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Accounting for transfer pricing adjustments in customs valuation By: M.I. van Haaren, LLM, EU customs Law, 2015/2016

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Accounting for transfer pricing adjustments in customs valuation

By: M.I. van Haaren, LLM, EU customs Law, 2015/2016

Table of contents

1. Introduction and overview ............................................................................................... 1

1.1 Transfer pricing adjustments and customs valuation ............................................... 1

1.2 How to account for transfer pricing adjustments in customs declarations ................ 1

2. What are related parties? Norms for affiliation ................................................................ 2

2.1 Related parties for transfer pricing purposes ........................................................... 3

2.2 Related parties for customs purposes ..................................................................... 3

2.3 Conclusion for companies within multinationals groups ........................................... 4

3. Transfer pricing .............................................................................................................. 4

3.1 Background ............................................................................................................. 4

3.2 Determining the transfer price ................................................................................. 5

3.3 Transfer pricing adjustments ................................................................................... 7

4. Customs valuation .......................................................................................................... 9

4.1 Background ............................................................................................................. 9

4.2 Customs valuation methods: transaction value first ................................................10

4.3 Customs value; specific additions and subtractions ................................................12

4.4 Customs law and intra-group transactions ..............................................................13

5. Customs valuation and transfer pricing, similarities and differences ..............................13

5.1 The same principle yet different practical methods .................................................13

5.2 Correcting for known practical differences ..............................................................14

6. Accounting for transfer pricing adjustments ...................................................................14

6.1 The use of customs valuation for transfer pricing ...................................................14

6.2 Non-refundable customs duties ..............................................................................15

6.3 Is a transfer pricing adjustment reason to adjust the customs value? .....................16

6.4 Timing issues .........................................................................................................16

6.5 Incomplete customs returns ...................................................................................17

6.6 The agreement between importer and customs ......................................................18

7. Conclusions and recommendations ...............................................................................19

7.1 The same valuation principle means moving in synchronization .............................19

7.2 Customs legislation should be improved ................................................................19

7.3 Proposition for improving customs legislation .........................................................19

8. Literature list ..................................................................................................................19

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1. Introduction and overview

1.1 Transfer pricing adjustments and customs valuation The intersection between transfer pricing and customs The emergence of global value chains and the expansion of activities of multinational enterprises have increased the value of intra-group trade flows.1 A large share of world trade is conducted between related parties.2 International intra-group transactions with goods bring about an interesting intersection between corporate income tax transfer pricing and customs that is not provided for by legislators. Both taxes (corporate income tax and customs) need to determine a fair market value for the same goods to prevent tax avoidance. The movement towards globalisation and increasing international intra-group trade has not been missed by tax authorities. Pricing of intra-group transactions is arbitrary and malleable. Transfer pricing offers tempting possibilities to shift taxable profits to low tax jurisdictions. Relieving multinationals of this temptation, governments have implemented transfer pricing rules.3 Because of their arbitrary nature these rules often bring about transfer pricing discussions and transfer pricing adjustments. Transfer pricing adjustments and customs value Historically transfer pricing specialists focus on the corporate income tax aspects of such transfer pricing adjustments. However, international intra-group trading of goods involves importations and/or intra-community supplies and will therefore impact the determination of, respectively, the taxable base for value added tax (‘VAT’) purposes and the customs value.

1.2 How to account for transfer pricing adjustments in customs declarations

Transfer pricing and customs valuation, the same basic valuation concept for the same transactions The same basic valuation concept is used for determining customs value and transfer prices. For both purposes the valuation is based on the price unrelated parties would agree to.4 Both aim to determine an 'objective' fair market value of the goods to avoid manipulation. Because transfer pricing regulations and customs valuation rules have different objectives, the implementation of the same basic valuation principle differs on a practical level. Transfer pricing aims to fairly allocate worldwide taxable profits between tax jurisdictions. Customs valuation aims to provide a fair base for the levy of customs duties. Lowering the transfer pricing means lowering the customs value too As the European Union is a relatively high tax jurisdiction companies shipping in goods are tempted to search for the upper bound of the range of acceptable transfer prices, effectively shifting profits towards lower tax jurisdictions. This means that tax authorities often feel they have to intervene by lowering the transfer prices charged to European group companies to protect the European taxable base. This ‘landscape’ provides the base example for the

1 R. Lanz, a.o., Intra-Firm Trade: Patterns, Determinants and Policy Implications, OECD Trade Policy Papers, no. 114, OECD Publishing. 2 The exact share of world trade conducted between related parties varies substantially between different sectors of industry and globally aggregated data is not available. For a broad impression I refer to the OECD Economic Outlook, Volume 2002, no. 1, Chapter VI. 3 OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, OECD Publishing 2010. 4 The ‘transaction value’ or the ‘arm’s length price’.

