December, 2014

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Reference Pricing —
A Disturbing Trend in Customs Valuation

Mark K. Neville, Jr.

We have often discussed the intersection of customs valuation in related party transactions and transfer pricing for income tax purposes1 and we return to that topic again. Specifically, we will be focusing on the tendency of some customs authorities to oversimplify the solution to these complex issues. As will be seen, the oversimplification arises even in third party transactions, and thus all import transactions are at risk in a significant number of customs territories. Let’s start with related party transactions first.

Related party customs valuation rules

To recap, the importer in a related party transaction,2 has the burden of establishing that the sales price in a transaction value appraisement3 is acceptable.4 The importer has a choice here, either showing that the price has not been influenced by the relationship under a Circumstances of Sale (COS) analysis or showing that the price closely approximates one of the so-called “Test Values.”5 The Test Values are the alternative bases of appraisement, and they include the transaction value of identical or similar merchandise which were imported at or about the same time as the subject importation.

Importer/Taxpayer in the middle

The importer has a similar burden to validate its purchase price for the income tax authorities, who are committed to revenue collection to the same extent as their customs authority brethren. The problem for the importer is that he is caught in the middle of a tug-of-war. The customs officers are pushing to increase the customs value so that a greater duty is collected when the ad valorem duty is applied against the customs value. At the same time, the income tax authorities seek to lower the customs value because that will be reflected in a lower cost of goods sold (COGS) for the imported merchandise and the income tax collected will necessarily be boosted because the importer/taxpayer will have earned a greater profit, and thus a higher taxable income, on the resale. The following will illustrate this dynamic at play:

Import Price Duty At 10%   COGS Resale Price Taxable Income
  80   8   88 150 62
100 10 110 150 40
120 12 132 150 18

In this and all other transfer pricing cases, the importer will want to satisfy both revenue authorities, but you will have seen the natural tension created by the conflicting revenue enhancement imperatives.

Transfer Pricing rules

In “controlled transactions,” which is the income tax term for related party transactions, the taxpayer has the burden of establishing that the sale price meets the arm’s length standard and, as the OECD observes,

a controlled transaction meets the arm’s length standard if the results are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.

In this task, the taxpayer will want to demonstrate that its purchase price meets one of the transfer pricing methods. Unlike the CVA and domestic implementing customs valuation laws, the transfer pricing methods are not embedded in a hierarchy. Instead, the taxpayer must use the “best method.”6 The best method is the one that provides the most reliable measure of an arm’s length result. Two primary factors that determine the most reliable measure are the degree of comparability between the controlled transaction and any uncontrolled comparable transaction and the quality of the data and the assumptions used in the analysis.

In the US, those methods will first include the three “traditional transaction” methods: comparable uncontrolled price or

CUP (comparing the price charged for property transferred in a controlled transaction to the price charged fro property transferred in a comparable uncontrolled transaction in comparable circumstances);
resale price method;
and cost-plus method

The latter two are based upon a comparison of gross profit on sales to third parties.
These are followed by two profit-based methods

Comparable Profit Method (CPM)—operating margin
Profit –Split Methods—allocate profit based upon functions performed, risks assumed and resources employed. There are two such methods, the comparable profit-split and the residual profit split method.

Finally, there is a method that is styled an “unspecified” method (in the OECD: “other method”) that allows for hybrids or for derivations from the specified methods. This is analogous to the last method employed in customs valuation, the so-called “fallback” method.7

Note that the OECD relies on a similar methodology with one major exception in that the transactional net margin method (TNMM) is a specified OECD transactional profit method. The TNMM is actually used in perhaps as much as 70% of the active transfer pricing studies. While not a specified US method, the TNMM still finds its way to acceptance in the US by means of fitting within the unspecified method.

