International Taxation: IRS' Administration of Tax-Customs Valuation Rules in Tax Code Section 1059A (Letter Report, 02/04/94, GAO/GGD-94-61). This report provides information on the Internal Revenue Service's (IRS) enforcement of section 1059A of the Internal Revenue Code, which deals with transfer pricing regulations. Section 1059A was meant to prevent the federal government from being whipsawed by an importer, on property acquired from a related party, who claims a low valuation for customs purposes and a higher valuation for tax purposes. GAO discusses IRS' difficulties in applying the section and a July 1992 IRS legal opinion on the applicability of section 1059A to transactions between a U.S. parent firm and its Mexican related parties. GAO also discusses proposals to reconcile differing IRS and U.S. Customs Service valuation rules that affect the use of section 1059A. --------------------------- Indexing Terms ----------------------------- REPORTNUM: GGD-94-61 TITLE: International Taxation: IRS' Administration of Tax-Customs Valuation Rules in Tax Code Section 1059A DATE: 02/04/94 SUBJECT: Customs administration Tax administration International economic relations International trade regulation Foreign corporations Income taxes Tariffs Investments abroad Underpayments Tax law IDENTIFIER: North American Free Trade Agreement NAFTA Mexico Mexican Maquiladora Program ************************************************************************** * This file contains an ASCII representation of the text of a GAO * * report. Delineations within the text indicating chapter titles, * * headings, and bullets are preserved. 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We are unable to accept electronic orders * * for printed documents at this time. * ************************************************************************** Cover ================================================================ COVER Report to the Chairman, Subcommittee on Oversight, Committee on Ways and Means, House of Representatives February 1994 INTERNATIONAL TAXATION - IRS' ADMINISTRATION OF TAX-CUSTOMS VALUATION RULES IN TAX CODE SECTION 1059A GAO/GGD-94-61 Tax-Customs Valuation Rules Abbreviations =============================================================== ABBREV GATT - General Agreement on Tariffs and Trade IRS - Internal Revenue Service NAFTA - North American Free Trade Agreement USTR - United States Trade Representative Letter =============================================================== LETTER B-253763 February 4, 1994 The Honorable J. J. Pickle Chairman, Subcommittee on Oversight Committee on Ways and Means House of Representatives Dear Mr. Chairman: This report responds to your request for information on the Internal Revenue Service's (IRS) enforcement of section 1059A of the Internal Revenue Code (the Code). Congress enacted section 1059A in 1986 to improve IRS' enforcement of transfer pricing regulations. Section 1059A was designed to prevent the federal government from being whipsawed by an importer, on property acquired from a related party, who claims a low valuation for customs purposes and a higher valuation for tax purposes.\1 In this report we provide information on IRS' difficulties in applying the section and a July 1992 IRS legal opinion on the applicability of section 1059A to certain specific transactions that IRS found between a U.S. parent and its Mexican related parties. At the request of the Subcommittee, we also present proposals to reconcile the different IRS and U.S. Customs Service (Customs) valuation rules that affect the use of section 1059A. Our review was performed between June 1992 and November 1993 in accordance with generally accepted government audit standards (see app. I). -------------------- \1 Section 1059A provides that in transactions between related persons, the amount of any costs that are taken into account in computing the basis or inventory cost of imported property may not be greater than the amount of any costs that are also taken into account in computing the customs value of the property. Appendix II has the exact wording of the section. RESULTS IN BRIEF ------------------------------------------------------------ Letter :1 Since its enactment in 1986, IRS has included section 1059A issues in nine tax audits. Related to one of the audits, IRS' Office of Chief Counsel issued a technical advice memorandum\2 in July 1992 on the applicability of section 1059A (see app. III). The memorandum concluded that section 1059A could not be used to prevent a U.S. taxpayer from including certain expenses in the taxpayer's cost or inventory basis for tax purposes. The expenses at issue--which included electric and telephone bills, legal and consulting fees, entertainment and travel expenses--were paid on behalf of a Mexican related party but were not subject to customs duties because they were not includible in duty valuation. We agreed with IRS' legal opinion. We were not able to estimate the total federal revenue loss attributable to the practice of making payments on behalf of related parties because of the few cases audited by IRS, which involved mostly U.S. taxpayers with Mexican related parties. According to a November 1993 House of Representatives report, tariffs on U.S. imports from Mexico would be reduced over 15 years with approval of the North American Free Trade Agreement (NAFTA).