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illustration of this thesis, namely a Dutch company buying goods from a Chinese group company for a price that is later deemed too high. A primary transfer pricing adjustment generally takes place only in the form of a corporate income tax adjustment years after the transaction was concluded. VAT that is due on import generally is refundable if used for VAT taxable activities. In contrast, customs duties are in principle non-refundable. Furthermore the VAT due on import is based on the customs value.5 Therefore the largest financial interest for companies is with lowering the customs duties after a transfer pricing adjustment. Practical differences between transfer pricing and customs valuation aside, it seems logical and fair that a lowering of the transfer pricing determined for a shipment of goods also leads to a lowering of the customs value. A reasonable and holistic fiscal approach entails that a downward transfer pricing adjustment is followed by a lowering of the customs duties due. Customs valuation rules do not account for transfer pricing adjustments The customs duty, which is based on the customs value, is in principle non-refundable. This poses a problem if, for instance, a retroactive transfer pricing adjustment results in the lowering of a price for a particular shipment of goods. Unfortunately the customs legislation lacks provisions designed to account for retroactive transfer pricing adjustments. It does not offer a clear remedy to retrieve the customs duty after a decrease of the transfer prices paid for goods entering the European Union. In the absence of provisions specifically designed to account for transfer pricing adjustments it is unclear how companies should best account for retroactive transfer pricing adjustments in their customs declarations. In this thesis I will explore some alternative options that companies have to retroactively adjust the customs value after a transfer pricing adjustment. The research question of this thesis is: how to account for retroactive transfer pricing adjustments in customs valuation of intragroup transactions of goods.

2. What are related parties? Norms for affiliation

5 Article 19, section 1, Dutch Act on Value Added Tax.

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In order for the transfer pricing rules to apply and to be able to choose the correct customs valuation method, it is necessary to ascertain whether or not the parties involved in the transaction at hand are considered to be related. There is no universal definition of the term related parties. In this chapter the definition of 'related parties' will be briefly discussed.

2.1 Related parties for transfer pricing purposes Associated enterprises The OECD Transfer Pricing Guidelines do not offer a definition of the term 'related parties'. In article 9 of the OECD Model Tax Convention a rather broad definition of 'associated enterprises' is given.6 Direct or indirect participation in the management, control or capital by one company in another makes those companies associated (vertical association). If one person directly or indirectly participates in the management, control or capital of two or more other companies, those companies are also associated (horizontal association). A majority of countries have further clarified these criteria by setting a quantitative threshold in the form of a percentage of the total shares or voting rights to be held. When this threshold is exceeded parties are deemed to be related. The Dutch codification of the arm's length principle in article 8b of the Corporate Income Tax Act does not quantify the capital- or voting rights-threshold. Considering the risk of abuse safe harbours bring about, the open norm of the OECD Model Tax Convention was not further clarified in the law. The State Secretary of Finance, who is responsible for tax laws, has stated that, to establish affiliation for the application of article 8b, Corporate Income Tax Act, it is essential that one company has influence over the pricing actions of another company.7

2.2 Related parties for customs purposes The definition of related parties for customs purposes is more expansive in the sense that it is possible that parties are not related for transfer pricing purposes but are related for customs valuation purpose. Furthermore the customs definition of 'related parties' is, as is to be expected, more focused towards natural persons compared to the transfer pricing/corporate income tax definition that deals primarily with companies. Article 15.4 of the Agreement on the Implementation of Article VII of the GATT defines the term 'related parties' and is implemented in article 143 of the Implementation Regulation to the Community Customs Code.8 Persons are deemed to be related only if:

1. they are officers or director of one another's businesses, 2. they are legally recognized partners in business, 3. they are employer and employee, 4. any person directly or indirectly owns or controls 5% or more of outstanding voting

stock and/or shares, 5. one of them directly or indirectly control the other, 6. both are directly or indirectly controlled by a third person, 7. together they directly or indirectly control a third person, or 8. they are members of the same family.

6 Definitions of the term 'related parties' are also found elsewhere in the Dutch Corporate Income Tax Act (e.g. article 10a, section 2) and in International Accounting Standard IAS 24. These definitions are mostly narrower than the one used for transfer pricing purposes e.g. the capital ownership threshold for affiliation is higher. 7 Dutch parliamentary documents: Kamerstukken II, 2001-02, 28 034, no. A, p. 7. 8 Commission Regulation (EEC) No 2454/93

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For multinationals the 5% capital ownership requirement (no. 4) and the 'control' requirement (no. 5) will be the most important.

2.3 Conclusion for companies within multinationals groups Companies within multinational groups will generally be related parties Although the affiliation norm for corporate income tax purposes is rather open natured and in most instances narrower that the affiliation norm for customs purposes, it seems safe to say that for most multinationals doing large amounts of intra-group trade, the trading companies will be related under both norms. Therefore I would assume that a large part of international trade is done by multinational groups that are related parties for transfer pricing purposes as well as for customs valuation purposes.

