Transfer Pricing and Customs Valuation Memorandum D13-4-13 Post-Importation Payments or Fees “Subsequent Proceeds” - What Every Customs Professional Should Know 8 March 2011 Daniel Kiselbach, Miller Thomson LLP Rhonda MacKenzie, KPMG LLP Angelos Xilinas, KPMG LLP

This presentation was original prepared for IE Canada’s Western Canada Conference “Maximizing Your Knowledge In Trade & Customs” which was held March 8, 2011 in Calgary, AB. This presentation is provided as an information service and is a summary of current legal issues. This information is not meant as legal opinion and readers are cautioned not to act on information provided in this presentation without seeking specific legal advice with respect to their unique circumstances.

Contents 1.

What is Transfer Pricing?

2.

Background

3.

Comparison of Customs and Transfer Pricing

4.

Subsequent Proceeds

5.

Onus of Proof

6.

Penalties and Voluntary Disclosures

7.

Getting Support

8.

Conclusion

1. What is Transfer Pricing

What is Transfer Pricing? Importance of this Topic The Inherent Problem

What is Transfer Pricing? • Transfer pricing refers to the pricing of contributions (assets, tangible and intangible, services, and funds) transferred within an organization •

E.g. goods from a parent company may be sold to a foreign subsidiary –

Typical market mechanisms that would normally establish prices between third parties don’t exist

–

Thus the transfer price will affect the allocation of profit among the parts of the company

• Tax and Customs authorities worry that multi-national entities set transfer prices on cross-border transactions to reduce taxation • Thus the rise of customs value and transfer pricing regulations and enforcement, making customs value transfer pricing a major tax compliance issue

Importance of this Topic • Customs valuation and transfer pricing (“TP”) have much in common, but often have competing interests • Lack of attention to customs valuation by companies • Customs professionals not consulted in the internal process by tax department Thus: • Importers use prices determined for TP to set customs values • Little consideration of customs valuation methodologies • Use standard customs value (standard cost) and fail to adjust the declared value to reflect actual prices (actual cost)

Importance of this Topic • Rules are developed/promoted by organizations with different objectives – Customs: Canada Border Services Agency – TP: Canada Revenue Agency

• Discord leaves companies exposed to audits, investigations and/or penalties • How does a company bridge differences to enable one intercompany pricing policy to work for customs and TP?

The Inherent Problem • Price adjustments impact valuation (e.g. a transfer price adjustment related to goods affects customs value) • Companies reallocating profits must take into account the possibility of increasing the value for duty • Executives not always ready to share transfer pricing information outside the boardroom • Executives know what is happening so “reason to believe” is satisfied • If they do not communicate this to the customs managers to make adjustments, penalties may be assessed

2. Background

Non-convergent approaches and mandates of the CRA and Canada Customs Memorandum D-13-4-13

Background • Both customs valuation and TP attempt to reach arm’s-length values – Due to differing methodologies and standards, TP transfer price may not be suitable for customs value (and vice versa)

• Multinational companies need to comply with both TP rules and customs valuation rules

Background

V A L U E

CRA looks to assert adjustments when prices are too high

V A L U E

Customs looks to assert adjustments when prices are too low

Customs Environment (Canada) • Customs – Increasingly better trained auditors – Looking more to financial reporting systems to establish pricing – AMPs penalties may be assessed respecting incorrect value declarations – CBSA Memorandum D13-3-6 and D13-4-13

Transfer Pricing Environment (Canada) • TP – Increase in transfer pricing audits and penalties – Financial crisis increasing aggressiveness of CRA – Financial crisis increasing companies undertaking restructuring activities •

CRA aggressively denying Canadian subsidiary a deduction

– Increased emphasis on documentation to avoid penalties •

Includes need for intercompany agreements

•

Additional details on existence and ownership of IP

3. Comparison of Customs and Transfer Pricing

Transfer Pricing vs. Value for Duty (VFD) Case Studies

Customs v. Transfer Pricing Approach Differences

Customs

CRA

Different Objectives

Increase COGS / Import Value

Reduce COGS / Import Value

Different Law

Customs Act

Income Tax Act

Different Focus

Per unit price of imported goods

Taxable income of importer or exporter

Different Time Periods

Entry-by-entry declarations

Annual period (normally)

