe, supra note 2, at para. 1510.04, at 401.

15OECD, supra note 1, at para. 3.10; Levey and Wrappe, su-pra note 2, at para. 1510.04, at 401.

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each of them must be separately evaluated and de-clared under the duty rates of tariff classification uponthe entry of each item.16 That means each item’s cus-toms value should be at an arm’s-length price for cus-toms purposes, regardless of business strategies.

II. Cases Showing InconsistencyThe differences explained above often give rise to

inconsistency concerns regarding transfer pricing andcustoms valuation. Complying with transfer pricingrules sometimes results in difficult customs valuationissues. This article will analyze two recent Koreancases showing how inconsistency issues arise.

A. Watch Manufacturing MNE1. Facts and CircumstancesThis case (Tax Tribunal, Josim 2012 Gwan 0008,

Dec. 11, 2012 (R.O.K.)) involved a Korean company(KC) and a foreign company (FC). Both companieswere members of an MNE group manufacturing andselling luxury watches. KC was engaged in the businessof importing luxury watches from FC and selling themto customers in Korea. In May 2006, KC entered intoa unilateral APA with the National Tax Service of Ko-rea. The APA adopted the transactional net marginmethod and set an arm’s-length net margin rate at 6.8percent. In order for KC to maintain the arm’s-lengthnet margin rate described in the APA, FC lowered itsselling prices prospectively twice, by 14.3 percent inAugust 2006 and again by 11 percent in August 2007.KC paid customs duties under such adjusted prices.The Korea Customs Service (KCS) regarded these priceadjustments as influenced by the relationship betweenKC and FC. Thus, the KCS imposed additional cus-toms duties on KC, and KC appealed to the TaxTribunal.17

2. HoldingThe Tax Tribunal held that it was not a general

practice between unrelated parties to adjust importprices downward under an APA. However, the TaxTribunal found certain facts showing the possibilitythat the relationship between KC and FC might nothave influenced import prices regardless of price ad-justments. Accordingly, the Tax Tribunal reversedKCS’s position and ordered it to re-audit the case.

B. BMW Korea1. Facts and Circumstances

In BMW Korea (Seoul High Court [Seoul High Ct.],2012 Nu 1961, Nov. 30, 2012 (R.O.K.)), BMW Korea,a Korean company, imported automobiles and compo-nents from BMW AG, its German parent company,

and sold them to customers in Korea. BMW AG estab-lished a transfer pricing policy that set import prices soas to reflect market risks and currency risks. The keypoints of the transfer pricing policy included the fol-lowing:

• if BMW Korea generated losses over a longperiod of time, these were compensated by BMWAG with future effect by the adjustment of plantsales prices;

• BMW Korea’s sustained currency changes out ofthe targeted currency band were compensated bythe adjustment of plant sales prices; and

• BMW Korea’s target range for operating marginwas between 1.5 and 3.5 percent.

Because of the sharp increase in the currency ex-change rates during 2008, BMW Korea’s margin dete-riorated to -10.83 percent. Accordingly, BMW AG andBMW Korea made a compensating adjustment in orderto maintain BMW Korea’s operating margin within therange of 1.5 to 3.5 percent. Specifically, BMW AGlowered transfer prices by 14 percent retroactively andreturned €38 million to BMW Korea in December2008. In 2009 BMW AG and BMW Korea made anamendment in order to clarify the price adjustmentmeasures resulting from currency change or the differ-ence between expected sales and actual sales. BMWKorea requested a refund of €38 million in customs,arguing that the compensating adjustment was basedon a price review clause and the retroactively adjustedtransfer price was the actual transaction value of im-ported goods. However, the KCS declined BMW Ko-rea’s request and BMW Korea appealed to the TaxTribunal. After the Tax Tribunal affirmed KCS’s posi-tion, BMW Korea filed a lawsuit in the Incheon Dis-trict Court. However, the Incheon District Courtagreed with KCS’s position, and BMW Korea appealedthe decision to the Seoul High Court.

2. Compensating Adjustment and Price Review Clause

The concepts of the compensating adjustment andthe price review clause are critical in understandingthis case. In order to reduce transfer pricing compli-ance risks, many MNEs enter into APAs with tax au-thorities about the relevant transfer pricing method andthe arm’s-length price of related-party transactions.However, the APA process usually requires so muchtime and cost that taxpayers often establish transferpricing policies by taxpayer-initiated transfer pricingstudies instead of APAs.18 If taxpayers develop transferpricing policies, they may make self-initiated compen-sating adjustments at the end of each business year,when the results of their transfer pricing policies are

16U.S. Customs and Border Protection, supra note 8, at 14;Levey and Wrappe, supra note 2, at para. 1510.04, at 400-401.

17In Korea, the Tax Tribunal is a mandatory administrativeappeal process before filing a lawsuit in the court.

18U.S. Customs and Border Protection, supra note 8, at 14;Damon V. Pike and Lawrence M. Friedman, Customs Law, 222(2012).