\3 Also, the extent of the payments practices in other countries not affected by NAFTA has not been determined by the executive branch at this time. IRS and Customs officials cited resource and legal authority constraints for not collecting information on a worldwide basis to determine the full extent of direct payments practices among related parties. Implementation of section 1059A in those situations that involve direct payments effectively ceased following the issuance of IRS' technical advice memorandum. While we agree with the IRS position that it is inappropriate to use section 1059A to disallow the practice of making direct payments on behalf of foreign related parties, we are concerned by the revenue implications of this practice. The cases examined by IRS indicate that the use of direct payments by U.S. firms may result in a net revenue loss to the federal government. Since the information necessary to estimate the worldwide extent of this revenue loss is not available, we only present in this report the various options available to reconcile the valuation differences and the agencies' comments on them without recommending a specific course of action. There are two general options available to resolve the inconsistency in the valuation definitions that affect the use of section 1059A--multilateral renegotiation of the Customs Valuation Code of the General Agreement on Tariffs and Trade (GATT) or unilateral congressional amendment of either section 1059A of the Internal Revenue Code or section 402 of the customs legislation (19 U.S.C. �1401a).\4 These legislative options are described in appendixes V and VI. In response to our inquiry on legislative options, IRS' Office of Chief Counsel concluded that the issue addressed in the technical advice memorandum is not a tax problem (see app. VIII). Rather, it believed that the problem is with customs valuation, resulting from a loophole in customs legislation. Thus, IRS' Office of Chief Counsel concluded the issue should be resolved by amending customs law. Customs, in its response to our inquiry, concluded that the two legislative options would violate GATT (see app. IX). According to Customs, the amendatory language would place the U.S. valuation legislation in conflict with the Customs Valuation Code, which was negotiated between the United States and its major trading partners. Private sector representatives, including trade associations and businesses, generally opposed any U.S. legislative amendment because they believed it would violate GATT and they were concerned that U.S. firms might be placed at a competitive disadvantage from retaliation by GATT members. -------------------- \2 A technical advice memorandum provides advice or guidance as to the interpretation and proper application of internal revenue laws, related statutes, and regulations to a specific set of facts. The memorandum is furnished by the National Office upon request of a district office in connection with the examination of a taxpayer's return or consideration of a taxpayer's return claim for refund or credit. \3 North American Free Trade Agreement Implementation Act, House of Representatives, Committee on Ways and Means (Report 103-361, Part 1, Nov. 1993). \4 The valuation system used by the United States and its major trading partners was negotiated in the Tokyo Round of multilateral negotiations of GATT. The valuation agreement is known as the Agreement on Implementation of Article VII of GATT, or the Customs Valuation Code. The Customs Valuation Code was implemented into U.S. law through the Trade Agreements Act of 1979, which amended section 402 of the Tariff Act of 1930. Section 402 provides various methods for computing the value of imported items and defines the terms used in the section, including the term "assist." BACKGROUND ------------------------------------------------------------ Letter :2 Transactions between affiliates\5 constitute a major part of U.S. merchandise trade. As shown in table 1, in 1989 U.S. merchandise exports between affiliates were $120 billion. These exports represented 33 percent of total U.S. merchandise exports. In 1989, U.S. merchandise imports between affiliates were $201 billion and represented 42 percent of U.S. merchandise imports. Table 1 Merchandise Trade Between Affiliates: U.S.-Controlled Corporations Dominated U.S. Exports and Foreign-Controlled Corporations Dominated U.S. Imports in 1989 (Dollars in billions) U.S. U.S. exports imports ---------------------------------- ----------- ----------- U.S.-controlled corporations From U.S. parent to foreign $86 NA affiliate From foreign affiliate to U.S. NA $71\a parent Foreign-controlled corporations From foreign parent to U.S. NA 130 affiliate From U.S. affiliate to foreign 34 NA parent ============================================================ Total $120 $201 ------------------------------------------------------------ \a Imports from Canada shipped by foreign affiliates to their U.S. parents were $33 billion, or 46 percent of $71 billion. Imports from Mexico shipped by foreign affiliates to their U.S. parents were $6.4 billion, or 9 percent of $71 billion. Seven of nine cases audited by IRS under section 1059A would be in this latter group. Source: U.S. Department of Commerce. According to IRS officials, manipulation of intercompany transactions can take various forms. For example, setting prices too high or too low in a related party transaction can result in income being shifted from one country to the other and taxes being avoided. In another example, allocating costs between related and nonrelated parties that both contribute to adding value to the product can result in lowering the duty valuation of the imported item and duties being avoided. Section 1059A was enacted in 1986 to improve IRS' enforcement of related party transactions. Appendix II provides the complete text of section 1059A. When section 1059A was enacted, the revenue estimates were that it would raise less than $5 million annually. The legislative history of the section indicates that the section was intended to address the Tax Court holding of Brittingham v. Commissioner.