March, 2015

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Customs valuation issues of
imported prototypes

Mark K. Neville, Jr.

In this ever more hectic time we come to prize the simple things, the straightforward way of doing things, what we might call the “straight lines of life.” In fact we might long to see simplicity itself become enshrined as a fifth cardinal virtue.1 It is with this mindset that one may approach the customs valuation system as established by the Customs Valuation Agreement2 (CVA). That system is based upon an oft-touted simplicity. After all, what could be simpler than looking to the price negotiated between a buyer and a seller-- the “Price Actually Paid or Payable” (the PAPP), which is the core of Transaction Value? It turns out that we will be disappointed--that everything is relative, and that there are a lot of things simpler than customs valuation.

A seemingly simple application of the customs valuation law can quickly prove that the valuation law is often shaded with interpretations and can call for very nuanced interpretations.

For example, whenever we engage in the appraisement of goods that that have been sold between related parties, we encounter a layer of complexity, and one that is tied into transfer pricing for income tax purposes. But that particular problem, as interesting as it is generally, is not of interest at this opportunity. Alternatively, we should look for a review of other customs valuation issues based on the “simple vs. complicated” scale. We do not have far to look.

Those professionals who spend time in customs valuation already know that the true state of affairs is that one can rely on the invoice price for the imported goods to furnish the basis for customs valuation for all purposes only so. That point where reliance on the invoice price is left behind and a more complicated and unstable environment is reached at the outset of the process whenever pertinent questions go unasked or remain unanswered.

In short, we find that we can get into a similar state of confusion when we venture into but do not pass safely through the territory of Article 8 of the Valuation Agreement, the land of what I call the five “statutory additions.”3 We are going to be looking into the point of intersection between Article 1, which calls for an application of Transaction Value, and its working definition of the “Price Actually Paid or Payable” (the PAPP)—there’s that deceptively complex term again—and Article 8. And the point to make here is that Article 8 and its mandatory adjustments (read “additions”) to PAPP will always apply to a customs valuation being organized under Article 1. Whenever proceeding on a Transaction Value valuation—and to be clear, that means 100% of the time—the importer or its professional advisor must ask if there are any Article 8 adjustments that are possibly in play.

Indeed, one of the early questions raised in the customs valuation process is whether the off-invoice payment or the cost element in question should be examined (i) under Article 1, i.e., whether the amount in question is a part of the PAPP, or (ii) under Article 8. This discussion is going to be one of those where close attention to detail is needed, so pay attention to this next section.

Dutiable Assist defined

One of the 5 statutory additions is for “dutiable assists,” which many readers will recognize as one of the following elements that are provided free or at reduced cost in the production or sale for export
  • Materials incorporated into the imported goods
  • Tools, dies, molds
  • Materials consumed in the production
  • Engineering, development, artwork, design work undertaken outside the country of importation and necessary for the production of the imported goods.
ol> You will notice that the listing of elements that comprise the various categories of assists does not include monetary payments. In fact, this is one of those nuanced points. There is a distinction between money provided to the manufacturer to acquire, say, materials and the furnishing of the materials themselves. To be sure, the payment of the money has a customs valuation consequence. It is considered to be a part of the PAPP and, thus, dutiable. This was the result in the United States where payments to the seller, inter alia, to produce tooling were considered part of the PAPP.4 Thus, it would be a mistake to automatically conclude, as many do, whenever buyers’ payments for Article 8-style elements to be acquired by the manufacturer are discovered that there is a dutiable assist in play. For those who would argue that it hardly makes any difference to distinguish between status as a part of the PAPP and as an assist, because either status will give rise to a duty, I would say that it does make a difference when apportionment is considered.

Apportionment of dutiable assists

In the case of dutiable assists, the Customs Valuation Agreement provides for an apportionment of one category of dutiable assists, which is defined at Art. 8.1 (b). The Interpretative Note to Article 8, which is made an integral part of the CVA, specifies that in the case of the subsection (b) (ii) cost elements—tools, dies, moulds and similar items used in the production of the imported goods—there is an opportunity to apportion the value of the assists in a reasonable manner and in accordance with generally accepted accounting principles (GAAP). The Note goes on to observe that the method used will depend upon the importer’s documentation.