Different Comparable Sets

Product / Industry comparability

Functional comparability

Different Tests

Circumstances of Sale Test / Test Values

Arm’s length principle

Different Measures if not Arm’s Length

Rejection of transaction value / invoice price

Adjustment of transfer price / invoice price

TP and Customs Valuation Methods Transfer Pricing: z

CUP

Customs: z

• Price paid/payable for same goods under same terms and conditions

z

Resale Price

• Price paid/payable when the goods are sold to the country of importation plus certain specified adjustments z

• Price paid/payable for same goods under same terms and conditions z

Cost Plus

Profit split/TNMM • Profit based

Deductive Value • Resale value in country of importation less certain costs incurred including SG&A

z

• Cost of the good or service plus an arm’s length mark-up z

Transaction Value (identical or similar goods)

Computed Value • The costs of manufacturing plus a reasonable profit

z

Residual Method • Any other reasonable method, usually a modified version of the above methods

TP and Customs Valuation Methods Transfer Pricing:

Customs:

• CUP

• Transaction Value (identical or similar goods)

• Price paid/payable for same goods under same terms and conditions

• Resale Price • Price paid/payable for same goods under same terms and conditions • Cost Plus • Cost of the good or service plus an arm’s length mark-up • Profit split/TNMM • Profit based

• Price paid/payable when the goods are sold to the country of importation plus certain specified adjustments • Deductive Value • Resale value in country of importation less certain costs incurred including SG&A • Computed Value • The costs of manufacturing plus a reasonable profit • Residual Method • Any other reasonable method, usually a modified version of the above methods

Customs – Transaction Value Under TV commercial invoice must adjusted for other charges to the purchaser + z

Packaging costs

z

Design/artwork/plans

z

Sales commissions

z

Royalties/licence fees

z

Engineering costs

z

Warehousing & logistics

z

Buying commissions

z

Assembly, etc… in country of import

z

Transport/insurance from country of export (duty)

Case Study 1 – Compensating Adjustments T-shirts sold using Standard Cost @ $1/unit and 10,000,000 units sold at no-profit

Good bought using Standard Cost for $10,000,000

• Customs value declared on import is based on $1 (+/adjustments for customs purposes) which is the standard cost • Balancing payment to subsidiary at year-end to achieve 5 percent OM – DR Cost of goods – CR A/P

$500,000 $500,000

Discussion on Case Study – Balancing Payment • The cost of the goods have increased by $500K • The value of each good increase by 5 percent • The value for duty is $1.05 • In this instance, an adjustment must be made to correct the value for duty and the duty plus interest must be tendered within 90 days of the adjustment (Customs Act ss. 32.2(2)) • Thus the adjustment is for: – 6109.10.00 T-Shirts $10,000,000 * 5 percent = $500K * 18 percent or $90,000

4. Subsequent Proceeds

Subsequent Proceeds and Transaction Value Subsequent Proceeds - Past Practice Subsequent Proceeds - New Policy (Memorandum D13-3-13) Targeted Payments Not a Condition of Sale Policy Subsequent Proceeds excluded from Value for Duty

What are Subsequent Proceeds? Subsequent Proceeds” – Legislation: Customs Act • 48. (1) Subject to subsections (6) and (7), the value for duty of goods is the transaction value of the goods if the goods are sold for export to Canada to a purchaser in Canada and the price paid or payable for the goods can be determined and if… (c) where any part of the proceeds of any subsequent resale, disposal or use of the goods by the purchaser thereof is to accrue, directly or indirectly, to the vendor, the price paid or payable for the goods includes the value of that part of the proceeds or such price is adjusted in accordance with subparagraph (5)(a)(v); …

Subsequent Proceeds and TV Transaction Value • If not already included in the price of the goods, the following must be added: a) Certain (selling) commissions and brokerage; b) All packing costs and charges; c) The value of certain goods and services provided free or at a reduced charge by the purchaser for use in the production of the imported goods (assists); d) Certain royalties and licence fees; e) The value of any proceeds from the subsequent resale, disposal or use of the goods which accrue to the vendor; and f) The costs of transportation and associated costs relating to the movement of the goods to and at the place from which the goods were shipped directly to Canada.

Subsequent Proceeds - Past Practice Historical Policy • CBSA rarely questioned management fees; • R&D costs were allowed to be split between research (non-dutiable unless work resulted in an import) and development costs, which are generally dutiable; • Costs for marketing rarely questioned; and • No clear expectations from importers on what was required as proof.

