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HQ 544686

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August 31, 1994

VAL CO:R:C:V 544686 CRS

CATEGORY: VALUATION

District Director
U.S. Customs Service
1 East Bay Street
Savannah, GA 31401

RE: Internal advice; related parties; transfer price; dutiability of royalties/proceeds

Dear Sir:

This is in reply to your memorandum of March 18, 1991, under cover of which you forwarded a request for internal advice (IA), dated May 18, 1990, submitted by counsel Katten, Muchin & Zavis, on behalf of Komatsu Dresser Company (KDC), concerning the method of appraisement applicable to imported construction equipment, components and spare parts. Further information in regard to the IA was provided by counsel under cover of letters dated August 30, 1991, and July 14, 1993. In addition to the IA, counsel submitted a ruling request, dated August 30, 1990, on the dutiability of certain royalty payments made by KDC. The ruling request was subsequently consolidated with the instant IA request. See Headquarters Ruling Letter (HRL) 544563 dated May 3, 1991. Additional information concerning the royalty payments was provided under cover of letters dated August 30, 1990, and February 12, 1992. Meetings with counsel were held at Customs Headquarters on August 7, 1991, and April 2, 1993. We regret the delay in responding.

Counsel has requested that certain information provided in connection with the IA request be treated as confidential pursuant to section 177.2(b)(7), Customs Regulations (19 C.F.R. ? 177.2(b)(7)). Accordingly, the portions of this ruling that appear in brackets will be deleted from any copies that are made available to the public.

FACTS:

KDC is a partnership between Komatsu America Corporation (KAC), Komatsu America Manufacturing Corporation (KAMC) and Dresser Finance Corporation (DFC), all of which are U.S. corporations. KAC, KAMC and DFC have partnership interests of, respectively, 49 percent, 1 percent and 50 percent. KAC and KAMC are wholly-owned subsidiaries of Komatsu Ltd. (KL), a Japanese corporation; DFC is a wholly-owned subsidiary of Dresser Industries U.S.A. (DI).

KDC purchases and imports construction equipment, including bulldozers, excavators and dump trucks (the "machinery"), and spare parts therefor from its related party, KL. In addition, KDC imports certain components from KL, which together with domestic components, are used to manufacture construction equipment in the U.S. KDC imports through a number of ports, including Atlanta, Savannah, Charleston, New Orleans, Philadelphia, Chicago, Dallas-Fort Worth, San Francisco and Los Angeles.

In 1989-1990, KDC was audited by the Atlanta Branch, Regulatory Audit Division (RAD), Southeast Region. The purpose of the audit was to review antidumping duties paid by KDC on spare parts imported from KL; however, information obtained during the audit led RAD and the responsible import specialist to question the use of transaction value as a basis of appraisement in KDC's related party importations. Audit Report No. 431-90-CEO-001 at 11. As a result of these concerns, RAD advised KDC under cover of a letter dated March 9, 1990, that transaction value was unacceptable and that instead, deductive value appeared to be the correct basis of appraisement.

This determination was based on a review of certain agreements between KL and KDC, and between KL and several third party suppliers. The specific agreements are: the Komatsu Supply Agreement with KDC (the "Supply Agreement"); a Side Agreement on Transfer Prices between KL and KDC (the "Side Agreement"); a Supplemental Agreement between KL and KDC (the "Supplemental Agreement"); Spare Parts Supply Agreements between KL and [Company A] and between KL and [Company B] (the "Spare Parts Agreements"); and a Purchase Agreement between KL and [Company C] (the "Purchase Agreement").

KL sells machinery, components and spare parts to KDC. Under the terms of the Side and Supplemental Agreements, the transfer price of machinery and components sold by KL to KDC is based on the [***] plus packing, inland freight, brokerage, shipping, ocean freight, insurance and similar charges. The term [***] is defined as the whole product manufacturing cost, including [***], plus general and administrative expenses (G&A), transportation costs and certain interest costs. Thus to restate, the transfer price essentially equals manufacturing cost, plus G&A, interest and certain shipping costs.

The transfer price of spare parts purchased by KDC is determined with reference to KL's spare parts price list. Pursuant to the Supplemental Agreement, the ex works total cost of spare parts is equal to [**] percent of KL's list prices, plus interest expense and transportation costs.

KL also purchases certain components and spare parts from unrelated third party vendors including [Company A and Company B]. Pursuant to the Spare Parts Agreements, these items are purchased from, respectively, Company A, at discounts ranging from [** to **] percent of [Company A's] list prices, and [Company B], at discounts of between [** and **] percent of Company B's list prices. As set forth in Section 3 of the Supplemental Agreement, KL, in turn, sells these components and spare parts at [**] percent of its list price. In addition, KL purchases merchandise from Company C at prices specified in Annex C of the Purchase Agreement. KL resells this merchandise to KDC at the same price paid to Company C, plus handling costs and interest expense.

