Kenya trial to bridge transfer pricing and customs in landmark customs audit case

By Mourad Chatar & Sarah Bahous, Partners at Value Square, Dubai

In a judgment delivered on 29 October, the Kenya Tax Appeal Tribunal ruled in favour of the taxpayer against the Commissioner of Customs and Border Control, which had advocated that the deductive value method should have been used in determining the customs value of the products instead of the transaction value method.

The case is interesting as it is yet another one that sheds light on the interplay between transfer pricing and customs. Although in this specific case, it is probably the transfer pricing method applied which inspired the Kenya Customs Authority to reject the customs valuation method.

The case also underpins the double-edged character of transfer pricing documentation – which, on the one hand, was demonstrating that the parties acted at arm’s length but, on the other hand, was opening the door to customs authorities to apply another customs valuation method which was more at their advantage.

The case

After a post-clearance audit, the Kenya Customs Authorities adjusted the customs duty bill of pharmaceutical company GSK for undervaluation of imported toothpaste over the period of 2015 to 2019.

Given the transaction was between related parties and based on the transactional net margin method for transfer pricing purposes, the Kenya Customs Authorities advocated that the customs value was influenced by the group relationship and applied the deductive value method to adjust the price of the toothpaste tube from (GBP) 0.52 to 0.94 and claimed KES 30 million (USD 267,000) in additional customs duties on the difference.

The tribunal had noted that GSK had shared its transfer pricing documentation and valuation methodology with the Kenya Revenue Authority.

WCO guidance on transfer pricing & customs

In its last edition (2018), the World Customs Organization (WCO) issued a detailed guide on the linkages between transfer pricing and customs valuation.

The guide is designed primarily to assist customs officials responsible for customs valuation policy or who are conducting audits and controls on multinational enterprises (MNEs). It is also addressed to the private sector and tax administrations who have an interest in the topic.

The guide provides useful technical background, offers potential solutions, and shares ideas and national practices. It is however not a definitive approach given the Technical Committee on Customs Valuation continues to discuss the issue.

What is at stake?

For customs valuation purposes, import transactions between two distinct and legally separate entities of the same MNE group are treated as “related party transactions”. Such transactions may be examined by customs post-clearance audit teams to determine whether the price declared for the imported goods is “influenced” by the relationship. In other words, is the price at which the goods have been sold at a lower level than it would have been had the parties not been related and the price had been freely negotiated?

The methodology for determining the customs value for imported goods subject to ad valorem duty rates is set out in the Agreement on Implementation of Article VII of the General Agreement on Tariffs and Trade 1994. All World Trade Organization (WTO) member countries have an obligation to implement the agreement and apply this methodology. It is applied to the vast majority of all international trade.

MNEs also have a direct taxation liability on company profits in most countries around the world. The mechanism by which MNEs determine prices for goods, services, and assets bought and sold within the group is known as “transfer pricing”. The OECD has developed guidelines based on the “arm’s length principle” for the setting and testing of transfer prices for direct tax purposes. The arm’s length principle is generally accepted as the international standard used by businesses and tax authorities.

Post clearance audit & transfer pricing documentation

The relationship between customs valuation and transfer pricing has been discussed in various national and international fora over several years. The business community has raised the issue as a matter of concern, in particular advocating that customs consider available transfer pricing information prepared for direct tax purposes when examining related party transactions and consider the impact of transfer pricing adjustments on the customs value.

The essence of the issue is contained in the following question: to what extent can information contained in transfer pricing documentation, primarily developed for taxation purposes, provide useful information for customs to determine whether the price declared for imported goods has been influenced by the parties’ relationship, to make a final determination of the customs value?

The Technical Committee on Customs Valuation has confirmed the basic principle that transfer pricing documentation may provide useful information for customs in respect of related party transactions, on a case-by-case basis.

However, post-clearance audit teams and customs valuation departments do not have the technical background to examine and interpret transfer pricing documentation which may be helpful to assess whether there is a customs under-valuation risk.

The other key question is the impact of adjustments made (after importation) for transfer pricing purposes; in which cases, if any, should such adjustments be considered by customs in determining the customs value of the imported goods?

Additionally, the World Customs Organization, the OECD, and the World Bank Group encourage customs and tax administrations to establish bilateral lines of communication to exchange knowledge, skills, and data, where possible, which will help ensure that each authority has the broadest picture of an MNE’s business and its compliance record and can make informed decisions on the correct revenue liability.

To date, the best example in the Middle East of such bilateral communication is the Kingdom of Saudi Arabia, which went a step further in completely merging both administrations into one single body, i.e., Zakat, Tax & Customs Authority (ZATCA).

