U.S. companies with affiliates operating in maquiladoras often export materials from the United States to Me xico and then import finished products into the United States .  Both the export transaction and the import transaction require that the classification, value, and quantity of the products being shipped be reported to the Bureau of Customs and Border Protection, formerly U.S. Customs Service. 

   Under a recently announced initiative, the U.S. Internal Revenue Service will begin analyzing the data provided to Customs.  In addition to the taxpayers that would otherwise be subject to a tax audit, the IRS will select a sample of cases where the reported import or export value is outside what is deemed to be the normal range for products of the reported import or export classification.  The U.S. taxpayers in the selected sample will be subject to a transfer pricing audit.  If the sampling process suggests to the IRS that this approach is likely to raise revenue, the IRS will use the Customs data more broadly for selecting taxpayers to audit.  The specter of an IRS audit that would not otherwise occur, provides new incentive for companies to carefully monitor values, classifications, and quantities reported on import and export documents.

Basis of new Initiative

   Penn State University Finance Professor Simon Pak and Florida International University Finance Professor John Zdanowicz have been studying transfer pricing for more than a decade.  Their research focuses on the alleged manipulation of import and export values as a means of tax avoidance, tax evasion and money laundering.  Senator Byron Dorgan (D-N.D.), ranking member of the Appropriations Committee subcommittee that oversees the Treasury Department is convinced by the professors’ research, so much so that he secured a $2 million grant to provide for further study on transfer pricing by these two professors.

   The grant was awarded to the professors who have continued to study trade data and identify discrepant value information that they suggest is indicative of wrongdoing.  The professors estimate the total 2001 U.S. tax loss to be $53.1 billion.  After the United States Treasury Department linked three Yemeni honey companies to Osama Bin Laden, the professors were quick to examine the honey trade.  They found that in 2000 honey was shipped to Yemen from the U.S. at a price per kilogram 38 percent higher than the average price and it has been suggested that the inflated prices were a means of funding terrorist cells in the United States .  It is understood that the professors have now been made Internal Revenue Service employees so that they have greater access to U.S. Customs’ records. 

   Transfer pricing generally refers to the price at which related or commonly controlled companies transfer goods, materials, services, intangibles or other items of value between themselves.  When related parties in different countries set a transfer price they are determining how much taxable income will be generated in each country.  When one of the related parties is a U.S. importer, the transfer price is often also the price on which U.S. Customs duties are calculated.  Accordingly, both the IRS and Customs require that, for purposes of determining taxable income and dutiable value respectively, transfer prices must be arm’s length prices.

   If the IRS believes that taxable income arising from related party transactions is less than that which would arise under arm’s length transfer prices it can increase the taxpayer’s taxable income.  Conversely, to reflect an arm’s length result in its original timely filed tax return, a taxpayer may report less income than it actually earned, unless Section 1059A of the Internal Revenue Code (addressing reconciliation of Customs and tax values) applies.  Whether transfer prices are arm’s length for IRS purposes is determined based on a comparison of the prices used with certain benchmarks, typically derived from the data of independent public companies.  The comparison is performed pursuant to one of the several methods prescribed by regulation, and sometimes an unspecified method can be used. 

   Taxpayers are required to maintain self-compliance, by measuring their own prices against available comparables and reporting at least the income found to be appropriate based on such analysis even if it is more than the income actually earned.  Taxpayers are required to maintain documentation to support the analysis performed and income reported.  Such documentation is usually the first thing required to be produced in an IRS transfer pricing audit. 

   If Customs suspects that the relationship between parties affects the transfer price of goods imported into the United States it will challenge the use of transaction value as the basis of appraisement of the imported goods purchased from the related party.  Transaction value is the price actually paid or payable for the goods plus certain enumerated additions to value, such as assists, and not including certain other elements of value, such as international freight.  A relationship between the parties is not alone enough to disqualify an importer from utilizing transaction value.  Transaction value will be accepted where it is supported by either test values or the circumstances of the sale.

   Transaction value is supported by test values where it closely approximates the import appraisements of other identical or similar merchandise.  The circumstances of the sale test is subjective and may look at the organization of the parties, how they arrive at prices, and whether the prices ensure cost recovery plus a profit.  If transaction value is rejected by Customs, importers are required to revert to an alternative method of appraisement, which must generally be selected in the following order—transaction value of identical or similar merchandise, deductive value, computed value and derivative value.

   The transaction value of identical or similar merchandise is generally only available if the U.S. importer sources the same product from both its related company and an unrelated company in the same foreign country.  If there are not imports of identical or similar merchandise then the importer must use deductive value, which calculates dutiable value by taking the resale price in the United States and deducting components of value like normal U.S. profit and general expenses and international freight, unless the importer elects, at the time of entry, to use computed value.  Computed value is based on the factory’s financial statements and derives a price for manufactured items by calculating the cost of materials and production, the value of any assists provided by the buyer, and an amount for profit and general expenses of the factory.