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different from what they have expected.19 The BMWKorea case is a good example of compensating adjust-ments. In this case, BMW AG lowered transfer pricesretroactively and gave €38 million back to BMW Koreaat the end of 2008 because they could not maintain thearm’s-length profit targeted in their transfer pricingpolicy because of the unexpected currency change.

Commentary 4.1 of the WCO Technical Committeeon Customs Valuation states that the price reviewclause is usually used when an importer imports goodsat a provisional price and the final price will be deter-mined according to factors described in the contract.20

Commentary 4.1 illustrates a few examples of the pricereview clause as follows:

The first is where the goods are delivered someconsiderable time after the placing of the originalorder (e.g. plant and capital equipment made spe-cially to order); the contract specifies that the fi-nal price will be determined on the basis or anagreed formula which recognizes increases or de-creases of elements such as cost of labor, rawmaterials, overhead cost and other inputs incurredin the production of the goods. [Para. 2 of Com-mentary 4.1.]

The second situation is where the quantity ofgoods ordered is manufactured and delivered overa period of time; given the same type of contractspecification described in paragraph 2 above, thefinal price of the first unit is different from thatof the last unit and all other units, even thougheach price was derived from the same formulaspecified in the original contract. [Para. 3 ofCommentary 4.1.]

Another situation is where the goods are provi-sionally priced but, again in accordance with theprovisions of the sales contract, final settlement ispredicated on examination or analysis at the timeof delivery (e.g. the acidity level of vegetable oil,the metal content of ores, or the clean content ofwool). [Para. 4 of Commentary 4.1.]

3. Holding

The Seoul High Court held that the price reviewclause would apply to situations in which certain fac-

tors such as manufacturing costs or qualities of mer-chandise played a role in determining import prices,and the change of these factors led to the final determi-nation of import prices. In other words, the price re-view clause would not apply unless such factors existor change. However, the Seoul High Court stated thatthe compensating adjustment of the BMW Korea casefunctioned as a tool for making profits fall within thearm’s-length price range by reflecting market risks orcurrency risks and was basically targeted at the saleresults taking place after the import process.

Accordingly, the Seoul High Court found that thecompensating adjustment of BMW Korea and BMWAG was not directly connected with the price paid orpayable for the goods, because the adjustment wasbased on the unexpected change in the currency ex-change rate. For these reasons, the Seoul High Courtagreed with KCS’s position and concluded that theprice review clause did not cover the compensating ad-justment. After the adjudication, BMW Korea gave upits appeal to the Supreme Court of Korea.

C. Summary

What do we learn by examining these two cases?First, tax and customs authorities usually have differentperspectives on related-party transactions. A customsauthority has a tendency to argue that an importerpays less than an arm’s-length price in order to reducecustoms duties. In contrast, a tax authority tends toassume that the importer paid more than an arm’s-length price to a foreign related party in order to re-duce the tax base. These contradictory standpoints ormotivations can lead to inconsistent results regardingtransfer pricing and customs valuation.21

Second, complying with transfer pricing rules doesnot always guarantee satisfaction of the arm’s-lengthprinciple for purposes of customs valuation. In theBMW Korea case, BMW AG and BMW Korea made acompensating adjustment on a year-end basis in orderto follow their transfer pricing policy. But the KCS re-jected BMW Korea’s refund request. As a result, the

19Juan Martin Jovanovich, Customs Valuation and Transfer Pric-ing: Is it Possible to Harmonize Customs and Tax Rules? 113 (2002);Pike and Cylinda Parga, ‘‘U.S.: Customs’ new landmark transferpricing policy,’’ Corp. Bus. Tax’n Monthly, 17, 19-20 (Dec. 2012);Lawrence A. Pollack, ‘‘Tax Treaty Planning,’’ in: Marc M.Levey, ed., U.S. Taxation of Foreign Controlled Business, para.3.11[5][a], at 7 (2012); Victor H. Miesel, ‘‘Economics in Estab-lishing a Sound Transfer Pricing Policy,’’ in: Marc M. Levey, ed.,U.S. Taxation of Foreign Controlled Business, para. 8.03[3][b], at 23(2012); Mark K. Neville, Jr., ‘‘Customs Issues for ImportedGoods,’’ in: Marc M. Levey, ed., U.S. Taxation of Foreign Con-trolled Business, para. 9.05[10][f], at 23 (2012); Pike and Fried-man, supra note 18, at 222.

20Para. 1 of Commentary 4.1.

21International Chamber of Commerce, ‘‘Transfer Pricing andCustoms Value,’’ 2 (Feb. 2012), available at http://www.iccmex.mx/correos/2012/mayo/TransferPricingFebruary.pdf; Todd R.Smith and Clark Chandler, ‘‘Recent Developments in IntegratingCustoms, Transfer Pricing,’’ 19 Tax Mgmt. Transfer Pricing Rep.,600 (Sept. 9, 2010); Henry An, Domenick Gambardella, andZara Ritchie, ‘‘Transfer Pricing and Customs Nirvana: Is It Pos-sible?’’ 18 Tax Mgmt. Transfer Pricing Rep. 1033 (Jan. 28, 2010);American Bar Association Section of Taxation, ‘‘Options forTax Reform in the Transfer Pricing Provisions of the InternalRevenue Code,’’ 15 (Oct. 1, 2012), available at http://www.americanbar.org/content/dam/aba/administrative/taxation/100112letter.authcheckdam.pdf; Ping and Silberztein,supra note 6, at 36; Rosennow and O’Shea, supra note 10, at 84;Levey and Steven Wrappe, supra note 2, at para. 1760, at 445.