Subsequent Proceeds - Recent Policy CBSA Policy: Memorandum D13-3-13, July 8, 2009 • Subsequent proceeds are subject to the following two conditions: – The payments accrue directly or indirectly to the vendor of the goods; – The payments are based on, or a result of, the resale, disposal, or use of the goods in Canada. • Consequently, if the payment does not meet the above then the CBSA will apply the definition of “Price Paid or Payable”

Targeted Payments for Inclusion in the VFD To establish the value for duty of imported goods under the transaction value method, several kinds of postimportation payments must be examined: a) Any payments based on the resale of the goods that cannot be related by the importer to services received; b) Management or administration fees; c) Contributions to research and development; d) Contributions to worldwide marketing or promotion; e) Overhead expenses related to the manufacturing of the goods but not captured in the selling price and recovered after the importation of goods (appeal has been filed); f) Interest on deferred payments; and g) Other payments made after importation.

Not a Condition of Sale Policy is not Dispositive to Date • According to the CBSA, these subsequent proceeds do not have to be a condition of sale of the goods – Nor be directly related to goods being imported

• As such, importers should examine any payments they make to the vendor separately from the payment for the goods to determine whether they have to include these payments when determining the value of the goods for duty purposes

Subsequent Proceeds Excluded from the VFD When are fees excluded from duty (includes GST/HST): • The services must have been rendered for the operation of the business in Canada; • The amount of the charge must be in accordance with an arm’s length charge; • The services provided are justified for the operation of the business in Canada; • In addition, payments such as dividends are excluded from the customs value.

5. Onus of Proof

Onus of Proof Lies with Importer upon Audit of Fees Documentation a MUST! Documentation

Onus of Proof Lies with Importer upon Audit of Fees • The onus is on the importer to prove the nature of the services provided and that the fees paid are truly for the operation of the business in Canada • The CBSA says it will presume that service fees are subject to duty, unless the importer can provide evidence that the fees are in accordance with the arm’s-length principle, and that they relate to justifiable services that were actually rendered for the Canadian operation

Documentation a MUST! • Importers must be able to provide the CBSA with documents that verify: – The nature of the services for which payment is made; – The basis on which the payment is made (options for cost allocations); – That actual services are provided.

• Our experience is that most companies do not have sufficient proof to support inter-company fees.

Documentation • Documentation must include commercial invoices, agreements, or other proof of payment, depending on the circumstances • If the CBSA determines that such fees are subject to duty and have not been included in the declared value of the goods, the importer may risk costly assessments, penalties, and lengthy appeals

6. Penalties and Voluntary Disclosures

Penalties, Penalty Mitigation and Voluntary Disclosures

Penalties, Penalty Mitigation and Voluntary Disclosures • Penalties – Contravention C083 - authorized person failed to make the required corrections to a declaration of value for duty within 90 days after having reason to believe the declaration was incorrect (normally applied by compliance verification officers usually after an audit, examination or verification or previously identified errors or failure to correct after reason to believe) – Second level penalty will apply to each accounting document not corrected to a maximum of $200,000 for the reassessment period, to a maximum of $400,000 depending upon the level of the penalty imposed

Penalties, Penalty Mitigation and Voluntary Disclosures • Disclosure Procedure – Important to enter into a mutual non disclosure agreement – Mutual non disclosure agreement is to prevent investigators from gaining access to information prior to the completion of a voluntary disclosure

• Interest – Policy is that interest should be charged – Legislation indicates that interest may be waived – Remember: If you don’t ask, you don’t get…

7. Getting Support

Getting support from the C suite

Getting Support from the Corporate Executive Level • Ask if you can attend any tax meeting regarding transfer pricing • Be prepared to explain why it is important • Be prepared to answer questions • Explain the penalty situation but don’t be too threatening • Explain options if there are past exposures • Ask to be part of the tax team on a go forward basis

Getting Support from the Corporate Executive Level • Where inter-corporate transfers or corporate restructuring is planned, suggest that the customs duty as well as the tax consequences be reviewed • Consider an annual review respecting customs and tax planning issues as the law or the underlying factual assumptions respecting transfer pricing may change • Follow up to ensure compliance with any customs verification, reports or other advice received with respect to transfer pricing issues

8. Conclusion

Conclusion • Differences exist between valuation methodologies • CBSA and CRA becoming increasingly aggressive • CBSA and TP often have competing interests and methodologies • With proactive planning, it is possible to develop transfer prices and TP documentation that are acceptable for CBSA and CRA • Understand Subsequent Proceeds and learn to spot them in your organization

9. Questions and Discussions

Thank You Presentation by Daniel Kiselbach, Miller Thomson LLP Rhonda MacKenzie, KPMG LLP Angelos Xilinas, KPMG LLP