Customs duty considerations.

Failure to recognize the significance of customs duty issues during business planning could cause missed opportunities worth millions and create a duty or customs penalty exposure if not properly addressed. It is critical to understand how a decision to acquire another company, reorganize existing global structure, introduce royalty income arrangements or alter intercompany transfer-pricing strategy may have a significant effect on a company's customs duty liability. Thus, an effective international tax strategy must take into account the customs duty and indirect tax implications. This item presents some practical examples of the link between customs and income tax planning.

Corporate Reorganizations

The global corporate structure and supply chain that a multinational corporation (MNC) adopts may yield an opportunity for significant annual savings in customs duty. Thus, an effective global customs-duty strategy must be evaluated at the planning stages of a reorganization.

U.S. and European Union customs laws include the customs valuation concept of "earlier or first sale" (first sale). Under this concept, if goods are imported under a multi-tiered international supply chain, it might be possible to use an earlier transaction in the supply chain as the basis for customs duty. In the U.S., this approach finds support in Nissho Iwai American Corp., 982 F2d 505 (Fed. Cir. 1992), which interpreted the customs valuation statute in 19 USC Section 1401a. For example, if Asian contract manufacturer X produces and sells goods for $100 to European middleman/entrepreneur company Y, which in turn sells the goods for $130 to U.S. importer Z, it might be possible to use the $100 that Y paid, as opposed to the $130 that importer Z paid, as the basis for customs duty assessment. MNCs considering or planning a global corporate reorganization for tax efficiency or other purposes should look into the potential customs duty opportunities from implementing a "first sale" strategy, if appropriate.

Further, during merger and acquisition planning, a target's potential customs liability should be evaluated during due diligence, along with the target's other tax and corporate liabilities. If the target has not addressed its customs compliance obligations effectively as part of its normal business operations, there might be potential liabilities in duty or customs penalties accruing and waiting for the unsuspecting acquirer. These liabilities can accrue as far back as five years under the customs statute of limitations, and, under 19 USC Section 1592, might range from 20%-100% of the imported goods' value, even if the goods are duty free. Thus, from a risk-management perspective, the target's customs exposure must be diagnosed as part of the acquisition, particularly in today's environment--in which the government is scrutinizing customs compliance and supply chain issues more closely than before.

Intangible Property, but Tangible Duty Effect

Under 19 USC Section 1401a(b) (D), customs duty may be assessed on the value of royalties or license fees paid by U.S. importers to foreign intangible rights holders (e.g., for trademark, design, advertising, commissionaire or distribution rights). For example, if a royalty is paid by a U.S. importer to a foreign licensor who is also the seller/exporter of the goods (or even if the licensor is merely related to the foreign seller/exporter), the value of the royalty or intangible right may be included in the duty basis of the imported goods. This may be true even when the licensor is unrelated to the seller/exporter or is a domestic company.

U.S. importers may be unaware that, depending on how such royalty and import agreements are structured, the duty basis of imported goods might be increased inadvertently if the royalty is deemed a "condition of sale." There may be ways to mitigate this from a customs perspective. If not addressed during the planning stages, however, not only does the company risk increasing its indirect tax liability (which directly affects the bottom line), but it might be exposed to potentially hefty customs penalties if the dutiable royalty stream is unreported to the U.S. Customs Service.

Retroactive Price Adjustment

MNCs may adjust their inter-company transfer prices retroactively over several years (e.g., as part of a competent authority or advance pricing agreement negotiation). If these adjustments occur between an importing U.S. company and its foreign seller/exporter, the importer inadvertently may have adjusted the customs duty basis of previously imported goods. For example, if duty at a rate of 6% ad valorem was paid on goods imported and valued at $100 in FY 2000, but in 2003 the importer retroactively increases its transfer price for the goods to $120 for FY 2000, the U.S. Customs Service would require another 6% in duty on the retroactive $20 increase.

A company's failure to consider such effects when setting transfer-pricing policy may cause an unexpected increase to its duty liability and budget. This may also expose a company to customs penalties for undervaluing imported goods. However, if addressed timely, there may be ways to mitigate the duty effect, and lessen the company's exposure to customs penalties through protective disclosures.

The Sec. 1059A Ceiling

For goods imported in a transaction (directly or indirectly) between related persons, Sec. 1059A limits the inventory cost/tax basis of imported goods to the customs value declared at final liquidation. Liquidation is a fixed customs event that occurs approximately one year after importation and signifies the final computation of customs value, or duty basis, accruing on an import entry.

Accordingly, under Sec. 1059A, the IRS may disallow tax deductions for retroactive transfer-price increases by the amount that the new (retroactive) transfer price exceeds the customs value ceiling declared at liquidation. Without proper planning, the practical effect can be that a company will not be able to deduct the full amount of its cost of goods imported more than one year ago. In addition, U.S. Customs will expect an additional payment of duty on the retroactive price increase, as discussed above.

Conclusion

Tax advisers should keep informed about the significant overlap between tax and customs duty planning. The above examples emphasize the importance of coordinating customs duty and direct tax strategy.

FROM LUIS ABAD, J.D., NEW YORK, NY

Annette B. Smith, CPA 

Partner

Washington National Tax Service

PricewaterhouseCoopers LLP 

Washington, DC