Transfer Pricing: Avoid Paying For Hidden Customs Duty Costs

Multinational Enterprises (MNE) invest considerable time, effort and professional fees in building a robust transfer pricing mechanism that meets their regulatory obligations while optimising tax efficiency. This is a strategic way to get ahead in a competitive marketplace and is widely used. However, international trade has recently seen an upward trend in the number of businesses taking a blinkered approach to transfer pricing and, in doing so, fail to see the implications on customs duty costs, which very often rocket, leaving any tax savings dwarfed by comparison.

Adam Wood, Head of Commercial at Barbourne Brook commented:

“When implementing a transfer pricing strategy, there are many traps that organisations can fall into which affect customs duty. It’s not uncommon for businesses to look at transfer pricing and fail to make the necessary changes to their customs declarations, and HMRC are wise to this. It’s a hot topic for any regulatory customs audit, and the price of falling into these traps can be high – especially when you add penalty charges to the unpaid duty. To mitigate these risks, a review of customs operations is essential following the implementation of any transfer pricing campaign.”

Surprisingly, customs does not form part of core professional accountancy training, and so it follows that it is often overlooked by Financial Directors in terms of potential savings, or incurred costs. In many organisations, customs duty spend is accepted with very little review, especially in relation to adjustments made elsewhere like transfer pricing. Customs is often managed by a completely different department to other forms of taxation with very little visibility or shared information passing between the two.

The Bear Traps Businesses Fall into when Implementing Transfer Pricing

1. The Choice of Transfer Pricing Method Increases Duty Costs

The transfer pricing process often presents several acceptable methodologies and ranges of acceptable profits between the entities. Businesses typically choose a methodology and point within the range that optimises their tax position within these acceptable norms, often without directly considering the secondary implications of any associated customs duty costs.

For example, a business historically ships its clothing directly from a Chinese manufacturer to its customers in the European Union. It acts as the importer in the EU, using a customs broker as its indirect representative. The clothing is subject to a duty of 12% on the Chinese factory invoice of $100 plus insurance and freight. The business plans to change its supply chain and route the clothing through its UK warehouse to use economies of scale.

It also set up a subsidiary sales company in Germany, which takes minimal commercial risk.

The clothing sells at $205 to the customer. After discussions with its advisers, the business decides to adopt a net margin method transfer price and allocate 2% of the sales to the subsidiary to reflect their limited risk.

The selected transfer pricing methodology will almost double their customs duty costs in the EU, which will be levied at 12% of $198.85, assuming that the business implements customs warehousing or inward processing in the UK to negate having to pay duty twice.

The duty increase could dwarf the envisaged commercial savings in this instance.

2. Moving Intellectual Property to a Low Tax Jurisdiction

Intellectual property is inherently mobile, presenting multi-national businesses some flexibility on where to locate it and how to charge for it. Businesses should look beyond the direct tax rate and IP implications before deciding on any movement because customs valuation rules can mean licence fees are subject to duty*.

For example, a clothing business in the UK has built up a valuable brand. It imports clothing from a Chinese supplier. The clothing is subject to a duty of 12% on the Chinese factory invoice of $100 plus insurance and freight.

The business is expanding internationally, and as part of its restructuring, it decided to move the IP in the brand to a low-tax jurisdiction and license the usage of the brand from its subsidiary located there at 5% of the sales of branded garments. The clothing sells for $205 in the UK. HMRC seeks to charge a customs duty of 12% on the $100 supplier invoice and 12% of the $10.25 licence fee.

*Note that intellectual property is a sensitive issue for customs duty and direct tax purposes. It is the focus of OECD and BEPS initiatives (see BEPS actions 2,5,8-10 & OECD Pillar 2).

3. Retrospective Transfer Price Adjustments

A transfer price will typically provide an acceptable profit range. A business may set its transfer price for a period based on several assumptions, such as standard costs and exchange rate forecasts to target a profit in that range. The forecasts and assumptions will never be 100% accurate, leaving the business to determine how to account for this variance in its transfer pricing policy.

If the business resolves this variance historically, adjusting the original transfer price value will cause customs issues.

For example, the clothing business in example one sets the transfer pricing on standard costs and forecasts, issuing an invoice for $200. It decides to include a retrospective adjustment in its transfer pricing to ensure the sales company hits the 2% margin.

At the end of the period, actual costs are 5% higher and a cross-charge is made to bring the transfers back into the acceptable range. Firstly, the final value is not known at the time of import, so the original value is not acceptable for customs valuation purposes. As such, the business either must use an alternative customs valuation method, i.e. run two different transfer pricing methodologies, or seek the customs authority’s approval to make periodic corrections to the initially declared value.

Depending on the direction of the transfer price movement, the business will have under-declared the customs value at the time of import and, therefore, have underpaid the customs duty. This will lead to additional duty demands and potential penalties.

Note that in other circumstances, e.g., the actual costs being 5% lower, the customs value would be over-declared at the time of import. In this case, the business would have overpaid customs duty. In certain cases, this overpaid customs duty can be reclaimed. Businesses often forget retrospective transfer price adjustments and they only picked up at regulatory audits.