Navigating Tariffs and Income Taxes and Transfer Pricing

The reality of tariffs is forcing companies to reexamine their supply chains and contracts. Many U.S. importers are positioned to mitigate tariffs. Some can do so by making operational changes, even small ones; others, by revisiting their customs valuation methods. For example, importers in multi-tiered transactions may be able to lower the customs valuation by applying the First Sale Rule to declare the customs value of goods based on the price paid in the first sale rather than the price paid by the importer. That said, mitigation efforts such as the First Sale Rule are not immune from scrutiny and downstream tax controversy risk. It is therefore important for companies to coordinate their customs, operational planning, and transfer pricing policies, and to plan for the possibility that supply chain tariff planning—even if temporary—could lead to long-term disputes with taxing authorities.

Key tax objectives include:

• Protect Inventory Deduction. An importer's inventory cost for income tax purposes is generally tied to its customs value which, with adjusted valuation methods like the First Sale Rule, may be lower than the price paid. In many cases, it is possible to increase the inventory cost well beyond the customs value.
   
• Preserve Transfer Pricing. Changes in customs value and tariff responsibility can impact transfer pricing policies in multiple jurisdictions. In a related-party sale, tariffs and transfer pricing have an inverse relationship. Transfer pricing adjustments reduce the income of one transacting party while increasing the counterparty's income, which will attract attention and possible challenge. Also, deviations from Advance Pricing Agreements agreed with governments may require renegotiation.
   
• Defend Structure Changes. Restructurings to mitigate tariffs can present risks unrelated to intercompany pricing. The IRS and other tax authorities have been aggressive in challenging the business purpose for restructuring transactions, invoking anti-abuse rules such as the economic substance doctrine to recast or disregard transactions where tax avoidance is perceived. Further, structural changes to supply chains could themselves trigger tax consequences, including with respect to effective tax rates, VAT, exit, and other taxes, and foreign tax credits, leading to increased examinations and potential litigation. 

A thorough understanding of the customs and income tax valuation concepts is essential for effective tax planning and trade management.