Co-written by J. Harold McClure and Yanan Li
Hamamatsu Photonics is a Japanese manufacturer of various optical devices, which are sold in Europe by Hamamatsu Photonics Deutschland GmbH (HPD). HPD obtained an Advance Pricing Agreement (APA) with the German and Japanese tax authorities that targeted an operating margin. On December 20, 2017, the Court of Justice of the European Union (CJEU) issued a ruling objecting to this targeting of an operating margin when HPD lowered its transfer pricing, where the actual financial results showed an operating margin below the targeted margin. According to Associate Editor for American Shipper, Brian Bradley:[1]
A December ruling by Europe’s highest court could impact the ability of multinational companies doing business in the EU to make etroactive transfer pricing adjustments for purposes of customs valuation, trade analysts familiar with the case said recently. “This case is pivotal,” said Claire Reichstein, international trade attorney for Ford Motor Company, at the American Association of Exporters and Importers (AAEI) conference in Baltimore in June. “It’s going to be a game changer. It stands for the proposition that transfer pricing is not relevant for customs value” …Between Oct. 7, 2009, and Sept. 30, 2010, the German subsidiary imported goods from more than 1,000 consignments from the parent company, and tariffs ranging from 1.4 percent to 6.7 percent were levied on the taxable goods, the ruling states. The German subsidiary’s operating margin during that period was lower than expected, and transfer prices were reduced as a result, and the subsidiary thus received a credit of €3,858,345.46, the ECJ ruling states. Hamamatsu Photonics Deutschland then applied to German customs to recoup €42,942.14 in duties, but customs rejected the request, saying the action would be incompatible with Article 29(1) of the Community Customs Code, “which refers to the transaction value of individual goods, not that of mixed consignments,” the ruling states. The question remains whether the Hamamatsu case was fact-specific and therefore isn’t applicable to other situations or whether it will apply to transfer pricing for customs valuation more broadly…
Whether a multinational can make post-importation adjustments and the role of transfer pricing (TP) methodologies has a parallel history in the U.S. as Mark Neville notes in his commentary on this CJEU ruling:[2]
…some argued that if the tax authorities had accepted an APA or a TP policy, the customs authorities should accept it as conclusive proof that the TP was acceptable, i.e., as showing that the relationship had not influenced the price. One reason advanced was that the TP methods were analogous to the Valuation Agreement valuation methods. Others, many of whom were customs authorities, argued the polar opposite—that the APA, TP policy, or other work product undertaken for income tax purposes should be irrelevant for customs valuation. For them, the differences between the two disciplines, in methods and more generally, were profound.
One of the authors of this piece, J. Harold McClure noted in a paper for the Tax Executive Institute, an intermediate view.[3] While the economic analysis prepared for an APA application may provide useful information, two caveats apply. This first, that not all transfer pricing analyses are informative on what an appropriate pricing policy would be. The second caveat is that the issue of post-importation may involve a different question, which customs officials often allude to by reference to “industry standards”. Much of income tax transfer pricing addresses technical issues with respect to the benchmarking of a distributor’s margin based on its function and assets, while many of the customs issues revolve around implementation issues. Third party distributors negotiate an appropriate gross margin based on its functions and assets involved in carrying out its responsibilities as the distributor of a manufacturer’s products. The deductive value method is fundamentally equivalent to the use of a Transactional Net Margin Method (TNMM) to construct the appropriate gross margin.
Interestingly, the 2008 paper[4] discussed a similar situation, which was the subject HQ 548482 involving a U.S. distributor that imported bananas and other fresh fruits:
While the Comparable Profits Method evaluates that appropriate amount of operating profits, gross profits can be seen as the sum of normal operating expenses and a normal operating profit. As long as the analysis is attempting to evaluate the appropriate gross profit margin in terms of the normal operating expense to sales ratio and the normal operating margin, the Comparable Profits Method is a useful component of the modified Resale Price Method, which is equivalent to the Deductive Value Method. In other words, the three methods do generate the same numbers in terms of the average gross margin, the average operating expense to sales ratio, and the average operating margin.
This statement was a prelude to noting two important differences between the Deductive Value Method and any application of TNMM or the Comparable Profits Method. One involved situations where the distributor has multiple product lines. In the illustration of the Hamamatsu issues, it was assumed the functions performed in the distribution of product 1 were less than the functions performed in the distribution 2. As such, a customs authority would rightfully expect the gross margin on the first product line should be lower than the gross margin on the second product line. If both product lines were afforded a 20 percent gross margin, the transfer price for product 1 would be below the arm’s length standard.