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compensating adjustment eventually caused an incon-sistency between transfer pricing and customs valua-tion, making it difficult to fulfill the two kinds ofarm’s-length tests at once.22

Third, there is no clear solution to link compensat-ing adjustments with customs valuation. The price re-view clause is not a perfect answer, because examplesin Commentary 4.1 did not list the compensating ad-justment, as explained in the BMW Korea case. Thisleads to discussions of whether and under what condi-tions a compensating adjustment might trigger a post-importation adjustment to customs value.

III. Recent Harmonization Developments

A. Commentary 23.1After Joint WCO/OECD conferences of 2006 and

2007, the WCO Technical Committee on CustomsValuation announced new guidance on the relationshipbetween transfer pricing and customs valuation in Oc-tober 2010. According to Commentary 23.1 of theWCO Technical Committee on Customs Valuation, atransfer pricing study can be used for examining thecircumstances of sale test on a case-by-case basis.Commentary 23.1 is significant because the WCO offi-cially acknowledged that a transfer pricing study couldbe a good source of information to verify the arm’s-length price for customs purposes. In particular, Com-mentary 23.1 is based on the position that using trans-fer pricing studies of importers for customs valuationpurposes is appropriate in applying the circumstancesof sale test. On top of that, the OECD affirmed thatcustoms valuation might be a useful source for evaluat-ing an arm’s-length price for transfer pricing pur-poses.23 However, neither the WCO nor the OECD hasproposed concrete instructions or guidelines thus far.

B. ICC ProposalsIn February 2012, the International Chamber of

Commerce (ICC) published six proposals for harmo-nizing transfer pricing and customs valuation. The sixsolutions are based on Commentary 23.1 and can besummarized as follows:

• customs administrations should recognize thearm’s-length principle of transfer pricing in deter-mining customs value24;

• customs administrations should recognize post-transaction adjustments (upward or downward)resulting from a voluntary compensating adjust-ment or a tax audit25;

• in reviewing customs value regarding post-transaction adjustments, customs administrationsshould follow the application of the weighted av-erage customs duty rate or the allocation of thetransfer pricing adjustment26;

• importers should be exempted from the obligationto submit an amended declaration for each initialcustoms declaration and the payment of penal-ties27;

• customs administrations should consider similarityof goods and functions of related parties in ac-cepting the OECD transfer pricing methods28; and

• customs administrations should accept transferpricing documentation.29

C. CBP Ruling: HQ W548314

On September 23, 2011, the U.S. Customs and Bor-der Protection (CBP) requested public comments on itsnew position on the relationship between transfer pric-ing and customs valuation.30 After reviewing all com-ments, the CBP revoked its former ruling, HRL547643, and announced its final ruling, HQW548314.31 HQ W548314 was effective July 30, 2012.Under HQ W548314, the CBP would apply the trans-action value method to related-party transactions andmake a post-importation adjustment to customs value,either upward or downward, if the following require-ments (five-factor test) are met:32

(1) a written ‘‘Intercompany Transfer Pricing De-termination Policy’’ is in place before importationand the policy is prepared taking IRS code sec-tion 482 into account;

(2) the U.S. taxpayer uses its transfer pricingpolicy in filing its income tax return, and anyadjustments resulting from the transfer pricingpolicy are reported or used by the taxpayer infiling its income tax return;

(3) the company’s transfer pricing policy specifieshow the transfer price and any adjustments aredetermined regarding all products covered by thetransfer pricing policy for which the value is to beadjusted;

22U.S. Customs and Border Protection, supra note 8, at 14;Levey and Wrappe, supra note 2, at para. 1520, at 400-401; An,Gambardella, and Ritchie, supra note 21, at 1035.

23OECD, supra note 1, at para. 1.78.24ICC, supra note 21, at 3.25Id. at 6.

26Id.27Id.28Id. at 7.29Id.30U.S. Customs and Border Protection, ‘‘Notice of Revoca-

tion of a Ruling Letter HQ 547654 Relating to Post-ImportationAdjustments; Transfer Pricing; Related Party Transactions; Rec-onciliation,’’ 4, Customs Bulletin and Decisions, Vol. 46, No. 23(May 30, 2012), available at http://www.cbp.gov/linkhandler/cgov/trade/legal/bulletins_decisions/bulletins_2012/vol46_05302012_no23/gennot_23.ctt/gennot_23.pdf.

31Id. at 2.32Id.

