Tariffs and Transfer Pricing: Navigating the cross-border tax tightrope

Understanding the two concepts

Transfer pricing refers to the pricing of goods, services, or intellectual property exchanged between related entities within a multinational group. These prices must align with the ‘arm’s length’ principle, which requires that the prices charged between related entities be similar to those that would have been agreed upon if the entities were independent. If a multinational group’s transfer pricing does not meet international standards or the arm’s length principle under local law, it can potentially create issues of tax avoidance or evasion.

Customs law also mandates that prices between related entities within a multinational group be set as if they were independent. In the UK, the primary method for determining the customs value is based on the World Trade Organization Valuation Agreement, which generally considers the actual price paid or payable for the imported goods, with specific adjustments. When the buyer and seller are related, the customs price can only be accepted if the relationship did not influence the agreed price. The same principles are recognised in the US, where the transaction value, defined as “the price actually paid or payable for the merchandise when sold for exportation to the United States…" (19 U.S.C. §1401a(b)), is the principal methodology employed by importers when declaring a basis of appraisement to customs. Transaction value may not be used if the buyer and seller are related, unless the importer demonstrates that the “circumstances of the sale” of the imported merchandise indicates that the relationship between the buyer and the seller did not influence the price paid or payable (19 U.S.C. §1401a(b)(2)(B)).

This is similar to the direct tax principle, which requires transfer pricing to reflect an arm’s length price. However, the methodologies for direct tax and customs valuation differ, meaning that a transfer price accepted for tax purposes may not automatically be acceptable for customs valuation purposes.

A key point of friction between transfer pricing and customs valuation arises from differing cost inclusions. Certain costs or value-add activities, such as intercompany management services, may be included in the transfer price but not in the customs value. Conversely, customs law requires all relevant costs to be included in the dutiable value, but not all of these may appear in the transfer price of imported goods and may instead be captured in additional intercompany transactions such as procurement services.

This tension has been amplified by the onset of new and reciprocal tariffs, particularly between the US and the rest of the global economy - especially China. Tariffs, which are taxes imposed on imported goods, have led multinational groups to consider using transfer pricing adjustments to offset rising costs. However, such adjustments may lead to unintended consequences, including violations of the arm’s length principle, especially if they are made impulsively rather than through careful analysis.

Walking the tightrope

The importer of record is technically responsible for covering the cost of any tariffs on imported goods. However, this cost is often passed on to consumers through higher product prices, which can negatively affect brand value and market share. In the long run, businesses seeking to maintain their competitive edge and preserve profit margins may consider restructuring their supply chains to mitigate the impact of tariffs. This process takes time and isn’t as simple as papering a change in the country of origin for the products. A more immediate strategy could involve reducing imports or capitalising on any temporary suspension of tariff enforcement to import large quantities of goods into high-tariff markets. These actions can have significant transfer pricing implications, such as potential misalignments between actual business activities and the recognised profit from the sale of goods.

Since tariffs are an absolute cost to the business, companies need to carefully evaluate where the tariff cost should be allocated. For instance, should the burden fall on the entity that ultimately controls the pricing of the goods to the market? This control also includes the ability to make decisions on how to respond to associated risks and the actual performance of these decisions. It may be reasonable to share the economic cost of the tariff between the importer of record and either the entity that sold the goods or the ‘head office,’ where key pricing, procurement, and supply decisions are made.

Importing large quantities of goods into specific markets could also affect how local distributors are characterised for transfer pricing purposes. For example, the importer might be seen as a low-risk distributor if it enters into contracts in its own name, makes sales independently, and executes a centrally developed marketing strategy. In this case, the importer would hold the product for a very brief period, with title passing at the moment of sale. Local risks, such as inventory, warranty, currency, and bad debt risks, would typically be borne by another entrepreneurial group entity. However, if inventory risks (such as unsold stock) increase, the importer may be re-characterised as a full-risk distributor, which would affect the group’s transfer pricing policy. In such cases, a one-sided method, like a target operating margin, may no longer be suitable for determining the importer’s compensation.