3. Transfer pricing

3.1 Background The international allocation of taxation rights

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Transfer pricing is the setting of the price for goods and services sold between related legal parties. Although the basic valuation concept for transfer pricing is remarkably similar to that used in customs valuation (see chapter 5), the function of transfer pricing differs quite a bit from that of customs valuation. The main goal of transfer pricing rules is to allocate the yearly taxable profits of multinational enterprises fairly between the different states of establishment. This covers goods and services. For the purpose of this thesis I will focus on the valuation of goods because services are generally not subject to customs duties. For customs valuation the main goal is to determine the customs duty due on just one shipment of goods at one moment in time (see paragraph 5.1). Base erosion and profit shifting Transfer pricing can be used as a powerful tool for corporate income tax avoidance. By charging relatively high prices to group entities in high tax jurisdictions it is possible to artificially shift profits to low or no tax environments, where little or no economic activity takes place. In this way the taxable profit and therefore the effective tax rate can be lowered substantially. Increased attention for this issue has culminated in the recently published OECD/G20 final package of measures for the Base Erosion and Profit Shifting Project (‘BEPS’).9 The BEPS project provides governments with solutions for closing the gaps in existing international rules that allow corporate profits to be shifted artificially. Documentation requirements Multinationals are generally required to provide transfer pricing documentation to substantiate the used transfer prices showing what methods and data were used to calculate the transfer prices. The documentation requirements are not universally set and differ between tax jurisdictions. For the Netherlands article 8b, section 3, Corporate Income Tax Act requires companies to add to their administration data (documents) showing that the transfer prices were set in accordance with the arm's length principle. Generally transfer pricing documentation requirements include an analysis of the intra-group transaction, a substantiation of the transactions that were used for comparison and a description of the transfer pricing method used.

3.2 Determining the transfer price The OECD Transfer Pricing Guidelines The OECD Transfer Pricing Guidelines are widely considered to be the governing rules on transfer pricing within the European Union.10 Although the OECD Transfer Pricing Guidelines are not legally binding and therefore not enforceable in the courts, they factually govern transfer pricing practices in the absence of other authoritative rules. The OECD Transfer Pricing Guidelines provide recommendations and methods for determining the correct transfer prices. The arm's length principle Central to the OECD Transfer Pricing Guidelines is the arm’s length principle.11 The arm’s length principle requires that the intra-group transaction is analysed and compared to a similar transaction between unrelated entities (‘comparables’). Usually a number of comparables can

9 OECD Publication of 5 October 2015. 10 The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, published most recently by the OECD on 22 July 2010. 11 See chapter 1 of the OECD Transfer Pricing Guidelines.

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be found resulting in a range of acceptable prices. The intra-group transaction price should be within the price-range used for the comparables. Five comparability factors The analysis of the intra-group transaction and the selection of comparables is key to the transfer price determined. Under the OECD Transfer Pricing Guidelines a transaction is comparable if the differences that do exist cannot materially affect the conditions being examined or can be reasonably and accurately eliminated. There are five comparability factors listed. The relative importance of the respective comparability factors depends on the transfer pricing method used (these methods are discussed below). The five comparability factors are:

1. The characteristics of the products (or services). 2. The functions performed, the risks incurred and the assets used by each of the

involved parties. This factor, the functional analysis, is in many cases the most decisive aspect.

3. The contractual terms used. 4. The economic circumstances. 5. The business strategies used.

Because the OECD Transfer Pricing Guidelines offer no guidance on the total selection of comparables this may be regarded as the weakest link within the whole process. Manipulation of the total group of comparables makes the process very malleable. The lack of guidance combined with the relative importance of the total selection of comparables makes this the source of a substantial part of the discussions regarding transfer pricing between multinational enterprises and tax authorities. Five transfer pricing methods Under the OECD Transfer Pricing Guidelines there are five different methods for comparing intra-group transactions with comparables for the end goal of determining an arm’s length transfer price. Each method compares a different aspect of the intra-group transaction with the comparable transactions. The five methods are split into two categories; the transaction based methods on the one hand, and the profit based methods one the other hand. The transaction based methods are:

1. The comparable uncontrolled price method (‘CUP’) which compares the transaction price charged with a comparable uncontrolled transaction. This is the preferred method.

2. The cost plus method (‘CP’) that begins with the cost incurred by the supplier and then adds an appropriate mark-up. This method is mostly used for real estate.

3. The resale minus method (‘RM’) that begins from the price that the product is eventually sold at to a third party. This resale price is reduced with an appropriate margin from which the reseller would seek to cover its selling and other operating expenses and a profit margin, taking into account the functions performed, the assets used, the risk incurred.

The profit based methods are:

1. The profit split method (‘PS’) that seek to determine the division of profit that independent parties would have expected to realize from a certain transaction. This method is used in cases involving a number of strongly interrelated transactions.

2. The transactional net margin method (‘TNMN’) determines an appropriate margin relative to a defined base such as the assets used or the sales realized. It compares

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the profit margin for the controlled transaction with that of comparable uncontrolled transactions.

Transaction based methods first The transaction based methods should be regarded before the profit based methods. These latter methods are to be used as a ‘last resort’.12 The most direct and preferred way to establish a just transfer price is to compare the prices charged between related entities with prices charged for comparable transactions between independent parties. The CUP method is the preferred method for transfer pricing purposes.13 Note here that this preferred method is remarkably similar the most commonly used method for customs valuation, namely the transaction value (see paragraph 5.2).