\6 In this case, IRS determined that a U.S. importer paid more than an arm's length price\7 for ceramic tile imported from a related party in Mexico. The purchase price exceeded the value reported for customs duty purposes. The court held, however, that the IRS Commissioner acted unreasonably in determining that the customs value constituted an arm's length price for the sale. The legislative history indicates that Congress understood that Brittingham supported the proposition that some importers could claim a transfer price for income tax purposes that was higher than would be consistent with the transfer price claimed for customs purposes. It also states that Congress was particularly concerned that such practices between related parties could improperly avoid federal tax or customs duties. Although Congress was concerned about tax and duty avoidance, the legislative history notes that Congress did not express the view that valuation of property for customs purposes should always determine valuation of property for federal income tax purposes. Congress acknowledges that the Secretary of the Treasury would provide rules for coordinating customs and tax valuation principles when customs pricing rules may differ from appropriate tax valuation rules. Treasury regulations to provide the public with guidance needed to comply with section 1059A were issued September 8, 1989.\8 -------------------- \5 A foreign affiliate is a foreign business enterprise in which there is direct U.S. investment, that is, in which a U.S. person owns or controls 10 percent or more of the voting securities or the equivalent. \6 66 T.C. 373 (1976), aff'd 598 F.2d 1375 (5th Cir. 1979). \7 An arm's length price is the price one unrelated party charges another unrelated party for a product or service. See International Taxation: Problems Persist in Determining Tax Effects of Intercompany Prices (GAO/GGD-92-89, June 15, 1992). \8 Treasury regulations to provide foreign-owned U.S. corporations and foreign corporations engaged in a U.S. trade or business with guidance to comply with the information reporting and records maintenance requirements of the Code, including the reporting of imports from related parties and their valuation for tax and duty purposes, were issued June 19, 1991. This information is reported in Part VI of IRS Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business (see app. IV). IRS Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, does not contain a similar reporting requirement. FEW IRS AUDITS HAVE INVOLVED A SECTION 1059A ISSUE ------------------------------------------------------------ Letter :3 According to IRS officials, since 1986 IRS has raised section 1059A issues in nine audits. Furthermore, when raised in audits, its application has been primarily directed at taxpayers operating under the maquiladora program--U.S.-owned manufacturing and assembly operations in Mexico (maquiladoras) that export their products back to the United States. About 2,100 maquiladoras exported products to the United States in 1991. According to IRS officials, in a maquiladora operation the U.S. firm establishes a related party operation (the maquiladora). The U.S. firm establishes a contract in which the maquiladora supplies a product and the U.S. firm pays for the product. The U.S. firm may also make direct payments to other Mexican firms that cover some of the maquiladora's operating costs. For example, the U.S. firm may pay a Mexican electric company for the electricity used by the maquiladora. For tax purposes, the U.S. firm would claim its total costs, including this direct payment, as a deductible expense. However, for customs valuation purposes, only the costs on the maquiladora's books (excluding, for example, the electrical payment) would be declared as dutiable value added by the Mexican operation. Seven of the nine cases IRS identified in which it included section 1059A issues as part of an audit involved firms associated with the maquiladora program. In two of the nine cases, the taxpayer agreed to the IRS adjustment. In two cases, IRS is pursuing the issue. In a fifth case, IRS withdrew the section 1059A issue following the sale of the firm. In the remaining four cases, IRS withdrew the section 1059A issues after its July 1992 technical advice memorandum found that the legal basis for its proposed income adjustment could not be justified. DIFFERENT IRS AND CUSTOMS VALUATION RULES PROMPTED IRS' TECHNICAL ADVICE MEMORANDUM ------------------------------------------------------------ Letter :4 In general, according to IRS officials, IRS district offices proposed to use section 1059A to disallow the deductions for expenses paid by U.S. parents on behalf of their foreign related parties when they were not reflected in the customs valuation for the items imported from the related foreign parties. Thus, IRS auditors adjusted the parent's income and tax due accordingly. According to an IRS official, taxpayers took the position that the transactions were in accordance with Treasury regulations for section 1059A and the duty valuation provisions of the customs legislation. TAX VALUATION RULES ---------------------------------------------------------- Letter :4.1 Section 1059A provides that in transactions between related persons, the amount of any costs that are taken into account in computing the basis or inventory costs of imported property may not be greater than the amount of any costs that are also taken into account in computing customs value of the property. The Treasury regulations for section 1059A provide that taxpayers, in determining the limitation on claimed basis or inventory cost of property, may increase the customs value of imported property by certain amounts. Four types of adjustments are cited in the regulations: freight charges; insurance charges; the construction, erection, assembly, or technical assistance provided with respect to the property after its importation into the United States; and any other amounts that are not taken into account in determining the customs value, that are not properly includible in customs value, and that are appropriately included in the cost basis or inventory cost for income tax purposes. CUSTOMS VALUATION RULES ---------------------------------------------------------- Letter :4.2 Under the Trade Agreements Act of 1979, the customs value is generally the transaction value of imported merchandise. Generally, it