U.S.-China Supply Chain: Mitigating Transfer Pricing and Customs Risk in 2022

January 2022

BY

Enoch HsuManaging Director, Specialized Tax Services-Transfer Pricing

James PaiSenior Manager, International Tax-Customs and International Trade Services

This article was originally published in Reuters’ December 2021 Customs & International Trade Newsletter.

The recurring outbreaks of COVID-19 variants continue to disrupt the global economy, and in particular the global supply chain. As we all know, the ports of Long Beach and Los Angeles, the two West Coast hubs that account for approximately 40% of ocean freight entering the U.S., are heavily affected by this disruption. Carriers that have spent several weeks crossing the Pacific Ocean must spend yet more time waiting to dock and unload containers, which means they incur additional costs. Adding to this, ongoing trade disputes between the U.S. and China further complicate multinational corporations’ intercompany pricing formulas for cross-border transactions. Accordingly, many multinationals are seeking business strategies to maintain cash flow, improve liquidity, control profit allocation and recover losses caused by supply chain delays and the China tariffs. We discuss these tactics here.
 

1. Consider Year-End Transfer Pricing Adjustments

Traditionally, many multinationals headquartered in China have employed a streamlined supply chain model in which their U.S. distribution subsidiary bears only limited business risk and maintains a fixed profit level; whereas, the Chinese principal undertakes greater economic risk and earns greater rewards (or bears losses).

When borders shut down at the onset of the pandemic, ocean freight, transportation and global mobility came to a halt. Global supply chains were critically impacted and the profit levels of most multinationals dropped significantly; now they can no longer achieve reasonable and stable profit uplifts for their U.S. distributor subsidiaries. However, the arm’s-length principle — the price charged in a controlled transaction between two related parties — should be the same as that in a transaction between two unrelated parties on the open market. Arm’s length expects that reasonable and stable profit uplifts be maintained for these U.S. entities because their business operations profile within the global supply chains remains unchanged from the pre-pandemic era.

Many multinationals evaluate and assess their existing transfer pricing policies during their year-end financial reviews. When needed, management will conduct year-end transfer pricing adjustments to meet compliance requirements and avoid a negative financial statement impact, especially when actual results deviate from forecasts. As the pandemic continues, year-end adjustments become important tasks because most original group-wide pricing policies did not anticipate the extensive disruption that ensued.
Whether these year-end adjustments are reportable to U.S. Customs & Border Protection (CBP) as part of the declared value for imported merchandise depends on two main issues, according to a landmark CBP ruling in 2012: (1) whether and when a related party price (determined pursuant the importer’s transfer pricing policy and other documentary evidence) may constitute a formula at the time of importation for transaction value purposes; and (2) whether post-importation price adjustments (either upward or downward) may be taken into account in determining the transaction value.

Regarding the first issue, CBP ruled that when the transaction value is determined pursuant to a pricing formula, that formula must be set before or at the time of importation and not subject to revisions after importation. Note, however, that the formula can change from time to time as management deems necessary and changes be documented.

Concerning the second issue, CBP noted that additional considerations (the so-called five-factor test) should be taken into account in evaluating whether an intercompany transfer pricing formula is an objective method when it provides for post-importation adjustments to the price. So, depending on these analyses, U.S. distributors/importers may need to adjust an already declared customs value based on post-importation transfer pricing adjustments to either claim a refund of duties or to pay additional duties. This is usually done through CBP’s Reconciliation Program. It is critical for multinationals with intercompany transactions to pay close attention to the CBP rules before making any year-end transfer pricing adjustments.
 