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(4) the company maintains and provides account-ing details from its books and/or financial state-ments to support the claimed adjustments in theUnited States; and(5) no other conditions exist that may affect theacceptance of the transfer price by the CBP.33

Also, HQ W548314 provided that the circumstancesof sale test and the five-factor test should be examinedseparately.34 Therefore, the CBP can make a post-importation adjustment to customs value if a U.S. im-porter meets both tests.

HQ W548314 is a noteworthy step forward in bridg-ing the gap between transfer pricing and customs valu-ation in many respects. First, the transaction valuemethod can apply to the adjusted transfer price basedon a transfer pricing policy, if the five-factor test ismet. In other words, the compensating adjustment aris-ing from a transfer pricing policy will be treated as notinfluenced by any relationships for customs purposes.

Second, the five-factor test is divided into two parts.Factors (1) and (2) are requirements relating to the pro-cedural reliability of self-initiated transfer pricing ad-justments and transfer pricing policies. The CBP canaccept such procedural reliability if a taxpayer has con-sistently complied with not only documentation rulesbut reporting requirements, and the same transfer pric-ing policy is applied to filing the income tax return andmaking adjustments to transfer prices. Factors (3)through (5) deal with substantive reliability when atransfer price adjustment is used for customs valuationpurposes. The substantive reliability of a transfer pric-ing policy may be accepted to the CBP if the transferpricing policy shows the mechanism to determinetransfer prices and make adjustments, and the adjust-ments are supported by accounting data.

Third, HQ W548314 acknowledges that transferpricing policies might be a legal ground for post-importation adjustments to customs value, whether up-ward or downward. This enables taxpayers to avoidcontradictory results arising from differences betweentransfer pricing and customs valuation.

Fourth, HQ W548314 affirms that a transfer pricingpolicy covers APAs, transfer pricing studies based onsection 482, foreign equivalents, or legally binding in-tercompany agreements.35 Therefore, taxpayers can re-quest a customs adjustment based on self-initiatedtransfer price adjustments, such as compensating ad-justments.

Fifth, the CBP has taken the position that the five-factor test is different from the circumstances of saletest. According to the CBP, the five-factor test deter-mines whether a post-importation adjustment based on

a transfer pricing policy is appropriate, while the cir-cumstances of sale test deals with whether the adjustedtransfer price is influenced by any relationships be-tween related parties.36

IV. Revising the Current RulesInterpreting the current rules may not be sufficient

to solve the inconsistencies fundamentally. For in-stance, as explained in the BMW Korea case, it wouldbe difficult to assert that the price review clause coversa compensating adjustment. Consequently, we shouldanalyze how to revise the OECD guidelines as well asthe WCO rules and commentaries in order to bridgethe gap between transfer pricing and customs valua-tion. These rules and commentaries provide countriestheoretical grounds for each valuation system and havea great impact on each country’s practice. Therefore, itis important to change the rules or commentaries fromthe standpoint of the principal situations in which in-consistency concerns arise.

A. Importer Country Makes an AdjustmentGenerally, the tax authority of an importer’s coun-

try tends to make a downward adjustment to a transferprice in order to levy more tax on the importer. In thiscase, two issues will arise:

• what criteria should be used to determine theavailability of the adjusted transfer price for cus-toms valuation purposes; and

• whether the customs authority of the importer’scountry can make a downward adjustment to cus-toms value retrospectively or only prospectively.

1. Acceptance Criteria for Customs Purposes

In the case of an audit-initiated adjustment to atransfer price, substantive reliability rather than proce-dural reliability is critical to a customs authority. Thisis because the transfer price adjustment is made not bya taxpayer but by a tax authority. The substantive reli-ability requirements of the five-factor test can be usedin determining whether the audit-initiated adjustmentis available for customs valuation purposes. Specifically,a customs authority can acknowledge such reliability, ifthe mechanism of the audit-initiated adjustment is ex-plained in detail, the adjusted transfer price is relatedto customs valuation, and the audit-initiated adjust-ment is sustained by concrete financial data. Thus, theWCO needs to develop and introduce guidelines in itsrules or commentaries, based on the substantive reli-ability requirements of the five-factor test. Further,such guidelines should be included as part of the cir-cumstances of sale test, as described in Section IV.C.2.

2. Upward or Downward/Prospective or Retrospective

A customs authority would presumably not object toan upward customs adjustment. The point is whether a

33Id. at 13.34Id. at 12.35Id. at 9. 36Id. at 12.

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customs authority should make a downward adjust-ment to customs value. As explained in the ICC pro-posals, a downward customs adjustment is necessary todeal with the inconsistency problem and HQ W548314finally allowed it. Therefore, the WCO rules and com-mentaries need to be revised to permit a customs au-thority to make a downward customs adjustment. Fur-ther, the inconsistency problem may be solvedcompletely when a retroactive adjustment to customsvalue is officially adopted in the WCO rules and com-mentaries.