This is not the place or time to undertake an extensive discussion on the interaction of the two disciplines but our point here is to underscore that there may not be simple answers to such questions as,
  • What use can an importer/taxpayer make of transfer pricing studies?
  • Can the customs authorities learn anything from the income tax authorities?
One observation that we can make is that the answer to the first question is a “middle ground” answer, i.e., it depends on the facts and circumstances. This is true in the US, with the answer set forth in Customs and Border Protection’s Informed Compliance Publication on related party pricing, as well as at the World Customs Organization whose Technical Committee on Customs Valuation has issued its Commentary 23.1.

Role of the CUP and of the Test Values: Ensure that Apples are Compared to Apples

When the CVA was reached in 1979, it marked a radical departure from the Brussels Definition of Value (BDV) which was based on a market value concept known as “normal value.” Thus, regardless of the PAPP reached by a willing buyer and willing seller, customs valuation was assigned by means of a notional value. The CVA scrapped this, and in fact prohibited the very uses of such external referents as we are seeing now. To be clear, the CVA (Subsections of Art. 7.2) prohibits the use of
  • minimum customs values (f), and
  • arbitrary and fictitious values (g), as well as
  • a value that is based on the higher of two values (b) or
  • a value that is tied to a selling price in the country of importation (a).
In the case of related party pricing, under the customs valuation law, we have seen that the importer can make use of either a COS or a test value analysis. Under the COS, if the buyer and the seller, although related under the CVA, buy from and sell to each other as if they were not related, then they are demonstrating that the price had not been influenced. That leads, in turn, to two examples
  • The price was settled in a manner consistent with the normal pricing practices of the industry in question;
  • The price was settled in a manner consistent with the way the seller settles prices for sales to buyers who are not related to it.
For good measure, a third example is provided
  • The price is adequate to ensure recovery of all costs plus a profit that is equivalent to the firm’s overall profit realized over a representative period of time in sales of merchandise of the same class or kind.8
The emphasized text in the second exemplar is suggestive of the first of the two “Test Values,” which are the Transaction Value of Identical and of Similar Merchandise. And those, in turn, are similar to the CUP method. But what is clear is that comparisons with the prices shown in external transactions, whether it is (i) in a customs review of a third party sale or in a related party context under a COS or a Test Value analysis, or (ii) in a transfer pricing dialogue with income tax authorities, may be gravely erroneous. In the case of the Test Values, the CVA notes that they are to be used only at the initiative of the importer and then cautions against the use of Test Values as a substitute for the price declared in a related party transaction.9 When we get to the two Test Values being discussed, the customs valuation law insists on a proper apples-to-apples comparison. First, the definitions of “identical” and of “similar” merchandise make it clear that the merchandise must be “identical in all respects” or produced in the same country (preferably by the same person) and like the merchandise being appraised in characteristics and component material and is commercially interchangeable with the merchandise being appraised.10

Next, if there are two or more comparable prices, the lower or the lowest price must be used.11 The quantities involved in the comparison set must be comparable and the commercial levels must be the same.12 Where transportation and insurance charges are included in transaction value, due account must be made for such differences.13 In the context of a CUP under the OECD, we find here too a cautious approach. The uncontrolled and controlled transactions may be properly compared if one of two conditions is met:
  • None of the differences between the transaction or between the enterprises could materially affect the price in the open market, or
  • Reasonably accurate adjustments can be made to eliminate the material effects of such differences.
In the US, the Internal Revenue Service takes the same approach—there should be either no product differences or reasonable adjustments can be made to ensure product comparability. One point that is quite clear is that the CUP is probably the most reliable method IF the especially high product comparability14 requirement is met. Any product difference may materially affect the price of the transaction and it is often not practicable to make reasonably accurate comparability adjustments for such differences. As a result, the CUP is most often used in sales of commodities traded on the open market. In sum, use of these Test Values in customs valuation and of the CUP in a transfer pricing inquiry is severely circumscribed.

Valuation Databases

One current trend that augurs ill for the international trade community is that many countries are making extensive use of “customs valuation databases,” ordinarily organized on a tariff classification basis. This means that there is a set value that is associated with or assigned to a given tariff provision. The customs authorities will refer to that fixed value in appraising the imported goods, whether or not there is a related party transaction at issue. Of course, the CVA is established on the basis of the PAPP, and third party pricing is presumptively valid—or it should be presumptively valid.