Counsel contends that the transfer prices for the imported machinery, components and spare parts are negotiated on an arm's length basis and are adequate to ensure a profit. Consequently, counsel maintains that the relationship between KDC and Komatsu Japan does not influence the related party transfer price and that transaction value is the appropriate basis of appraisement. Counsel also maintains that certain royalties paid by KDC to KL under a Technical License and Assistance Agreement are not dutiable.

ISSUES:

The issues presented are: (1) whether the related party transfer price constitutes an acceptable transaction value; and (2) if transaction value is acceptable, whether certain royalty payments constitute an addition to the price actually paid or payable.

LAW AND ANALYSIS:

Merchandise imported into the United States is appraised in accordance with section 402 of the Tariff Act of 1930, as amended by the Trade Agreements Act of 1979 (TAA; 19 U.S.C. ? 1401a). The preferred method of appraisement under the TAA is transaction value, defined as the "price actually paid or payable for the merchandise when sold for exportation to the United States," plus certain enumerated additions, including any royalty related to the imported merchandise that the buyer is required to pay as a condition of the sale for exportation to the United States. 19 U.S.C. ?

However, imported merchandise is appraised under transaction value only if the buyer and seller are not related, or if related, the transaction value is deemed to be acceptable. Here the buyer and seller, i.e., KDC and KL, are related pursuant to section 402(g)(1)(G) of the TAA in that KAC and KAMC, two wholly-owned subsidiaries of KL, respectively own 49 percent, and 1 percent of KDC. 19 U.S.C. ? 1401a(g)(1)(G).

Section 402(b)(2)(B) of the TAA sets forth two conditions under which a transaction value between related parties will be deemed acceptable. The first is where an examination of the circumstances of sale indicates that the relationship between the parties did not influence the price actually paid or payable. The second is where the transaction value closely approximates certain "test" values. 19 U.S.C. ? 1401a(b)(2)(B).

Under the first approach, if the circumstances of sale indicate that while related, the parties buy and sell from one another as if they were unrelated, transaction value will be considered to be acceptable. In this respect, Customs will examine the manner in which the buyer and seller organize their commercial relations and the way in which the price in question was derived in order to determine whether the relationship influenced the price. If it can be shown that the price was settled in a manner consistent with the normal pricing practices of the industry in question, or with the way in which the seller settles prices with unrelated buyers, this will demonstrate that the price has not been influenced by the relationship. 19 C.F.R. ? 152.103(l)(1)(i)-(ii). In addition, Customs will consider the price not to have been influenced if the price was adequate to ensure recovery of all costs plus a profit equivalent to the buyer's overall profit realized over a representative period of time. 19 C.F.R. ? 152.103(l)(1)(iii).

Counsel maintains that the circumstances of the sales under consideration do in fact support the validity of KDC's transfer prices. In this respect counsel notes that the Supply Agreement was negotiated by unrelated parties, i.e., by KL and/or its affiliates and DI and/or its affiliates during the formation of KDC. Consequently, counsel argues that the transfer prices were established as the result of arm's length negotiations between what at the time were unrelated parties. Furthermore, counsel submits that the manner in which KDC operates indicates that the price was not influenced. In particular, counsel point to the fact that KDC: submits orders and sets resale prices; borrows in its own name; and extends its own warranties and absorbs warranty losses. However, no information has been submitted as would demonstrate that transfer prices were settled in a manner consistent with the normal pricing practices of the construction industry, nor with the manner in which KL settled prices with unrelated buyers. Accordingly, we find that KDC has not met its burden under 19 C.F.R. transaction value.

Counsel also contends that KDC has satisfied the "all costs plus a profit" test set forth in 19 C.F.R. ? 152.103(l)(1)(iii). In this regard counsel states that under the Side Agreement certain G&A and interest expenses were included in the setting of the transfer prices of the imported merchandise. While these expenses were identified as costs under the Side Agreement, counsel asserts that they " are appropriately classified as profit elements in the calculation of transaction value for customs purposes." Letter of July 14, 1993, at 2. In support of this theory counsel cites Accounting Research Bulletin (ARB) No. 43, Chapter 4 (June 1953), which deals with the "general principles applicable to the pricing of inventories of mercantile and manufacturing enterprises." ARB 43, ? 2.

ARB 43 states that the major objective of inventory accounting "is the matching of appropriate costs against revenues in order that there may be a proper determination of the realized income." Id. at ? 4. Counsel has identified a number of G&A expenses which it claims should not be included in the cost of inventory, for example, expenses associated with internal audit, public relations and personnel. Counsel asserts that the allocation of G&A expense to inventory increases the transfer prices paid by KDC. In view of this counsel concludes that these expenses should not be considered when evaluating the reasonableness of the transaction value for customs purposes. Counsel argues that these expenses constitute a profit element.

With the assistance of the Office of Regulatory Audit we have reviewed counsel's assertions in respect of ARB 43, viz., that certain expenses should not be included in the cost of KL's inventory. This argument relates to whether the transfer prices were adequate to ensure recovery of all costs plus a profit. 19 C.F.R. ? 152.103(l)(1)(iii). However, the only issue to be resolved here is whether KL does in fact treat these items as an expense. Based on the available information the costs cited by counsel were carried as an expense on KL's books. Consequently, unless evidence is presented to the contrary, we find that KDC has not demonstrated that its transfer prices satisfy the "all cost plus a profit" test.