The example given is of a mould provided to the producer to make imported goods, with the factory contracting to make 10,000 units. At the time of the first shipment of the goods, of 1,000 units, some 4,000 units have been produced. The importer has the option to apportion the value of the mould over the 1,000 units being entered, or the 4,000 units that have been produced, or the 10,000 unit anticipated full production run.

There are competing demands which will dictate which course the importer might take. On the one hand, if there is some degree of uncertainty that the full 10,000 units will be both produced and then imported into the jurisdiction, the importer might be hesitant to tender duty on a per unit basis for some units which might never be imported, let alone produced. Such an importer might want to tender duty on the full cost of the assist but only after having first determined the per-unit apportionment across the anticipated production and then applying that assist to the quantity of units actually being imported. In such as case, the importer would be taking a more conservative approach. To illustrate, if the mould cost 10,000 currency units, then the anticipated per unit effect of the assist would be 1 currency unit per each unit of the imported good. This would lead to a total adjustment of 1,000 currency units for the 1,000 articles being imported in that first shipment. The effect is significant—if the importer were required to apportion all 10,000 currency units to that first shipment of 1,000 articles, then the duty would be collected on the inflated basis of 10 currency units per article.

The other options could be for the importer to voluntarily tender duty on the full amount of 10,000 currency units at the time of the first shipment. Of course, the practical effect of doing so is to dramatically increase the per unit apportioned assist, from 1 to 10 currency units, as we have seen, on the 1,000 units being imported. Why would the importer ever do that? When the importer’s controls were not strong, and there is a risk that later entries of the finished goods might be made without the required adjustment, the result being that the importer would not be in compliance with the customs valuation law. In such a case, the importer might want to be safe and “get it over with” up front, despite the fact that the importer would be “pre-paying” or, if the full run was never imported, over-paying on the assist.

In addition, the Note to subsection (b) (iv) (engineering, development, artwork, design work, plans and sketches) makes it clear that flexibility and a reasonable approach based upon commercially available documentation are anticipated. Further, apportionment is also available for that category of assists.

Apportionment is also available in the form of allocating a portion of the full value of the assist only to those finished goods that are planned for importation into the customs territory. Within the earlier illustration, if one-half of the expected production run is expected to be sent to a third country, then the full value of the dutiable assist is only 5,000 currency units. This is not explicitly provided in the CVA but is implicit in Interpretative Note to subsection (b) (ii); the customs regulations in the United States make it clear that such a circumstance (partial production for markets outside the US) will support an apportionment.5

The PAPP

All of this discussion about assists and their apportionment leads us to the same question about the PAPP, i.e., is it possible to apportion a payment to the manufacturer for tooling in the same fashion as the value of the tooling itself might be apportioned if the latter were being provided to the manufacturer? This is a loaded question, because if the importer can apportion an assist but not the PAPP, the importer may want to characterize the amount in question as an assist. In the United States, we have gotten advice on this question that has evolved over time from Customs and Border Protection (CBP). In the first instance, there was 1991 authority that stated there is no basis for such apportionment. That was a ruling issued in response to an Internal Advice request from the port on the status of payments that had been made to produce prototypes. CBP noted

[W]e find that the payments for tooling, R&D and testing are part of the price actually paid or payable for the imported prototypes. We note that the Customs Regulations do not provide guidelines specifically for the apportionment of direct payments, as they do for assists. Consequently, under the circumstances no authority exists to apportion these expenditures over the anticipated number of units produced, as LCI's former counsel has requested.6

This ruling (no. 544381) was issued by CBP Headquarters in November 1991 and followed a January ruling which reached the exact opposite conclusion, i.e., payments that are considered a part of the PAPP may be apportioned over the entire production run.7 This conflict was later resolved through court action.

Chrsyler court (1993): The PAPP may be apportioned

In fact, ruling no. 544381 was implicitly invalidated by the 1993 decision in Chrysler Corp. v. United States, 17 CIT 1049 (1993), where the Court found that tooling costs were properly allocated over the number of engines anticipated to be produced as opposed to the number of engines imported.