B. Exporter Country Makes an AdjustmentIf the tax authority of an exporter’s country X

makes a primary adjustment, the competent tax au-thority of an importer’s country M needs to make acorresponding adjustment in order to prevent doubletaxation.37 Usually, the tax authority of X makes anupward adjustment to the transfer price of exportedgoods in order to impose more tax on the exporter. Intheory, double taxation can be avoided completelywhen the competent tax authority of M recalculatesthe importer’s income by accepting a downward adjust-ment to income paralleling the primary adjustment.However, the competent tax authority is outside X’sjurisdiction and may not accept the validity of the pri-mary adjustment. In practice, the tax authorities con-sult each other in order to determine correspondingadjustments.38

In addition to the corresponding adjustment issue, aprimary adjustment can give rise to a customs valueconcern. If the competent tax authority of M acceptsthe primary adjustment made by X, the adjusted trans-fer price for imported goods will be higher than thecustoms value initially declared during the importationprocess. As a result, the inconsistency issue betweentransfer pricing and customs valuation can arise in theimporter’s country. In order to deal with this problem,the customs authority of an importer’s country shouldbe permitted to take part in the consultation processregarding corresponding adjustments. Therefore, theOECD guidelines need to be revised to guarantee theparticipation of a customs authority in the consultationprocedures.

C. Importer Makes a Compensating Adjustment1. Conditions for Customs Adjustment

In addition to audit-initiated transfer price adjust-ments, MNEs often make self-initiated transfer priceadjustments based on their own transfer pricing poli-cies. These adjustments are usually referred to as com-

pensating adjustments. The compensating adjustmentsare not basically different from the audit-initiated ad-justments, because both adjustments have similar sub-stantive effects on customs valuation. Consequently,like a transfer price adjustment made by tax authori-ties, the self-initiated compensating adjustment can bea legal basis for an adjustment to customs value. Thekey point about the compensating adjustment is theconditions under which it can be used for customsvaluation purposes, since a customs authority mayraise a question about the credibility of transfer pricingpolicies and self-initiated adjustments. Hence, it is nec-essary for the WCO to develop clear standards aboutsuch credibility in the WCO rules or commentaries.

As explained above, the five-factor test provides keyrequirements to guarantee the minimum reliability of aself-initiated transfer price adjustment for customs valu-ation purposes. It is significant that the five-factor testdeals with not only the substantive aspect but also theprocedural part of the self-initiated adjustment. Thus,the five-factor test will serve as a good starting pointfor in-depth discussions by the WCO. In particular,further studies should focus on developing the proce-dural and substantive requirements of the five-factortest into more definite rules or guidelines. If the WCOestablishes such rules or guidelines about compensatingadjustments, it will contribute to bridging the gap be-tween transfer pricing and customs valuation.

2. Are the Tests Different?Usually, a customs authority applies the circum-

stances of sale test when there is an indication that therelationship between the importer and the exporter in-fluenced the price.39 The circumstances of sale test isan important tool for determining whether an importprice is influenced by any such relationship. In apply-ing the circumstances of sale test, a customs authoritytakes into account how the importer and the exporterorganize their relations and determine the price.40 Asmentioned above, the CBP differentiates the circum-stances of sale test from the five-factor test and requiresimporters to meet both of them.

However, the five-factor test is not essentially differ-ent from the circumstances of sale test. Therefore, it isappropriate for the WCO to establish rules or guide-lines based on the five-factor test as part of the circum-stances of sale test. First, if an importer meets the five-factor test, that means the transfer price adjusted by a

37Levey and Wrappe, supra note 2, at para. 1720, at 437-438;OECD, supra note 1, at para. 4.32.

38OECD, supra note 1, at para. 4.33.

39Article 1.2(a) of the agreement; Ian Cremer and MakiKitaura, ‘‘Custom Value,’’ in: Anuschka Bakker and BelemaObuoforibo, eds., Transfer Pricing and Customs Valuation: TwoWorlds to Tax as One, 61, 71-72 (2009); Pike and Friedman, supranote 18, at 141.

40Para. 2 of the interpretative note to article 1.2 of the agree-ment.

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transfer pricing policy is consistent with the arm’s-length principle of customs valuation as well as trans-fer pricing.41 Fulfilling the five-factor test leads to theconclusion that the adjusted transfer price is not af-fected by the relationship between importers and theirforeign suppliers. In other words, the objective of thecircumstances of sale test is achieved. Second, as ex-plained above, customs valuation of related-party trans-actions is basically a matter of the circumstances ofsale test. Thus, how to use a self-initiated transfer priceadjustment for customs valuation purposes should beexamined as part of the circumstances of sale test.Third, the WCO’s position is also based on the as-sumption that using transfer pricing studies of import-ers is related to the circumstances of sale test. TheWCO Technical Committee on Customs Valuationstates in relevant part:

1. This Commentary seeks to provide guidanceon the use of a transfer pricing study, prepared inaccordance with the OECD Transfer PricingGuidelines, and provided by importers as a basisfor examining ‘‘the circumstances surroundingthe sale’’ under Article 1.2 (a) of the Agree-ment. . . .