In regard to interest costs, counsel cites Financial Accounting Standards Board (FASB) statement No. 34 on the capitalization of interest costs in support of its argument that certain interest costs, capitalized under the Side Agreement, should not have been capitalized. The fact that they were capitalized effectively increased KL's prices to the point where they exceeded the amount necessary to recover its cost of production. Counsel therefore reasons that the interest element represents a profit element in the intercompany transfer prices. Once again, however, the issue is whether the transfer price covers all costs plus a representative profit. The only question to be resolved in this regard is whether the interest costs were capitalized in KL's accounts. The information presented indicates that they were. Unless counsel can present evidence to the contrary, we therefore find counsel's argument to be unpersuasive.

Alternatively, a transaction value between related parties is acceptable if it closely approximates, inter alia, the deductive or computed value "test values" for identical or similar merchandise. The term "test values" refers to values previously determined pursuant to actual appraisements of imported merchandise. Thus, for example, a computed value calculation can only serve as a test value if it represents an actual appraisement of imported merchandise determined pursuant to section 402(e) of the TAA. E.g. Headquarters Ruling Letter 543568 dated May 30, 1986. There are no previously determined deductive or computed values with respect to merchandise imported by KDC. Consequently, test values cannot be used to validate transaction value. Since KDC has been unable to demonstrate that the relationship with KL did not influence the price actually paid or payable, transaction value is inapplicable. Since transaction value is inapplicable, we have not addressed the issue of royalty payments.

If imported merchandise cannot be appraised on the basis of transaction value, it will be appraised in accordance with the remaining methods of valuation, applied in sequential order. 19 U.S.C. ? 1401a(a)(1). The alternative bases of appraisement, in order of precedence, are: the transaction value of identical merchandise or the transaction value of similar merchandise (19 U.S.C. the "fallback" method (19 U.S.C. ? 1401a(f)).

Both the transaction value of identical merchandise and the transaction value of similar merchandise are based on sales of merchandise, at the same commercial level and in substantially the same quantity, exported to the United States at or about the same time as that being appraised. 19 U.S.C. ? 1401a(c). However, KL does not sell to unrelated persons in the U.S.; furthermore, you have advised that there are no imports of identical merchandise produced by other Japanese manufacturers. The transaction value of identical merchandise therefore cannot be used to appraise merchandise imported by KDC. Once again, KL does not sell to unrelated persons and you have advised that there are no imports of similar merchandise produced by other manufacturers. Accordingly, the transaction value of similar merchandise cannot be used as a basis of appraisement in the instant case.

The next potentially applicable method of appraisement is deductive value. Under this method, merchandise is appraised on the basis of the unit price at which it is sold in the U.S., in the condition as imported, in the greatest aggregate quantity. However, the use of deductive value is subject to certain limitations in regard to the time within which the imported merchandise must be sold (up to ninety days); if it were not sold within the allowable time, deductive value would be inapplicable. If merchandise is not sold in the condition as imported, the importer may elect for it to be appraised pursuant to section 402(d)(A)(iii) of the TAA (the "superdeductive" method). In this case the unit price is defined as that as which merchandise is sold in the greatest aggregate quantity before the 180th day after importation. Since no information has been presented as to whether KDC sells any of the imported merchandise within the ninety day period allowed by the TAA we are unable to state whether deductive value is appropriate.

If deductive value is inapplicable, imported merchandise should be appraised in accordance with the computed value provided for in section 402(e) of the TAA. Under this method, merchandise is appraised on the basis of the material and processing costs incurred in the production of imported merchandise, plus an amount for profit and general expenses equal to that usually reflected in sales of merchandise of the same class or kind, the value of any assists, and packing costs. 19 U.S.C. ? 1401a(e)(1). No information on costs has been provided. Unless this information can be obtained, the computed value method will be inapplicable.

If merchandise cannot be appraised under the methods set forth in 19 U.S.C. ? 1401a(b)-(e), it should be appraised in accordance with 19 U.S.C. ? 1401a(f). The method provides that merchandise should be appraised on the basis of a value derived from one of the previous methods reasonably adjusted to the extent necessary to arrive at a value. 19 U.S.C. ? 1401a(f)(1). Assuming none of the alternative methods set forth above are applicable to the circumstances of the instant case, it may be appropriate to appraise the imported merchandise pursuant to a modified deductive value by waiving the time restrictions of section 402(d).

HOLDING:

The relationship between the parties influences the price actually paid or payable such that the use of transaction value is unacceptable. The appropriate basis of appraisement should be determined by proceeding sequentially through the alternative methods set forth in the TAA.

This decision should be mailed by your office to the internal advice requester no later than sixty days from the date of this letter. On that date the Office of Regulations and Rulings will take steps to make the decision available to Customs personnel via the Customs Rulings Module in ACS, and to the public via the Diskette Subscription Service, the Freedom of Information Act and other public access channels.

Sincerely,


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