Circumstances surrounding the sale & test values

Once it is established that the buyer and the seller are related and if, considering the information available, customs has grounds for considering that the relationship has influenced the price, it is necessary to conduct further enquiries with the importer before reaching a conclusion and rejecting the valuation method applied by the economic operator.

Two approaches are recommended by the World Customs Organization to assess whether the price was influenced by the relationship. The first one, the verification of the circumstances surrounding the sale, is led by the customs authority and the second, test values (or benchmark), should be provided by the importer.

When customs decides to conduct an enquiry, the importer should be given an opportunity to supply further detailed information as necessary to enable it to examine the circumstances surrounding the sale.

The guidance mentions three questions for the verification of the circumstances surrounding the sale Has the price been settled in a manner consistent with the normal pricing practices of the industry in question? Has the price been settled in a manner consistent with the way the seller settles prices for sales to buyers who are not related to the seller? Can it be demonstrated that the price is adequate to ensure recovery of all costs plus a profit which is representative of the firm’s overall profit realized over a representative period (e.g., on an annual basis) in sales of goods of the same class or kind?

For the test values, the importer needs to demonstrate that the transaction value closely approximates to one of the following: the transaction value in sales to unrelated buyers of identical or similar goods for export to the same country of importation, the customs value of identical or similar goods determined under the deductive value method, or the customs value of identical or similar goods determined under the computed value method.

Transfer pricing and customs valuations methods

From a customs perspective, the primary method is the transaction value method, and it is only if the transaction value cannot be used that alternative valuation methods can be used.

There are four alternative methods: the transaction value of identical goods, the transaction value of similar goods, the deductive value method, and the computed value method.

Similarly, from a transfer pricing perspective, there are five methods to determine or test whether an intragroup pricing meets the arm’s length principle: the comparable uncontrolled price method, the cost-plus method, the resale price method, the transactional net margin method, and the profit split method.

In the case at hand, the Kenya Customs Authority rejected the transaction value because it had doubts that the prices applied were not influenced by the group relationship of the seller and the buyer. However, although the Kenya Revenue Authority submitted that it applied the circumstances surrounding the sale test, the tribunal felt that the Kenya Revenue Authority failed to make such a demonstration.

On the other hand, GSK had provided the transfer pricing documentation supporting the application of the transactional net margin method to determine the transfer price of the goods given the functional profile of the buyer which was labeled as a sales, marketing, and distribution entity. Based on the transactional net margin method, the buyer was entitled to a fixed net margin to remunerate its functions and risks. The transfer pricing report did provide the demonstration that the transaction was at arm’s length.

It is very probable that the Kenya Revenue Authority might have used the transfer pricing documentation to advocate that the transactional net margin method used for transfer pricing purposes was de facto equal to the deductive value method for customs purposes. Consequently, the transaction value method should have been rejected and the deductive value method applied for customs purposes.

The deductive value method determines the customs value based on the unit price at which the imported goods or identical or similar goods are sold to an unrelated buyer in the country of importation after deduction of relevant expenses incurred.

Again here, the Tribunal found that Kenya Revenue Authority failed to provide sufficient explanations on the formula, or the computations made to determine the customs value by using the deductive value method and if its application was in line with the guidance provided in this respect.

Finally, in the GSK case, the Tribunal concluded that the Kenya Revenue Authority decision was arbitrary and not objective. The Kenya Revenue Authority had not demonstrated that the relationship between the seller and the buyer influenced the prices declared to justify the application of an alternative method to the transaction value method.

Concluding remarks

This case is not anecdotal and is rather symptomatic of a real convergence of two separate technical topics made possible through better access to data by customs and tax administrations. The increased regulatory requirements for transparency and the world of digitalization continue to be catalysts and accelerators of change.

It is believed that the Kenya Revenue Authority was probably on the right path but failed to make the technical demonstration of its position to the satisfaction of the Tribunal. The Kenya Revenue Authority made a good trial and failed in joining both topics at the last round probably because it needs further technical skills to interpret transfer pricing documentation and to make its point bulletproof. It is however only a question of time before the next successful case arises which will pave the way for all the others.

Although the technical debate is still ongoing, it should be also mentioned that the World Customs Organization has done a fantastic job in laying down the framework for the discussion to continue. A greater understanding of this issue and a sharing of ideas and solutions is beneficial for all stakeholders. On one hand, it will provide more certainty for governments and businesses, which will lead to a more consistent approach and an accurate determination of duty liabilities. On the other hand, burdens on business can also be reduced by taking a more joined-up approach, which can be seen as an important trade facilitation measure.

— Mourad Chatar & Sarah Bahous are regional tax partners at Value Square, Dubai