3.3 Transfer pricing adjustments Intensively scrutinized Due to increased concern about base erosion, transfer pricing practices are subject of ample attention from national tax authorities and international organisations. They are regularly scrutinized to assure that a correct amount of taxable profit is reported. Ambiguity and lack of hard and fast rules The setting of transfer prices is not an exact science. The methods provided by the OECD Transfer Pricing Guidelines will lead to a certain range of acceptable transfer prices. The inescapable vagueness of the transfer pricing rules and pliability of transfer pricing reports often lead to discussions with the tax authorities and to transfer pricing adjustments. The ripple effect of adjustments A transfer pricing adjustment can have several forms.14 To stay with our base example, the ‘primary adjustment’ is imposed on the Dutch group entity (a relatively high tax jurisdiction), lowering the price paid to a group company in a lower tax jurisdiction such as China. To avoid double taxation the primary adjustment should lead to a ‘corresponding adjustment’ in the state where the related party is established. A transfer pricing adjustment at the initiative of the taxpayer, aimed to prevent primary adjustments, is called a ‘compensating adjustment’. The legal basis for the primary adjustment is found in national law15 and article 9, section 1, of the OECD model tax convention. Article 9, section 2, of the OECD model tax convention provides a legal basis for the corresponding adjustment. The accounting of the adjustment Transfer pricing rules were created to provide national tax authorities (especially in high tax jurisdictions) with a tool to counter erosion of the taxable profitbase by charging prices that are higher than fair market value. Therefore primary transfer pricing adjustments are usually aimed at lowering the transfer price resulting in an increase of the taxable profit of the taxpayer. The balancing (counterpart) book entries follow a certain logic that may lead to adverse tax consequences on its own. Below two examples are given to illustrate this issue for an increase transfer pricing adjustment.

12 OECD Transfer Pricing Guidelines paragraph 3.50. 13 OECD Transfer Pricing Guidelines paragraph 2.6 – 2.7. 14 OECD Transfer Pricing Guidelines ‘glossary’. 15 For the Netherlands; article 8b of the Corporate Income Tax Act.

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An increase adjustment of the price paid by a parent company to a subsidiary company is also accounted for as a deemed dividend distribution, possibly triggering dividend withholding tax liability. In the books of the subsidiary the profit is increased. As this amount is usually not actually received a counterpart booking is needed to balance the accounts (there should be more money than there actually is). Because the price that was originally paid to the subsidiary was too low, the parent company was left a pecuniary advantage by its subsidiary. It is therefore deemed that the ‘missing part of the price’ has been received by the subsidiary but has immediately been distributed back to the parent company as a deemed dividend distribution. In the books of the parent company the taxable profit is decreased because they had to pay more for the products. To balance the accounts (there is more money than there should be) an amount of received dividend is booked. An increase adjustment of the price paid by a subsidiary company to a parent company is also accounted for as a deemed capital contribution, possibly triggering capital duties.16 In the accounts of the parent company the taxable profit will be increased. Because originally part of the arm’s length price was not actually paid to the parent company and therefore the subsidiary had a pecuniary advantage left to it by its shareholder a deemed capital contribution is accounted for. The counterpart booking is an increase in the capital investment in the subsidiary (the deemed capital contribution). In the accounts of the subsidiary firstly the profit is decreased, and secondly a deemed capital contribution is accounted for. A similar logic applies when the subsidiary does not directly deal with the parent company but with a sister company. When the taxable profit of the sister-company is increased, a deemed divided distribution from sister- to parent-company is accounted for followed by a deemed capital contribution by the parent into the first-mentioned subsidiary. VAT consequences VAT on imported goods should not be a cost factor. VAT that is due on import of goods is generally recoverable if they are used for VAT taxable activities. If a transfer pricing adjustment results in a decrease of the price charged by a Chinese group supplier to a European group company, this means a lower taxable base and less VAT due. If all VAT that was due has been recovered there will be no incentive to try to amend the VAT declaration. Only if the buyer of the goods cannot recover all its input VAT it may be worthwhile to revise the VAT declaration. Compensating adjustments and VAT It is possible that a compensating transfer pricing adjustment causes adverse VAT consequences. Again this is dependent on the extent to which the buyer can recover the VAT charged to him. Extra payments made from foreign- to European group companies that are not closely linked to a supply of goods could be deemed a consideration for a service. Business to business services are, under the default rule, taxed in the country where the receiver is established. If the receiver does not use the supplied goods for (VAT) taxable activities it will not be able to reclaim any VAT paid.

16 In the Netherlands no capital duty applies.

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4. Customs valuation

4.1 Background Determining the basis for customs duties The objective of customs valuation is to determine the basis for the customs duties due at the moment a shipment of goods enters into the European Union. Customs duties can be calculated in either specific or ad valorem terms or as a combination of both terms. A specific duty means that an amount of money is charged for a quantitative description of the good, e.g. € 5 per hectolitre of product. When such a specific term applies

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there is no need to determine the customs value of the goods, as the duty is not based thereon. In contrast, an ad valorem duty is calculated as a percentage on the value of the goods. If the rate of duty is ad valorem, the customs value is essential to determine the duty to be paid on an imported good. Without rules to determine the customs value, importers may be tempted to report relatively low values for their goods in order to lower the customs duties due. In earlier times this risk was countered by entitling the customs officers to buy the imported goods for the price that was declared. That way importers would not declare a value that was too low for the risk of actually having to sell their goods at rock bottom prices to the customs authorities. Creative importers quickly learned to bundle their goods in very large quantities so that the value would easily overshoot the customs officers’ creditworthiness. The actual value Article VII of the General Agreement on Tariffs and Trade contains the basis for the international system of customs valuation.17 The article stipulates that the customs value of imported goods should be based on the actual value of the imported merchandise on which duty is assessed or on similar goods. It is stated that customs valuation should be based on a fair, uniform and neutral system that precludes the use of arbitrary or fictitious customs values. The same basic valuation principle as transfer pricing Article 29, section 2 of the Community Customs Code18 demands that the relationship of the buyer and seller did not influence the price. This principle is very similar as the arm's length principle used for transfer pricing purposes. In both instances one is trying to determine a fair market value for goods to avoid manipulation. The timing difference between customs valuation and transfer pricing Because of its objective, customs valuation is only concerned with the value of goods at the moment they enter into the European Union (one point in time). This is a practical difference with transfer pricing as transfer pricing aims to distribute yearly assessed profits fairly between tax jurisdiction (a certain span of time).