The other issue involved “variations in the operating expense to sales ratio across time”:
If the actual operating expense to sales ratio significantly deviates from the average or normal operating expense, the related party distributor will have to choose from maintaining a fixed gross profit margin versus staying with the range of operating margins as established by the Comparable Profits Method.
Customs authorities often insist on a fixed gross margin approach arguing that third party distributors do not target operating margins. Interestingly tax authorities in Germany and Japan have often made similar arguments. Some transfer pricing practitioners, however, insist that distribution affiliates be seen as “limited risk” and argue for targeting operating margins. APA agreements are often written in terms of a band for an acceptable operating margin. Temporary variations in the operating expense to sales ratio would likely not lead to variability in the gross margin under arm’s length pricing.
It should be noted, however, two other possibilities. Permanent increases in the operating expense to sales ratio may emanate from function creep, that is, the distribution affiliate taking on more responsibilities. If the operating expense to sales ratio increased from function creep, a case can be made for lowering the transfer price to increase the gross margin commensurate with the new functions.
The other possible reason why HPD’s operating margin fell below its TNMM range may involve a reduction in the gross margin from an adverse exchange rate change rather than any increase in the operating expense to sales ratio. During the period relevant to this CJEU ruling, the Euro was devaluing with respect to the yen, which would tend to reduce the consolidated profit margin for Japanese manufacturers with German distribution affiliates. Which legal entity should bear this exchange rate risk has been an issue in transfer pricing for well over a generation.[5],[6]
One could argue that the intent of the Hamamatsu APA was to insulate HPD from all relative price risk and have the Japanese parent bear this risk. If so, any decline in the gross margin from a devaluation of the Euro with respect to the yen should have led to an adjustment in the transfer price to maintain the agreed upon gross margin under the Deductive Value Method.
The CJEU decision and many of the subsequent discussions of the Hamamatsu issue have been silent on what led to the reduced operating margin for HPD. We have noted three possible reasons. In two of these three scenarios, a case could be made for a reduced transfer pricing had the facts been more thoroughly developed. If, however, the fall in the operating margin was due to a temporary increase in operating expenses relative to sales, the CJEU denial of the retroactive price change appears to be warranted.
The Hamamatsu case raises the legal question is whether one can amend the invoice with a supplementary customs declaration, which is provided for in Belgium, France, Italy, the Netherlands, and Spain but maybe not in Germany and the UK. It still would remain whether the supplementary customs declaration adjusts the invoice price to the economic shock that lower the distribution affiliate’s operating margin. If the shock were a relative price shock such as from exchange rate fluctuations, a policy of targeting gross margins should allow an appropriate adjustment to the invoice price.
Our use of the term “operating expenses” presumes that cost of goods sold includes only the cost of products, while all value-added expenses are included in operating expenses. While the accounting for publicly traded companies uses comparables, this is not always so simple. The real issue for customs amounts is tied to which expenses are dutiable and which ones are not. Customs law often provides incredible detail on these matters, which makes it incumbent on the importing affiliate to review its income accounting in detail as well. One customs law practitioner, for example noted:[7]
Given the burdensome nature of deductive value (use of pro forma invoices; calculating product-by-product prices based on surrogate end customer selling prices), CBP should proceed cautiously with any further expansion of the deductive value methodology.
While this point is well taken, the advantages of being able to comply with customs expectations are clear. The question becomes whether the multinational has the appropriate tools to efficiently address these concerns.
[1] Bradley, Brian “Pivotal” EU ruling threatens use of transfer prices”, American Shipper, July 25, 2018, https://www.americanshipper.com/main/full/pivotal-eu-ruling-threatens-use-of-transfer-prices-71952.aspx
[2] “ECJ: Transfer Pricing Adjustments Derail Transaction Value”, Journal of International Taxation, March 2018.
[3] McClure, J. Harold. “Coordinating Transfer Pricing Reports for Income Tax and Customs: Can an OECD Report Be Tailored to Satisfy Both Section 482 and Customs Purposes”, 60 Tax Executive 435 (2008).
[4] “Coordinating Transfer Pricing Reports for Income Tax and Customs: Can an OECD Report Be Tailored to Satisfy Both Section 482 and Customs Purposes”, 60 Tax Executive 435 (2008).
[5] See for example, J. Harold McClure, “What Goes Up Must Come Down: Will Japan Adopt CPM Or Will the U.S. Accept Exchange Rate Risk Adjustments?”, BNA Transfer Pricing Report, April 21, 1999.
[6] Figure provides the yen/euro exchange rate over the period from 1999 to 2017.
[7] https://thecustomslawfirm.com/cbp-hq-issues-rare-deductive-value-ruling-2/