If transfer prices are lowered to maintain the importer’s profitability, the cost burden will shift to the manufacturer. Conversely, if the transfer price remains the same or increases to protect the manufacturer, the importer will bear more of the burden. Even if the tariff costs are shared, it is important to note that overreliance on benchmarking analyses alone without additional supporting evidence could create problems. Tariffs may distort the arm’s length profit margins earned by benchmarked comparables since businesses may allocate and treat the tariff costs differently. Groups should consider whether any adjustments to the benchmarking analyses (in-year) are warranted to adjust the impact of the tariffs on their transfer prices.

Any adjustments to transfer prices might not affect the customs value or a group’s overall tariff burden. This is because tax authorities may not accept the adjusted prices as accurately reflecting the true economic value of the imported goods. It is therefore important to ensure that tariffs are applied to the correct customs value, and not to the transfer price.

The transaction value method is the most common method to use to value the sale of goods for customs purposes. Despite the language of the statute, most imports into the US between related parties use transaction value based upon the representation that the relationship did not influence the terms and conditions of the sale. In this instance the buyer may need to demonstrate that the price paid to the related party seller was close to the transaction value of identical or similar goods exported to the US using alternative methods of valuation. This is akin to the Comparable Uncontrolled Pricing Method as discussed in the OECD Guidelines. Identical goods must be produced in the same country, exported to the US at or about the same time and be the same in all respects including physical characteristics, quality and reputation (although minor differences in appearance do not matter). Similar goods are those which are different in some ways from the goods to be valued but are produced in the same country, can carry out the same tasks and are commercially interchangeable.

Information provided to Customs should demonstrate that the buyer and seller trade with each other as though they are unrelated, the buyer pays the same price as unrelated buyers in the US operating at the same commercial level and purchasing similar quantities of the goods or that the price paid by the buyer is fully costed (it is a commercial sale where the buyer and seller have acted independently without influencing the transaction value).

Transfer pricing studies conducted by independent third parties are accepted by Customs as evidence to verify that the transfer price is not influenced by the relationship between the buyer and seller for customs valuation purposes only. In this instance Customs would not question nor verify the transfer pricing, as this falls under the remit of direct tax. In practice the Customs are seeking assurance that buyers do not receive preferential treatment under the inter-company pricing arrangements because of their relationship with the sellers.

A transfer price may be used as the basis of a transactional value if it fulfils the criteria set out above and all relevant costs are included in the dutiable value if paid separately from the transfer price of the imported goods. When considering if a transfer price meets the requirements, you must justify your basis of value under customs valuation law. Groups cannot rely solely on their transfer pricing methodology. We have highlighted below costs which can be considered dutiable and non-dutiable in nature when applied to the sale of goods. These are costs which may or may not be included in a Group’s transfer price.

The last point in the non-dutiable is arguably the most important as these are costs which are often included within a transfer price and that can be reduced for customs duty and as such tariff cost purposes.

Inconsistent transfer pricing and customs declarations can lead to audits, penalties, and adjustments by tax and customs authorities. It is therefore more important than ever to ensure that the right customs value has been derived. In tandem, multinational groups should seek to understand how risks are allocated across the group and how, or if, the introduction of tariffs impacts the supply chain, management of risks and the characterisation of each entity from a transfer pricing perspective. This will ensure that groups successfully navigate the cross-border ‘tightrope’ between tariffs and transfer pricing.

How should businesses react?

In the short term, multinational groups need to carefully assess tariff-related risks when setting or adjusting their transfer prices. These prices should accurately reflect the economic reality of the transaction, considering the actual roles and decision-making responsibilities of the entities involved. Beyond the tariffs themselves, the broader operational responsibilities of the entities impacted by these tariffs must also be taken into account. For instance, if the importing entity has control over key decisions like pricing, sourcing, or marketing, it makes more sense for that entity to absorb the tariff costs. This ensures that the risk allocation is aligned with the real decision-making power and functions of the entity. Changes to the transfer price may also affect other transactions, particularly if they use sales-based allocation keys. Since tariffs can impact the sales price of goods imported into a country, consideration should be given as to whether these costs are exceptional and if any allocation keys based on sales require some adjustment.

Additionally, multinational corporations must ensure that any adjustments to transfer prices comply with both transfer pricing and customs regulations. To do so, they need to maintain thorough documentation to justify pricing decisions, especially in light of scrutiny from tax and customs authorities. It is important to demonstrate that the pricing aligns with the arm’s length principle, supported by solid economic reasoning and well-documented analysis.

For more insight and guidance, get in touch with Kirsty Rockall and Adam Taylor.