4.2 Customs valuation methods: transaction value first The actual value is the transaction value Implementing the General Agreement on Tariffs and Trade, the articles 29 and 30 of the Community Customs Code revolve around the transaction value. In total the Community Customs Code defines six customs valuation methods that must be applied in sequential order, starting with the transaction value of the goods. Those methods are:

1. the transaction value of the imported goods, 2. the transaction value of identical goods, 3. the transaction value of similar goods, 4. the deductive value method, 5. the computed value method and 6. the residual value method.

These methods are discussed below.

17 The original GATT text (GATT 1947) is still in effect under the WTO framework, subject to the modifications of GATT 1994. 18 This article is based on article 1.2 of the agreement on the Implementation of article VII of the GATT.

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1. The transaction value of the imported goods Under the first method the customs value equals the ‘transaction value’ of the imported goods. This is usually the total amount invoiced to the buyer by the seller.19 This method is designated the leading method of customs valuation, it is applicable in virtually all (>95%) imports into the European Union.20 Article 29, section 1, Community Customs Code defines the transaction value as the price actually paid or payable for the goods when sold for export into the customs territory of the European Union. The use of the transaction value is subject to the following conditions:

1. There can be no restrictions regarding the use of the goods by the buyer other than those that: a). are imposed by law or the public authorities of the EU, b). concern the geographical area where the goods can be re-marketed, c). do not substantially change the value of the goods.

2. The transaction price is not subject to a condition for which the value cannot be determined with respect to the goods being valued.

3. No part of the proceeds of any subsequent resale, disposal or use of the goods by the buyer will accrue directly or indirectly to the seller, unless an appropriate adjustment can be made.

4. Buyer and seller are not related, or when they are related the transaction value is acceptable for customs purposes.

Which transaction? The customs valuation process ties in with the last sale before the goods were exported into the European Union. When a chain of transactions precedes the actual importation into the European Union it is usually more advantageous for the importer to use a transaction early on in the chain because prices tend to rise in every subsequent transaction. Under the Community Customs Code, article 147 of the implementation Regulation to the Community Customs Code, provided for the option to base the transaction value on the first sale for export. Unfortunately this option has not been continued in the Union Customs Code that will apply as from May first 2016. 2. The transaction value of identical goods Secondly when a transaction price does not meet the above conditions the customs value has to be based on the transaction value of identical goods that were sold for export into the European community in transactions occurring around the same time as the goods that must be valued, between buyers and sellers who are not related.21

3. The transaction value of similar goods In third instance the customs value has to be based on the transaction value of similar goods that were sold for export into the European community in transactions occurring around the same time as the goods that must be valued, between buyers and sellers who are not related.22 4. Deductive value method

19 Some costs are specifically included or excluded, see paragraph 4.3. 20 F. Idsinga a.o., Let’s Tango! The dance between VAT, customs and transfer pricing, International transfer pricing journal, IBFD september/october 2005. 21 Article 30, section 2, sub a, Community Customs Code. 22 Article 30, section 2, sub b, Community Customs Code.

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In fourth instance, the value should be based on the unit price at which the imported goods for identical or similar imported goods are sold within the Community in the greatest aggregate quantity to persons not related to the sellers.23 5. Computed value method The fifth valuation method in the sequence is the computed value. Under this method the customs value is the sum of the production costs of the goods being valued plus an amount for general expenses and profit. This method is rarely used. 6. Any reasonable means If none of the above valuation methods can be applied, the customs value can be determined using any reasonable means consistent with the basic principles.

4.3 Customs value; specific additions and subtractions After the customs value has been determined using one of the methods above, some costs are explicitly included or excluded, naturally only if they are incurred by the buyer at all. So for if for instance parties agree to a certain transaction value for a shipment of goods that does not include transportation and insurance costs because the buyer arranges for the transport himself, these costs should also be included in the transaction value. Also, sometimes certain costs are not settled on a per transaction base but on, for instance, a yearly base (e.g. royalties). If these costs fall within the scope of the articles 32 and 33 of the Community Customs Code, they should be added to the customs value. If they are incurred by the buyer and not already included in the customs value the following costs should be added:

1. Commissions and brokerage fees, except buying commissions. 2. The costs of containers which are classified together with the goods in question. 3. Packing costs. 4. The value of a number of defined goods and services supplied by the buyer to the seller

free of charge. These goods and services include inter alia; materials, moulds, tools, engineering and development services if they are used in the production process.

5. Royalties and licence fees that are a condition of the sale. 6. The proceeds of a resale that accrues directly or indirectly to the seller. 7. The costs of transportation and insurance to the place of introduction of the goods into

the European Union. The following elements are not to be included in the customs value of the imported goods:

1. Transportation and insurance costs for transport after the place of introduction into the European Union.

2. Charges for construction, erection, assembly, maintenance or technical assistance undertaken after importation into the European Union.