The interpretations of the Chrysler court were later characterized by CBP in the course of issuing a 1998 ruling on this subject of apportionments of the PAPP.8
These are worthy of your attention:

In that case, the court ruled that although certain shortfall and special application fees which the buyer paid to the seller were not a component of the price actually paid or payable, tooling expenses incurred for the production of the merchandise were part of the price actually paid or payable for the imported merchandise. The court found that payment for the tooling expenses could be subject to some form of allocation. The court further stated that what must be determined is the price actually paid or payable for the imported merchandise. The court emphasized that this price is the total payment which may be direct or indirect, and that the price may be the result of increases. The court concluded that what must be determined is which portion of the payments were directly or indirectly part of the price paid for the merchandise. The court apportioned the tooling expenses over the value of the total number of items intended to be produced and not the total number of items imported. The court stated that it would be "unrealistic and contrary to the facts of business life" to apportion the payments any other way. The rationale for this conclusion was that the payment was intended to affect the total number of items purchased and not merely those imported. This conclusion was based on purchase orders and contracts between the parties as well as testimony which indicated that the parties contracted to produce a minimum number of items during a specified model period.9

The Chrysler rationale had earlier been followed in a 1995 ruling, where CBP similarly left the apportionment door open on the issue of tooling payments, provided that the importer had documentary evidence to support the apportionment. As was the case in Chrysler, CBP reasoned

Similarly, in this case, the R&D costs could be allocated over the 60 prototypes produced, as opposed to the twenty that were imported. In Chrysler, the Court found that the importer provided uncontradicted evidence that the tooling costs were intended to affect all of the engines anticipated to be produced. In this case the importer states that only a small portion of the R&D cost was necessary for the development of the imported prototypes, however, the importer nevertheless states that it cannot segregate the costs which were incurred with respect to the imported prototypes without suffering an extreme administrative burden. Without evidentiary support for apportionment, we cannot determine what portion of the total R&D payment was for the imported prototypes. Unless the importer provides Customs with documentation in support of allocating the R&D costs over the 60 prototypes, we must necessarily find the total payment is part of the price actually paid or payable for the imported prototypes.

This ruling actually reveals the two phases of apportionment that are present in the above-cited Interpretive Note to subsection (b) (ii). First, the importer has an opportunity to apportion a tooling assist between goods that were produced an imported and those goods that were never produced and/or imported. The ruling is concerned with this first phase apportionment. Second, the importer can apportion the assist on a per-unit basis. As was enunciated in ruling no. 546771, the current CBP position is that PAPP may be apportioned—presumably in both respects-- so long as the method is reasonable and consistent with GAAP. As is so often the case with these discussions, only after this deep background dive do we come at last to the question that is of interest, the role of prototypes in all of this discussion of assists and PAPP.

Ford rulings

In the case of two Ford rulings,10 we have an opportunity to consider the customs valuation status of payments made in connection with engine prototypes imported from Japan, as well as the engines later imported once full production runs began. Originally the plan was to import 178 prototypes but that was later revised to an importation of 156 prototypes. The project was successful, and importation of the prototypes was followed by imports of full production run-engines. In addition to the prices paid for the prototypes, Ford was responsible for paying certain engineering, development and design fees associated with the production of the prototypes. Ford contended that these latter payments were assists in the context of the production engines. Apparently Ford then claimed that no duty should be paid on those assists because it had already paid duty on the prototypes. Not surprising to you at this point, you know what Ford did not know, i.e., these money payments cannot be classified as assists, on either the prototypes or on the production engines. The Internal Advice memorandum which forwarded the issue from the Port of Detroit is dated from March 1993, so it is possible that the issues were being framed in a pre-Chrysler context, in which there had been some question whether PAPP could be apportioned. It could be that Ford tried to argue for assist status because they felt that was their only hope of getting a lower duty payment via apportionment. In any event, CBP concluded that the prototypes are not assists whose value should be added to the PAPP of the imported production engines. The payment for the prototypes constitutes the PAPP of the prototypes.

While not recited in either the 1994 or 1996 Ford rulings, a 1995 Headquarters ruling11 states that the R&D costs (the development and design charges) for the prototypes were included in the customs value, i.e., were added to the PAPP, of the prototypes. The Ford ruling stated that the payment of the fees for design and development is attributable to the production engines and that amount should be added to the PAPP of the imported production engines. Similarly, the cost of all 178 prototypes produced, and not merely the 156 that were imported, is a part of the PAPP of the production engines and that cost should likewise be added to make the Transaction Value of those production engines.