   Where an importer’s transfer prices are designed, either through a self-compliance program or through the execution of an Advanced Pricing Agreement with the IRS, to meet the arm’s length requirement of the tax code, they may or may not constitute valid transaction values for Customs purposes because Customs’ testing methods differ from those of the IRS. 

   U.S. exporters must prepare a Shipper’s Export Declaration or electronically file the same basic information about a shipment through the Automated Export System.  The data required to be filed by exporters includes the commodity number as provided in Schedule B, Statistical Classification of Domestic and Foreign Commodities Exported from the United States , the net quantity, and the value.  Except for a limited number of items, the Schedule B number and the units of quantity to be reported on the export declaration are the same as the classification and units of quantity reported for imports.  The value for export purposes is the selling price or the cost of the article if not sold. 

   Importers must prepare an entry containing the HTSUS classification, entered value, and quantity of goods entered.  As discussed above, the value reported to Customs may be the price paid for the item or may be based on an alternative method of valuation.  Classification is often difficult to determine and may be subject to dispute with U.S. Customs.

Dangers of the new initiative

   The research methodology of the professors now being utilized and applied under IRS auspices is based on data collected by the government from export declarations and import entries.  Examples of suspicious transactions uncovered by the professors include the following.  A U.S. company imports toothbrushes valued at over $5,000 each, thus potentially shifting what would be taxable U.S. profits overseas or laundering the proceeds of illegal activities.  Similarly, self-propelled bulldozers are exported overseas at a declared value of $1,741.92, again potentially shifting taxable U.S. profits overseas and potentially providing a source of funds to terrorists. 

   These seemingly anomalous declarations of value on import and export documentation may be evidence of tax avoidance or an illegal scheme by the parties involved.  However, we have identified several reasons for concern that the professors’ methodology, now countenanced in part by the IRS, overlooks some basic explanations for discrepancies and thus threatens to cause difficulties for many more law-abiding businesses than criminals.

   If the professors believe that importers and exporters are misstating prices for unlawful purposes, why do they think that the same culprits correctly state the tariff classification or export commodity code and the quantity of the products?

   Clerical and careless errors in the preparation of government forms occur.  This is true as to the preparation of export declarations, at least those covering non-strategic commodities, because such declarations do not form the basis of any duty calculation or meaningful government controls.  It is also true with respect to articles that are duty free under a preference program such as NAFTA and for which, therefore, the value and classification are not perceived as critical.

   The professors cite lawnmower blades from Australia imported for $2,326 each.  The HTSUS heading for cutting blades is 8208.  In the case of blades for agricultural machinery, the correct subheading is 8208.40.  Within that subheading there are 2 statistical breakouts – “lawnmower blades” and “other,” both of which are duty free.  An importer may reasonably classify a giant highly engineered steel blade designed for use on a 25-ton tractor for clearing brush or hay in the statistical breakout for lawnmower blades, yet the professors suggest that the transaction perpetrates a fraud.

   The professors cite razors imported from the UK at $113.20 per unit.  A search of the HTSUS index reveals that razors are provided for in heading 8212.  Review of that heading reveals that “razors and razor blades” are covered by subheading 8212.10.0000 (Free).  An importer may select heading 8212 as the classification of its expensive electric razor imports.  Although this classification is likely in error because electric shavers are provided for in another heading, 8510.10.0000, which is also free, it is hardly evidence of money laundering or tax evasion, just a relatively routine mistake in choosing one out of over 16,000 tariff classifications for an imported product.

   When a company ships a 12 year-old bulldozer to its affiliate in Colombia and declares its depreciated book value of the bulldozer on the export declaration because the transaction is not a sale it has acted reasonably.  There are even Customs rulings that approve of such valuation for imports of used equipment where duties are assessed.  The professors’ methodology does not account for used goods because the commodity classifications for which statistics are collected do not distinguish such goods.

   The professors cite multiple vitamins imported from China for over $1,800 per kilogram and multiple vitamins exported to Finland at a declared value of $1.34 per kilogram as evidence of foul play.  Multiple vitamins packaged for retail sale are classifiable in HTSUS heading 3004.  All articles within that heading must be reported to Customs in kilograms.  However, the importer and exporter in such a transaction may be unfamiliar with the kilograms involved (because they are buying and selling bottles) and may, therefore, accidentally report the per bottle price or inaccurately translate the per bottle price into a per kilogram price. 

Conclusion

   We fear that the result of the IRS’ new cooperation in this study will be a transfer pricing audit for a significant number of companies that ship used equipment at depreciated values, make minor classification mistakes, or inadvertently confuse the unit of quantity on which a reported price is supposed to be based.  Customs and the IRS ought to mind these flaws in the professors’ broad brushed statistical analysis for identifying wrongdoers and apply some of their own judgmental experience acquired over many years of administering the tariff and tax laws to avoid government overreaction to relatively harmless errors.

   Me anwhile, importers and exporters ought to take even greater care to check the classifications, values and quantities they report on import entries and export declarations.

Jason Waite is an attorney in the Washington , D.C. office of Alston & Bird LLP. He specializes in international trade regulation and Customs law. Waite can be reached at jwaite@alston.com,  and at (202) 756-3300.