7. The question which then arises is whether atransfer pricing study prepared for tax purposes,and provided by the importer, can be utilized bythe Customs administration as a basis for exam-ining the circumstances surrounding the sale. . . .

9. Accordingly, the use of a transfer pricing studyas a possible basis for examining the circum-stances of the sale should be considered on acase-by-case basis. As a conclusion, any relevantinformation and documents provided by an im-porter may be utilized for examining the circum-stances of the sale. A transfer pricing study couldbe one source of such information. [Commentary23.1.]

3. Price Review Clause

As explained in the BMW Korea case, importers haveoccasionally relied on the price review clause of Com-mentary 4.1 in order to argue that a compensating ad-justment can trigger a customs adjustment. There is apublicized opinion to support such an argument,42

which can be summarized as follows:

• Commentary 4.1 is based on the position that cus-toms value may be determined later, if the final

determination of customs value is not possible atthe time of an import process43;

• the three examples of Commentary 4.1 are notthe only ones to which the price review clauseapplies44; and

• there is no significant difference between the threeexamples of Commentary 4.1 and the situation inwhich an importer cannot take advantage of cer-tain data at the time of an import process andwill be able to make a compensating adjustmentwhen relevant data becomes available later.45

However, as analyzed in the BMW Korea case, thereis strong opposition to this approach. The argument ismade that the price review clause is just for situationswhen certain factors function as determinants of im-port prices and the change of such factors determinesthe final import price. Also, the drafters of Commen-tary 4.1 took into account neither a compensating ad-justment nor a related-party transaction when establish-ing the price review concept.46 The three examples ofCommentary 4.1 did not mention any of them.

In summary, it is not easy to assert that the pricereview clause of the current WCO commentary andexamples can cover a compensating adjustment. Itmight be useful to add the compensating adjustment tothe examples of the price review clause by revisingCommentary 4.1. However, customs valuation regard-ing related-party transactions is basically a matter ofthe circumstances of sale test, not the price reviewclause, as explained above. Accordingly, it is necessaryto make an in-depth analysis of whether it is appropri-ate to put the compensating adjustment in the pricereview clause, instead of the circumstances of sale test.

4. Is a Downward Customs Adjustment Prohibited?

Some countries, including the United States,Canada, and Australia, deny any kind of price de-crease after importation for the purpose of determiningthe transaction value.47 For instance, 19 U.S.C. section1401a(b)(4)(B) states in relevant part:

(4) For purposes of this subsection —

(B) Any rebate of, or other decrease in, the priceactually paid or payable that is made or otherwiseeffected between the buyer and seller after thedate of the importation of the merchandise intothe United States shall be disregarded in deter-mining the transaction value under paragraph (1).

41U.S. Customs and Border Protection, supra note 30, at 12(indicating that a few commenters proposed similar positions onthe five-factor test of HQ W548314).

42Juan Martin Jovanovich, ‘‘Comparison between CustomsValuation and OECD Transfer Pricing Guidelines,’’ in:Anuschka Bakker and Belema Obuoforibo, eds., Transfer Pricingand Customs Valuation: Two Worlds to Tax as One, 157, 180-185(2009).

43Id. at 184.44Id. at 184-185.45Jovanovich, supra note 19, at 115-116.46Jovanovich, supra note 42, at 183.47Pike and Friedman, supra note 18, at 159.

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Is the compensating adjustment that lowers the im-port price after the importation ‘‘a rebate or other de-crease in the import price’’ described in 19 U.S.C. sec-tion 1401a(b)(4)(B)? This question is a significant issuefor the CBP and importers, because any discussion oncompensating adjustments and customs valuation maybe impossible or at least difficult, depending on how tointerpret 19 U.S.C. section 1401a(b)(4)(B).48

In HQ W548314, the CBP officially said:

[T]he post-importation adjustments represent anelement of the determination of the price actuallypaid or payable in accordance with 19 CFR [sec-tion] 152.103(a)(1). Therefore, the post-importation adjustments made pursuant to thetransfer pricing policy in this case simply reflectwhat should have been reported as the invoiceprice upon entry, had the exact price informationof the imported merchandise been available at thetime.49

This approach is based on Damon Pike’s theoreticalanalysis:

[T]he adjustment reflects what should have beenreported as the invoice price upon entry, had suchinformation been available at the time. . . . [T]hestatute’s legislative history shows that when theTrade Agreements Act of 1979 was enacted,Congress intended for the ‘‘post-importation re-bate’’ provision to be strictly limited to very spe-cific kinds of rebates and similar price de-creases. . . . [U]nder the age-old legal doctrine ofejusdem generis, common law courts have long heldthat where a statute or regulation provides spe-cific examples of items or circumstances that thelaw governs, anything not expressly enumeratedmust be of the same class or kind as that specifi-cally mentioned in order for the rule to ap-ply. . . . [I]n order to report the price that was ac-tually (finally) paid, the customs values must bere-stated based on the transfer pricing adjust-ments.50

To sum up, the CBP can make a downward post-importation adjustment to customs value based on acompensating adjustment or a transfer pricing policy.The CBP’s official position and the reasoning proposedby Pike will provide pertinent guidance for other coun-tries.