3. Interest charges for buyers credit provided that the financing agreement is in writing and the interest percentage is not higher than is customary for similar transactions.

4. The costs of the right to reproduce the goods within the European Union. 5. Buying commissions. 6. Import duties payable in the European Union.

23 Article 30, section 2, sub c, Community Customs Code.

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4.4 Customs law and intra-group transactions Customs law does not deem a transaction price unacceptable solely on the grounds that is was agreed to between related parties. The price will be accepted when examination of the transaction shows that it was not influenced by the affiliation.24 It is important to note that the customs authorities bare the burden of proving that the transaction value was influenced by the affiliation. In contrast, for corporate income tax purposes the taxpayer should provide documentation showing that the prices agreed to were set in accordance with the arm's length principle.

5. Customs valuation and transfer pricing, similarities and differences

5.1 The same principle yet different practical methods The same basic valuation principle Both transfer pricing and customs valuation use the same basic valuation principle for transactions of goods between related parties. For customs valuation it is called the transaction value and for transfer pricing it is called the arm's length price. In both instances one is trying to determine the fair market price that would have been reached between independent parties under full competition. Both transfer pricing and customs valuation offer a range of different practical methods to determine this fair market value. There is no escaping the notion that under all methods the 'fair market value' determined will remain, at least, somewhat arbitrary. Different goals Transfer pricing aims to allocate yearly profits fairly between tax jurisdictions, customs valuation aims to determine a fair and non-manipulated base for customs duties. An important

24 Article 29, section 2, Community Customs Code.

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difference is that transfer pricing aggregates goods and services, while customs valuation is concerned only with goods. Because of their different goals, conflicting interests arise within the fiscal authorities. A corporate income tax inspectors' job is to make sure the prices charged to the taxpayers in his jurisdiction are not inflated to shift profits abroad. A customs inspector should ascertain that the customs value presented is not artificially low to make sure enough customs duties are paid. Different practical valuation methods Because customs valuation and transfer pricing aim for different goals, they use different practical methods for reaching a fair market value of the goods. Both transfer pricing rules and customs valuation prescribe a number of methods to reach the fair market value of goods. For transfer pricing purposes the comparable uncontrolled price is preferred and for customs valuation the transaction value is preferred. Even although these preferred methods are very similar it is not always possible to converge the transfer price with the customs value. This is partly due to the specific additions and subtractions from the customs value. Illustrative are the transport costs after the point of entry into the European Union. Those costs are specifically excluded from the customs value but will generally be part of the transfer price.

5.2 Correcting for known practical differences Any specific differences between customs valuation- and transfer pricing-methods are clearly described in the legislation. Therefore it should be feasible to adjust the transfer price to reach a legally correct customs value. Differences in the practical valuation methods should not be a reason not to adjust the customs value after a transfer pricing adjustment.

6. Accounting for transfer pricing adjustments In this chapter I will discuss the situation multinational groups of companies find themselves in when confronted with a transfer pricing adjustment. The base example is a Dutch company buying goods from a Chinese group company for which the transfer price has been increased retroactively. What are the obstacles to adjusting the customs value too? What solutions can be found?

6.1 The use of customs valuation for transfer pricing

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In international literature the link between transfer pricing and customs valuation has been debated extensively.25 Until now this has only resulted in a rather non-committal comment in the OECD Transfer Pricing Guidelines. The OECD Transfer Pricing Guidelines discuss the use of customs valuation to set the transfer price. A rather conservative stance is being taken. The OECD states that 'customs valuation may be useful to tax administrations in evaluating the arm’s length character of a controlled transaction transfer price and vice versa':

“D.5 Use of customs valuations 1.78 The arm’s length principle is applied, broadly speaking, by many customs administrations as a principle of comparison between the value attributable to goods imported by associated enterprises, which may be affected by the special relationship between them, and the value for similar goods imported by independent enterprises. Valuation methods for customs purposes however may not be aligned with the OECD’s recognised transfer pricing methods. That being said, customs valuations may be useful to tax administrations in evaluating the arm’s length character of a controlled transaction transfer price and vice versa. In particular, customs officials may have contemporaneous information regarding the transaction that could be relevant for transfer pricing purposes, especially if prepared by the taxpayer, while tax authorities may have transfer pricing documentation which provides detailed information on the circumstances of the transaction. 1.79 Taxpayers may have competing incentives in setting values for customs and tax purposes. In general, a taxpayer importing goods may be interested in setting a low price for the transaction for customs purposes so that the customs duty imposed will be low. (There could be similar considerations arising with respect to value added taxes, sales taxes, and excise taxes.) For tax purposes, however, a higher price paid for those same goods would increase the deductible costs in the importing country (although this would also increase the sales revenue of the seller in the country of export). Cooperation between income tax and customs administrations within a country in evaluating transfer prices is becoming more common and this should help to reduce the number of cases where customs valuations are found unacceptable for tax purposes or vice versa. Greater cooperation in the area of exchange of information would be particularly useful, and should not be difficult to achieve in countries that already have integrated administrations for income taxes and customs duties. Countries that have separate administrations may wish to consider modifying the exchange of information rules so that the information can flow more easily between the different administrations.”