In its bid for reconsideration, Ford did not dispute that the development and design fees comprise part of the PAPP for the production engines, nor it dispute that duty should be paid on the prototype engines. But Ford took the view that duty was being paid on the prototypes twice, first on the importation of those prototypes themselves (and that duty was paid on the invoice prices plus an amount for the development and design) and then later when the cost of the prototypes was included within the PAPP of the production engines. CBP took the view that the prototypes were separate articles of commerce and that any duties attaching to their entry needed to be paid. Beyond that, CBP observed that all costs associated with the prototypes were inextricably connected to the design and development of the production engines and should all be considered to form a part of the PAPP of the production engines. CBP acknowledged that the prototypes could not be seen as assists if they were not returned to the manufacturer for use in the subsequent production process of the production engines, but that really made no difference to Ford’s duty liability.12 CBP disregarded the point that the prototypes had already been imported and duty paid thereon

the fact that many of the prototypes were previously imported is not relevant. The price actually paid or payable for the production engines, i.e., the total payment, includes all payments for the imported merchandise. As indicated above, Customs' position is that payments for prototypes are part of the price actually paid or payable for the imported production articles because these payments relate to the design and development of the production articles.

There is a certain gap in CBP’s logic here. If the prototypes must be evaluated in their own right and in a stand-alone capacity, then how can CBP then proceed to count all of the costs associated with them (comprised of both the invoice price and amounts for development and design) as being a part of the PAPP of the production engines? Should not their separate status preclude that treatment? In other words, if the prototypes were imported and duty fully paid thereon13 and the prototypes, remaining as they did in the US, could not be tied into the customs value of the production engines under the status as assists, it certainly does seem to run counter to the Chrysler decision to allow for double dipping of the government to collect duty again on the full customs value of the prototypes in the course of collecting duty on the production engines. Of course, if duty had not been paid on all costs associated with the prototypes, e.g., on the development and design fees, then it would appear that duty might be paid on such fees in the context of either the prototypes or the production engines--but not both. I would welcome an concerted analysis of this issue by an experienced cost accounting professional.

Summary

The foregoing shows clearly—if there is anything clear about the discussion—how murky this customs valuation law is, or at least, can become, once we begin a proper, meaning well-informed, inquiry.

The importer must always ask whether it can rely on the invoice price, which means asking whether there are any potential additions, either as one of the 5 statutory additions or as an integral part of the PAPP. We have seen that the value of the cost element itself can be the focus of an initial apportionment, to be followed by an apportionment to, or among, the imported goods. If only it were simple…

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1. The classicist will recognize the four cardinal virtues as prudence (or wisdom), justice, temperance and courage (or fortitude).

2. The Agreement on implementation of Article VII of the General Agreement on Tariffs and Trade 1994. The customs valuation statute in the US is found at 19 USC § 1401a.

3. In the US, this is 19 USC § 1401a (b).

4. See, e.g., ruling no. 544516 (1/9/91), aff’d in no. 544642 (6/24/91); no. 544376 (11/13/84).

5. 19 CFR § 152.103 (e); see also ruling no. 543806 (3/12/87).

6. Ruling no. 544381 (11/25/91).

7. Ruling no. 544525 (1/31/91). Here, CBP ruled that an importer had not forfeited the option to pro-rate the value of certain tooling payments due to its failure to declare the tooling payments at the time of importation, even though some of the entries had bee liquidated. In that case, the importer made tooling payments to the seller during the period 1986-1989. At the time of importation, certain of the merchandise was duty-free under the Generalized System of Preferences ("GSP"). The importer did not report the tooling payments to Customs until 1989, subsequent to importation. At that date, some of the countries from which the merchandise had been imported had been removed from the list of beneficiary developing countries under GSP. The field office contended that the importer should not be allowed to apportion the tooling payments to any entry which had been liquidated. This included all the entries to which GSP applied. Headquarters agreed with the importer and permitted the apportionment of the tooling payments over all relevant entries, including those which had been liquidated.

8. Ruling no. 546771 (3/27/98).

9. Ruling no. 545320 (2/28/95); see also ruling no. 546771 (3/27/98).

10. Ruling no. 545278 (4/7/94) aff’d by 545907 (10/11/96).

11. Ruling no. 545320 (2/28/95).

12. This is set forth in ruling no. 544642 (6/24/91).

13. The development and design payments associated with the prototypes would be dutiable. See ruling no. 545320 (2/28/95).

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