IRS Rules Deductive Value Method Exempt from Sec. 1059A Basis Limitation

Deductive Value Method Escapes Section 1059A Basis Cap

A U.S. importer has won a significant victory, securing a favorable private letter ruling from the IRS that allows them to potentially claim a higher tax basis for imported goods than their declared customs value. The core conflict arose because the taxpayer employs a specific transfer pricing method – the Advance Pricing Agreement/Residual Profit Split Method (APA/RPSM) – for income tax purposes, while U.S. Customs requires the use of the 'Deductive Value Method' for determining duties owed. The IRS ruled that Section 1059A of the Internal Revenue Code (IRC) does not limit the tax basis when the Deductive Value Method is used to determine customs value, because the resulting customs valuation is a derived figure, not a "cost" paid for the goods.

The Valuation Clash: Transfer Pricing vs. Customs

The taxpayer in the ruling imports products from a foreign parent and operates under an Advance Pricing Agreement/Residual Profit Split Method (APA/RPSM) for income tax. The APA/RPSM determines the arm's length price for tax purposes, which is often complex. Meanwhile, U.S. Customs requires the use of the "Deductive Value Method" to determine the duties owed on these imported goods.

Section 1059A of the Internal Revenue Code (IRC) generally limits the basis or inventory cost that a taxpayer can claim for federal income tax purposes for property imported from related persons. Enacted in 1986, Section 1059A was designed to prevent taxpayers from taking inconsistent positions, claiming high transfer prices for income tax purposes (to reduce taxable income through a higher cost of goods sold) while simultaneously declaring low values to U.S. Customs to minimize duties. Specifically, Section 1059A(a) states that the amount of any costs taken into account in computing the basis or inventory cost of imported property cannot exceed the amount of such costs taken into account in computing the customs value of such property, where the transaction is between related persons (within the meaning of Section 482, which governs transfer pricing). Section 1059A(b) defines customs value as the value used to determine customs duties.

However, the Taxpayer is required by Customs to use the Deductive Value Method, as specified under 19 U.S.C. § 1401a(d), to determine the customs value of its imported products. Unlike standard transaction pricing, the Deductive Value Method does not begin with the price paid to the foreign parent. Instead, it starts with the resale price in the United States at the first commercial level after importation. This resale price is determined based on the unit price at which the products are sold in the greatest aggregate quantity. The customs value is then derived by subtracting post-importation expenses from this resale price, including items like advertising, selling, general, and administrative expenses.

Why 'Derived' Values Are Not 'Costs'

As previously discussed, the Deductive Value Method does not begin with the price paid to the foreign parent. Instead, it starts with the resale price in the United States at the first commercial level after importation. This resale price is determined based on the unit price at which the products are sold in the greatest aggregate quantity. The customs value is then derived by subtracting post-importation expenses from this resale price, including items like advertising, selling, general, and administrative expenses.

The IRS based its reasoning on Section 1059A(a), which limits "any costs that are both ‘taken into account in computing the basis or inventory cost’ and ‘also taken into account in computing the customs value’ of property that a taxpayer imports from a related party." The key distinction lies in how customs value is determined under the Deductive Value Method, as governed by 19 U.S.C. § 1401a(d). Unlike the Transaction Value method, the final customs value produced by the Deductive Value Method is not a "cost" paid by the importer. Instead, it is a derived amount based on a formula dictated by customs law.

Specifically, the starting point under 19 U.S.C. § 1401a(d)(2) is the resale price, not a cost. While adjustments subtracted from the resale price under 19 U.S.C. § 1401a(d)(3)(A) might reflect related-party costs included in the basis or inventory cost, and thus potentially be limited by Section 1059A, the final customs value is not itself a "cost taken into account." The IRS concluded that Section 1059A does not treat the bottom-line customs value reached using the Deductive Value Method as a ceiling on inventory or cost basis. Although certain individual adjustments used to derive the customs value might be subject to the Section 1059A limitations, the ultimate customs value number is not an upper limit on the cost of goods sold for tax purposes.

Implications for Importers

Building on the conclusion that Section 1059A, which limits the tax basis of imported goods to their customs value, does not treat the final customs value reached using the Deductive Value Method as a ceiling on inventory or cost basis, this ruling suggests a potential advantage for certain multinational groups. Companies compelled by Customs to employ the Deductive Value Method—often due to the rejection of related-party transaction values—may possess greater flexibility in determining their tax basis than those utilizing Transaction Value under 19 U.S.C. § 1401a(b). This offers a possible shield against Section 1059A limits for specific importers. However, it is crucial to remember that Private Letter Rulings (PLRs) such as this one are directed only to the taxpayer who requested it. According to Treasury regulations, PLRs cannot be used or cited as precedent under Section 6110(k)(3).