In my opinion a less conservative approach offers opportunities to further optimize tax systems and improve on compliance and acceptance towards the fiscal system. The problem is not in transfer pricing rules but in customs legislation Furthermore because of timing issues discussed in paragraph 7.4, it would be more useful to multinationals to amend customs legislation.

6.2 Non-refundable customs duties VAT that is due on import generally is refundable if the goods are used for VAT taxable activities. This is in contrast to customs duties that are in principle non-refundable. Furthermore the VAT due on import is based on the customs value.26 Therefore multinationals have the most financial interest in lowering the customs duties after a transfer pricing adjustment is made.

25 P. Liu a.o., Transfer Pricing Customs Duties and VAT rules: Can we bridge the Gap?, World Commerce Review, Vol. 1, Issue No. 1, 2007 and M. Jovanovich, Customs valuation and transfer pricing, is it possible to harmonize customs an tax rules? Series on International Taxation, Vol. 28, Kluwer Law International, London 2002. 26 Article 19, section 1, Dutch Act on Value Added Tax. Based on directive 2006/112/EG, article 85.

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Unfortunately the customs legislation lacks provisions specifically designed to account for retroactive transfer pricing adjustments. It does not offer a clear remedy to retrieve the customs duty after a decrease of the transfer prices paid for goods entering the European Union.

6.3 Is a transfer pricing adjustment reason to adjust the customs value? High incidence of transfer pricing adjustments In chapter 4 the different methods for determining transfer prices have been discussed. In paragraph 4.2 I hope to have shown that, especially because of the arbitrary nature of the comparability analysis, transfer pricing remains far from being an exact science. From a global perspective the European Union is a relatively high tax jurisdiction. This may tempt companies shipping in goods to search for the upper bound of the range of acceptable transfer prices, effectively shifting profits towards lower tax jurisdictions. The arbitrary nature of the determination process combined with the financial incentive that goes with transfer pricing often leads to discussions with tax authorities. Tax authorities may feel they have to intervene by lowering the transfer prices charged to European group companies to protect the European taxable base. As discussed in paragraph 6.2, because specific differences are clearly described in the legislation it should be feasible to adjust the transfer price to reach a legally correct customs value. Differences in the practical valuation methods should not be a reason to not adjust the customs value after a transfer pricing adjustment. Transfer pricing increases are incorporated in the customs value Importers are obliged to declare any post-import price increases. If they do not declare these price increases they run the risk of being confronted with additional assessments and possibly fines. Transfer price increases are included in the customs value and additional customs duties will be due. Transfer pricing decreases should also be incorporated in the customs value Practical differences of an executive nature between transfer pricing and customs valuation aside, it seems logical and fair that a lowering of the transfer pricing determined for a shipment of goods also leads to a lowering of the customs value. The transfer pricing adjustment is usually unfavourable for the taxpayer. It is unfair to withhold the upside of lower transfer pricing, namely a lower customs value and lower customs duties due. Because both transfer pricing and customs valuation are basically aiming to set a fair market value of goods, it is hard to argue that the two should not move in synchronicity. A reasonable and holistic fiscal approach means that a downward transfer pricing adjustment is followed by a lowering of the customs duties due. Legally aligning transfer prices and customs valuation The conflicting interests that arise for multinational companies between customs valuation and transfer pricing provide a strong argument for legally aligning the two. If the interest for a low customs value (lower duties) is countered by an interest in a high transfer price (lower taxable profit) chances are high that most companies will naturally drift towards a more balanced approach, minimising costly discussions with revenue and customs authorities.

6.4 Timing issues

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A primary transfer pricing adjustment generally takes place years after the transaction was concluded and only as a corporate income tax adjustment. In many cases the statute of limitations on customs assessments is the reason that a transfer pricing adjustment does not result in an adjustment of the customs value. The customs assessment must be issued within three years after submission and acceptance of the customs declaration.27

And even if the transfer pricing adjustment is imposed within the statute of limitations of the customs assessment it is possible that customs authorities argue that it is in itself no legal ground for decreasing the customs value. Customs legislation should be improved to accommodate transfer pricing corrections The problem is that transfer pricing adjustments can be made for up to five years after the original corporate income tax return was filed. The main challenge for importers is to match the mostly disadvantageous transfer pricing corrections with an advantageous lowering of the customs value. Therefore I hope that in the near future legislators like the WTO and the European Union will introduce a legal provision that specifically facilitates an adjustment of the customs value after a transfer pricing adjustment. While we are waiting for customs legislation to improve In the absence of provisions specifically designed to account for transfer pricing adjustments it is unclear how companies should best account for retroactive transfer pricing adjustments in their customs declarations. In the following paragraphs I will explore some alternative options.

6.5 Incomplete customs returns One way a retroactive transfer pricing adjustment could be translated into a lower customs value is the provision for filing incomplete customs returns. Article 253 of the Implementation regulation on the Community Customs Code allows for the filing of incomplete customs declarations:

“1. The procedure for incomplete declarations shall allow the customs authorities to accept, in a duly justified case, a declaration which does not contain all the particulars required, or which is not accompanied by all documents necessary for the customs procedure in question.”