2. Consult with Advisors on Customs Implications

Year-end transfer pricing adjustments may also complicate management’s reporting obligations in China from both income tax and customs perspectives. Due to strict foreign exchange control, year-end adjustments, especially for trade-related transactions, require extensive negotiation processes with various authorities. Those entities include the Chinese State Tax Administration (STA), the Customs Authority and the State Administration of Foreign Exchange (SAFE). These three bureaus’ policies may contradict one another. For example, in the case of a Chinese entity importing goods from its overseas related party, the STA will focus on maintaining the arm’s-length profit so that the purchase price is not too high; the Customs Authority will focus on the imported price so that it is not below the market price of similar imported goods; and the SAFE will focus on the authenticity of the transactions. For this reason, approval must be obtained from these government bodies before year-end transfer pricing adjustments can be carried out in China.

Given the transfer pricing complexities, the management should consult their transfer pricing and customs advisors on how to mitigate risks in their current transfer pricing systems when accounting for the current economic climate and operating risks in each country involved.
 

3. Keep an Eye on U.S. and China Trade Policies and U.S. Policy against Forced Labor

Since 2018, both the U.S. and China have been imposing tariffs in addition to Normal Trade Relations (NTR) duties on many goods originating in their respective countries. Most notably, the U.S. has been imposing Section 301 tariffs, which are additional duties (on top of NTR duties) imposed a remedy to China’s unfair trade practices, on four different lists of Chinese-originating tariff items as follows: 1) Lists 1 through 3: 25% ad valorem; and 2) List 4A: 7.5% ad valorem. These additional duties remain unchanged under the Biden Administration.

On Oct. 5, 2021, the U.S. Trade Representative (USTR) released a notice inviting public comments on whether certain previously extended product exclusions from U.S. Section 301 tariff measures on Chinese goods should be reinstated. This new exclusion process applies only to the roughly 550 exclusions that had been previously granted, extended and then allowed to expire. With the comment period now closed, USTR is expected to announce any new exclusions once its decisions are made. For that reason, businesses in the affected sectors need to regularly monitor the USTR website for possible future exclusion notices.

Another significant issue is U.S. policy against forced labor in the Xinjiang Uighur Autonomous Region (XUAR) of China. Section 307 of the Tariff Act of 1930 prohibits the importation of merchandise mined, produced or manufactured wholly or in part in any foreign country by forced or indentured labor — including forced prison or child labor. If CBP receives information that reasonably (note that it does not need to be conclusive information) indicates that imported merchandise is being made with forced labor, the agency issues a Withhold Release Order (WRO) to prevent such goods from entering into the commerce of the U.S.

On Jan. 13, 2021, CBP issued a WRO on cotton and tomato products (including downstream products that incorporate raw material inputs) produced in Xinjiang based on information received during its investigation that revealed the apparent use of forced labor of the Uyghur people and other ethnic and religious minority groups. CBP issued another WRO on silica-based products on June 23, 2021, covering a specific manufacturer in Xinjiang. The WRO applies to this entity’s silica products no matter where they or their constituent materials are manufactured.

Once a WRO is issued, U.S. importers have three months to submit evidence substantiating that the specific merchandise on each withheld shipment was not produced with forced labor. In other words, the importer must prove a negative, a difficult task because the importer is not usually the producer of the goods. Importers must also substantiate the country of origin of all materials used in manufacturing the finished good. If an importer fails to submit this evidence, the detained shipment will be excluded from entry and may also be subject to seizure. Multinationals need to keep this concern top of mind when purchasing Chinese-origin parts, components, or finished products by thoroughly reviewing their downstream supply chains to determine whether any relevant merchandise contains items produced with forced labor.
 

4. Take Action Before — Not After — Importation

To manage the ongoing business impacts of COVID-19 and the evolving trade disputes between the U.S. and China, many multinationals will want to evaluate their existing transfer pricing policies and consider making retroactive transfer pricing adjustments. Given that transfer pricing and customs valuation are closely connected, organizations importing goods into the U.S. should consider how transfer pricing adjustments to prices may affect import duties. It is important to take action before importation to align the income tax and customs approach to mitigate the impact of any transfer pricing adjustment. Multinationals should also carefully monitor the continuing development of U.S.–China trade issues to mitigate the business impacts and to determine the appropriate course of action to manage relevant risks.