While valuation databases are meant to be used only in a very narrow application as a risk indicator in examining imports for customs fraud,15 anecdotal evidence suggests that several dozen countries are using these databases in ways that violate the CVA. The databases are the source of “reference” or “indicative” prices which are actually prohibited substitute or minimum prices, and the importer usually has little or no opportunity to challenge the validity of these prices.

All of the precautions discussed above that would rule out use of appraisement based on the TV of identical or similar merchandise or would disqualify a CUP are thrown to the wind with the indiscriminate and across-the –board use of valuation databases to furnish an alternative to a declared value. Gone is the carefully calibrated regime of built-in restrictions and of conditions that must be met, and ignored is the notion that a Test Value cannot be used as a substitute in a related party transaction. Query, how vexing is it that the comparability factors that preclude the use of these precisely crafted methods are disregarded with this wholesale use of databases?

To be clear, we are not saying that customs authorities must automatically accept any customs value declared by any importer. We are saying that importers and customs authorities alike must adhere to the CVA. Taken together, they should form a community of interest and those interests are aligned.

We are mindful that the CVA allows Members to satisfy themselves as to the truth and accuracy of any statement, document or declaration presented for customs valuation purposes.16 But we are just as mindful that such authority will not justify abuse.


The use of valuation databases to establish reference or minimum pricing—regardless of the “window dressing” that would state that they are being used only for risk assessment purposes—is based upon a gross oversimplification, on the false assumption that “a rose is a rose is a rose” for valuation purposes as well as for tariff classification. When used to provide an alternative customs value, the valuation database is neither more nor less than a tool to violate the CVA. It is a problem.


1. The most recent discussion was in August, Neville, “Chile and other stopping points on the customs and tax playing field,” 25 JOIT 19 (Aug 2014). To be sure, transfer pricing for income tax purposes will also be invoked in the pricing of services or in regard to the sale of intangibles between related parties, but this discussion is limited to the sale of imported tangible goods.

2. Recall that the buyer and seller are related under the Customs Valuation Agreement (CVA) parties with as little as a 5% share ownership or a common ownership.

3. The customs valuation law sets forth a hierarchy of methods for appraisement which must be strictly followed. The first method is transaction value (TV), which is based upon the price actually paid or payable for the goods ( the PAPP) when sold for export. The PAPP normally equates to the invoice price for the goods but with certain additions for off-invoice elements (the Five Statutory Additions, 19 USC § 1401a (b) (1)) where applicable.

4. 19 USC § 1401a (b) (2) (B), CVA, Art. 1.1 (d).

5. 19 USC § 1401a (b) (2) (B), 19 CFR §§ 152.103 (j) (2) and (l), CVA, Art. 1.2.

6. In the US, this is set forth at Treas. Reg. § 1.482-1 (c).

7. 19 USC § 1401a (f) (value if other values cannot be determined or used), CVA, Art. 7.

8. The US authority is found at the regulations, 19 CFR § 152.103 (l).

9. CVA, Art. 1.2 (c).

10. 19 USC §§ 1401a (h) (2) and (3), respectively.

11. 19 USC § 1401a (c) (2), CVA, Arts. 2.3 and 3.3.

12. 19 USC § 1401a (c) (2), CVA, Arts. 2.1 (b) and 3.1 (b).

13. CVA, Arts. 2.2 (b) and 3.2.Note that most jurisdictions include such charges in TV. The US and Canada are notable exceptions.

14. Treas. Reg. § 1.482-3 (b) (2) (ii) (A).

15. The World Customs Organization provides that [A]pplication of an appropriate risk assessment and management procedure ables Customs to exercise this right in a pragmatic manner. Such procedures may use, inter alia, a valuation database. WCO, GUIDELINES ON THE DEVELOPMENT AND USE OF A NATIONAL VALUATION DATABASE AS A RISK ASSESSMENT TOOL (2005) (para. 6) (emphasis added)

16. CVA, Art. 17.

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