V. Analysis of a Few Coordination Systems

Even with the necessity of revising the OECDguidelines as well as the WCO rules and commentar-ies, it would require considerable time and effort forthe OECD and the WCO to implement clear guide-lines. Thus, the current coordination systems of eachcountry play a critical role in reducing inconsistencyrisks for the time being. What follows are a few ex-amples of the current U.S. and Korean coordinationsystems and analyzing of certain limits of such sys-tems.

A. 26 U.S.C. Section 1059A

The arm’s-length price of transfer pricing may behigher than that of customs valuation because thetransfer pricing methods are different from the customsvaluation methods. As a result, an importer can deductmore for income tax purposes and pay less for pur-poses of customs duties by purchasing merchandisefrom a foreign related party.51 This is usually known as‘‘whipsawing.’’ Section 1059A of the Internal RevenueCode is targeted at preventing whipsawing, by placinga maximum limit on the basis or cost of importedgoods for tax purposes. The maximum limit is basedon the customs value of imported merchandise:52

(a) In general

If any property is imported into the United Statesin a transaction (directly or indirectly) betweenrelated persons (within the meaning of section482), the amount of any costs —

(1) which are taken into account in computingthe basis or inventory cost of such property bythe purchaser, and

(2) which are also taken into account in com-puting the customs value of such property,

shall not, for purposes of computing such basisor inventory cost for purposes of this chapter, begreater than the amount of such costs taken intoaccount in computing such customs value.53

The problem is that section 1059A allows the IRSand the CBP to treat valuation from each agency’sstandpoint.54 Different perspectives may give rise to

48Pike, ‘‘Compensating adjustments and customs duties,’’Transfer Pricing in a Recession (Tax Planning International: SpecialReport), 47, 48 (Apr. 2009), available at http://www.thepikelawfirm.com/articles/20090500%20Compensating%20Adjustments%20%26%20Customs%20Duties.pdf.

49U.S. Customs and Border Protection, supra note 30, at 14-15.

50Pike, supra note 48, at 48-49.

51OECD, supra note 1, para. 4.57.52Joint Committee on Taxation, ‘‘General Explanation of the

Tax Reform Act of 1986, H.R. 3838, 99th congress; Public Law99-514,’’ at 1062 (May 4, 1987), available at http://www.jct.gov/jcs-10-87.pdf.

5326 U.S.C. section 1059A(a).54Methenitis and Wrappe, supra note 6, at S-12; Mark A. Lud-

wig, ‘‘Managing the Transfer Pricing and Customs ValuationNexus,’’ 16 Tax Mgmt. Transfer Pricing Rep. 643, 646 (Dec. 13,2007).

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inconsistency concerns, especially when a transfer pric-ing adjustment is made.55 Treas. reg. section 1.1059A-1(c)(7) permits the IRS to make an upward or down-ward adjustment to the basis or inventory cost ofimported goods. However, a taxpayer is not allowed tomake an upward adjustment to such basis or cost,56

and the taxpayer’s rights set forth in Treas. reg. section1.482-1(a)(3) are limited.57 As a result, a taxpayer maynot be able to reduce its taxable income, even if theself-initiated upward adjustment to the basis or cost isconsistent with the arm’s-length principle.

If a taxpayer makes an upward adjustment to thebasis or inventory cost of imported goods based on avalid transfer pricing policy and pays the additionalcustoms to the CBP, the adjusted basis or cost needs tobe accepted for tax purposes. The adjustment is madebecause, in the taxpayer’s view, the adjusted basis orcost reflects the arm’s-length price of imported goodsmore accurately than the former one. Therefore, it isrecommended to allow a taxpayer to make an upwardadjustment to a basis or an inventory cost, when acompensating adjustment is made according to a trans-fer pricing policy and the increased customs duty ispaid. Recently, the American Bar Association Sectionof Taxation recommended that section 1059A beamended to include the additional basis or cost arisingfrom a retroactive transfer price adjustment, if the tax-payer reports the additional basis or cost and pays thecorrect customs to the CBP no later than 180 days af-ter the taxpayer timely files the income tax return.58

This suggestion is an effective proposal to address theinconsistency problem.

B. Reconciliation Program of the U.S.

The CBP established the Automated CommercialSystem Reconciliation Prototype (reconciliation pro-gram) in order to deal with indeterminable componentsof imported merchandise in the entry process.59 Under

the reconciliation program, an importer may be al-lowed to postpone submission of uncertain informationregarding imported goods at the entry stage and pro-vide the CBP with the finalized information withinprescribed due dates.60

In HQ W548314, the CBP officially recommendedthat importers use the reconciliation program in adjust-ing the customs value of imported merchandise basedon their transfer pricing policies.61 Thus, the reconcilia-tion program will play a key role in reconciling transferpricing with customs valuation in the United States.