Based on this article the customs value could be provided at a later date. The customs authorities will set a date before which the missing customs value must be supplied. Price review clause Buyer and seller could for instance incorporate a price review clause in their contracts making a transfer pricing adjustment a ground to adjust the price post-importation. When at the end of the corporate income tax book year any transfer pricing adjustments need to be made, they can do so and complete the customs declarations on the basis of the now complete transaction value. Administrative burden This method has several drawbacks. The first being that the time limit set for supplying the missing particulars is usually set no later than 12 months in the future. Therefore this option does not provide the needed time to cover all transfer pricing adjustments. The second problem with this method is the significant administrative burden that is incurred by the importer. He will be obliged to administratively manage a large amount of incomplete customs declarations.

27 Article 221, section 3, Community Customs Code.

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Retrospective discounts not part of the transaction value In some countries transfer pricing decreases may be considered retrospective discounts to the price paid and therefore no duty can be repaid. Because of the above-mentioned drawbacks, in practice this method is not extensively used to accomplish a customs duty refund after a decrease transfer pricing adjustment.

6.6 The agreement between importer and customs Based on article 78 of the Community Customs Code, the customs authorities are able to amend the customs declaration at the request of the importer:

“1. The customs authorities may, on their own initiative or at the request of the declarant, amend the declaration after release of the goods.”

In theory a multinational confronted with a transfer pricing adjustment could request the customs authorities to lower the customs value. Although the European Court of Justice ruled28 that Customs authorities are required to repay customs duties when the customs value should be decreased, not all member states interpret article 78 of the Community Customs Code in this way. In practice it proves difficult to actually obtain a refund based on a decrease transfer pricing adjustment. Civil law adjustment agreements In practice most European Union customs authorities will conclude agreements with importers to the effect that post importation price changes can be processed within a period of some months after the end of the year. This is obviously very practical, however this method is not based on article 78 or any other article of the Community Customs Code. These civil law agreements are so to say outside of the customs regulations. This poses a problem when disputes arise over whether or not the transfer price is usable for the customs value. In that case the importer does not have a specific legal action at his or her disposal to contend the decision of the customs authorities.

28 European Court of Justice, 20 October 2005, Overland Footwear, C-468/03.

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7. Conclusions and recommendations In this final chapter I propose some improvements in customs legislation.

7.1 The same valuation principle means moving in synchronization As discussed the basic valuation principle in both transfer pricing and customs valuation is the same. In both instances the objective is to avoid manipulation by determining a fair market value. This logically means that both valuation methods will arrive at the same price. Any practical valuation differences arising from the differences in objectives, may be eliminated as they are well described in the legislation. Moreover importers are legally obliged to declare increases in customs value. It is therefore unfair to disallow that a decrease transfer pricing adjustment cannot result in a decrease of the customs value.

7.2 Customs legislation should be improved Only in some very specific cases does the Community Customs Code allow the decreasing of a customs value after the declaration is made. At the current state of affairs importers have some practical options to account for retrospective decrease transfer pricing adjustments in their customs valuation. However these options fall short on the aspect of the time window offered and on the legal actions provided in case of a valuation dispute. This post-importation decreasing of the customs value is still a grey area that could potentially be moved forwards through litigation. Although evidently legislative clarification would be the preferred way to go.

7.3 Proposition for improving customs legislation The current legislative situation is unbalanced and unclear. There is a rather uncomplicated opportunity to improve the customs legislation in this respect. I propose a provision specifically allowing customs value adjustment to the extent the transaction has been subject to a transfer pricing adjustment. The statute of limitations on this provision could automatically follow the corporate income tax limitations.

8. Literature list

1. OECD, Model Tax Convention on income and capital, 2014.

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2. Deloitte – The link between Transfer Pricing and Customs Valuation – 2013 Country

Guide.

3. R. Lanz, a.o., Intra-Firm Trade: Patterns, Determinants and Policy Implications, OECD Trade Policy Papers no. 114, OECD Publishing 2011.

4. OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax

Administrations, OECD Publishing 2010.

5. P. Liu a.o., Transfer Pricing Customs Duties and VAT rules: Can we bridge the Gap?, World Commerce Review, Vol. 1, Issue No. 1, 2007.

6. E. Santoro, Transer Pricing and value added tax in the European Community: is there

room for interaction and, if so where?, International Transfer Pricing Journal, May/June 2007.

7. F. Idsinga a.o., Let’s Tango! The dance between VAT, customs and transfer pricing,

International transfer pricing journal, IBFD september/october 2005.

8. A. Bakker a.o., Transfer Pricing and Customs Valuation, Two worlds to tax as one, IBFD, International transfer pricing journal, Issue no 5, 2005.

9. M. Jovanovich, Customs valuation and transfer pricing, is it possible to harmonize

customs an tax rules? Series on International Taxation, Vol. 28, Kluwer Law International, London 2002.

10. OECD, Economic Outlook, Volume 2002, no. 1, Chapter VI.

11. UNCTAD, World Investment Report 1995, Transnational corporations and

competitiveness, www.unctad.org

12. WTO, General Agreement on Tarrifs and Trade, 1994.

13. WTO, Agreement on Implementation of Article VII of Gatt 1994.

14. European Commission, regulation EEC 2454/93 of 2 july 1993, laying down provisions for the implementation of Council regulations EEC 2913/92.

15. European Council, regulation 2913/92 of 12 october 1992, establishing the Community

Customs Code.