C. Correlative Adjustment of Korea

In July 2012, Korea implemented a new coordina-tion system called the correlative adjustment in orderto deal with inconsistency issues between transfer pric-ing and customs valuation.62 Under the new system,when the KCS makes an upward adjustment to cus-toms value due to the relationship between a Koreanimporter and a foreign exporter, the Korean importermay request the National Tax Service (NTS) to make adownward adjustment to corporate income tax, basedon the new customs value, as adjusted by the KCS.63

Similarly, if the NTS makes an upward adjustment tocorporate income tax by lowering transfer prices, theKorean importer may request the KCS to make adownward adjustment to customs value, based on thenew transfer price, as adjusted by the NTS.64

If the KCS or the NTS declines the request for adownward adjustment, the Korean importer can re-quest the Minister of Strategy and Finance (MOSF) tomediate the transfer price or the customs value beforefiling an appeal to the Tax Tribunal.65 Then, the Pric-ing Review Committee under the MOSF will reviewthe case and suggest its opinion to the MOSF. TheMOSF will make a recommendation to the KCS or theNTS, according to the committee’s opinion.66 Upon

55Mas, supra note 6, at 10-11. Mayra O. Lucas Mas analyzedcertain concerns arising from 26 U.S.C. section 1059A from thestandpoint of direct payments, royalties and fees, and taxpayer-initiated transfer pricing adjustments. This article will deal withthe inconsistency about taxpayer-initiated transfer pricing adjust-ments. For an in-depth analysis on direct payments or royaltiesand fees, see Mas, supra note 6, at 7-10.

56Treas. reg. section 1.1059A-1(c)(7).57Ralph H. Sheppard and Robert T. Cole, ‘‘Chapter 25 Trans-

fer Pricing Effects of Customs Actions and Customs Effects ofTransfer Pricing Actions,’’ in: Robert T. Cole, ed., Practical Guideto U.S. Transfer Pricing 25-1, 25-8 (3rd ed., 2007); Mas, supra note6, at 10-11.

58American Bar Association Section of Taxation, supra note21, at 17-18.

59U.S. Customs and Border Protection, ‘‘Automated Commer-cial System (ACS) Reconciliation Prototype; A Guide to Compli-ance, Version 4.0,’’ 4 (Sept. 2004), available at http://www.cbp.gov/linkhandler/cgov/trade/trade_programs/reconciliation/reference_desk/acs_recon_guide.ctt/acs_recon_guide.pdf.

60Id. at 6.61U.S. Customs and Border Protection, supra note 30, at 15.62Henry An, Joon-Kyoo Yang, and Young-Joo Kim, ‘‘PKN

Alert/TCDR Alert — Korea’s Transfer Pricing and CustomsHarmonization Procedure Comes into Effect,’’ 1 (July 25, 2012),available at http://www.pwc.com/en_GX/gx/tax/newsletters/tax-controversy-dispute-resolution/assets/pwc-koreas-transfer-pricing-customs-harmonization.pdf. The correlative adjustmentsand the pricing review committee were adopted on Dec. 31,2011, and became effective on or after July 1, 2012.

63Gukjejoseui jojeonge gwanhan beobyul [Adjustment of In-ternational Taxes Act], Act No. 11126, Dec. 31, 2011, article10-2 (R.O.K.).

64Gwansebeob [Customs Act], Act No. 11121, Dec. 31, 2011,article 38-4 (R.O.K.).

65Supra note 63, at article 10-3; supra note 64, at article 38-4.66Gukjejoseui jojeonge gwanhan beobyul sihaengryung [En-

forcement Decree of the Adjustment of International Taxes Act],Presidential Decree No. 23600, Feb. 2, 2012, article 17-3; supranote 64, at article 38-4.

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receiving the recommendation, the KCS or the NTSshould submit to the MOSF a plan to implement therecommendation.67

This new system is significant because it officiallyallows a Korean importer to request a refund of in-come tax or customs based on audit-initiated adjust-ments to customs value or a transfer price. Also, theMOSF’s recommendation can facilitate the cooperationof the NTS and the KCS in solving inconsistency is-sues, since they are branches of the MOSF. However,the correlative adjustment still has shortcomings. Theacts list only audit-initiated adjustments as a basis forcorrelative adjustment. It is uncertain whether APAs oradvance customs valuation arrangements may triggersuch adjustments.68 Further, it is not clear whether an

importer is allowed to request a refund of customsbased on a compensating adjustment arising from atransfer pricing policy.

VI. Conclusion

The inconsistency between transfer pricing and cus-toms valuation produces compliance issues and eventu-ally they undermine the arm’s-length principle. There-fore, the effort to overcome such inconsistency issues isimportant. Most of all, there are already some notableachievements that may be a cornerstone of bridgingthe gap between transfer pricing and customs valua-tion. This article has explored how to revise the OECDand WCO rules and analyzed a few current coordina-tion systems. It is time to discuss more developed solu-tions and then provide clear guidance for taxpayers aswell as tax or customs administrations. ◆

67Enforcement Decree, supra note 66, at article 17-3; supranote 64, at article 38-4.

68An, Yang, and Kim, supra note 62, at 3.

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