is the price paid or payable by the importer for the merchandise plus amounts equal to (1) packing costs; (2) selling commissions paid by the buyer; (3) royalties or license fees paid by the importer as a condition of sale; (4) the proceeds of any subsequent use of the imported merchandise that accrue to the seller; and (5) the value of any "assists," which are defined below. If the transaction value method cannot be used, secondary valuation methods are to be considered. LIST OF ASSISTS DOES NOT INCLUDE CONTESTED EXPENSES -------------------------------------------------------- Letter :4.2.1 Essentially, according to IRS officials, the question raised by the IRS audits was what expenses make up dutiable value. Specifically, the technical advice memorandum addressed what expenses qualified as assists in computing transaction value. Customs had generally defined assists as various general purpose equipment expenses and direct manufacturing equipment expenses. In response to IRS' questions about what is included in transaction value, Customs advised IRS that general, administrative, and overhead expenses are not assists. The following list, obtained from IRS' technical advice memorandum of July 10, 1992, contains the foreign related party expenses that IRS proposed to disallow that Customs subsequently advised IRS were not assists: office equipment rental fees, automobile depreciation, landscaping, janitorial supplies, office supplies, business expenses, electric bills, safety/medical expenses, telephone bills, postage expenses, removal of trash, legal fees, classified advertising, executive development, travel and entertainment expenses, professional dues and subscriptions, charitable contributions, consulting fees, and expenses attributable to conversion of currencies. On the basis of the differences between how IRS and Customs interpreted this aspect of duty valuation, an IRS district office requested technical advice from the IRS Office of Chief Counsel on the issue. The technical advice memorandum was issued on July 10, 1992, after consultations with Customs. The memorandum concluded that IRS could not apply section 1059A to prevent the U.S. taxpayer from including the expenses paid on behalf of its foreign related party in its cost basis because the expenses were not subject to customs duty. This reasoning was based on Customs' prior determination that the expenses were not assists includible in dutiable value and on IRS' own recognition that the expenses were the kind of items that were properly includible in cost basis for federal tax purposes. The memorandum concluded that the taxpayer was not prevented by section 1059A from including the expenses in its cost basis. We agree with the technical advice. Following issuance of the memorandum, IRS officials said the section 1059A issues were withdrawn from those ongoing audits in which adjustments would be inconsistent with the memorandum's conclusions. IRS and Customs officials have also discussed the possibility of administratively resolving this difference in valuation rules. CONDITIONS THAT MAY LEAD TO REDUCED U.S. GOVERNMENT REVENUES WHEN PAYMENTS ARE MADE ON BEHALF OF A FOREIGN RELATED PARTY ------------------------------------------------------------ Letter :5 On the basis of facts presented in IRS' technical advice memorandum and discussions with IRS officials knowledgeable about the maquiladora industry, we prepared an illustration of a U.S. parent firm and its Mexican maquiladora to show what happens to government and business revenues when the U.S. parent pays a portion of its maquiladora's expenses. MAQUILADORA ILLUSTRATION ---------------------------------------------------------- Letter :5.1 In the maquiladora illustration shown in appendix VII, we assumed that (1) a U.S. parent had a Mexican maquiladora under a cost-plus contract that paid 5 percent of total costs; (2) total maquila expenses were $20 million, of which $10 million were duty-free and $10 million were dutiable expenses incurred in Mexico; (3) the U.S. parent was able to pay half of the amount of dutiable expenses ($5 million) on behalf of the maquiladora and deduct the same amount for U.S. tax purposes; (4) the maquiladora did not declare dividends; (5) the Mexican corporate income tax rate was 35 percent; (6) the top U.S. corporate income tax rate was 34 percent; and (7) the customs duty rate on the maquiladora's imports was 4 percent.\9 The first assumption reflects the situation of a maquiladora that functions as a cost center, not as a profit center. While wage costs are lower in Mexico than in the United States, the Mexican tax rate (35 percent) is greater than the top U.S. tax rate (34 percent). Thus, the U.S. parent would not necessarily have an incentive to report a high level of taxable income in Mexico. The second assumption reflects the fact that many U.S. imports from the maquiladoras benefit from U.S. tariff provisions that allow manufacturers that assemble or process U.S. components abroad for reexport to the United States to pay duties only on that portion of the product's value that is added abroad, not on the product's final value. Using the above figures, we compared a baseline situation in which the parent and the maquiladora pay their respective expenses with a situation in which the U.S. parent pays half of the dutiable expenses ($5 million) of the maquiladora. The results of our comparison show that when the parent pays half of the maquiladora's dutiable expenses there would be an overall loss of U.S. government revenues of about 2 percent of the baseline's revenues, and the sum of the parent and the maquiladora's net incomes would increase by about 3 percent over the baseline's combined net income. The following are the specific revenue results explained in appendix VII: U.S. government: U.S. revenues from customs duties would decline by $210,000--a 48-percent loss. This is because the value of the imports on which the duties are due dropped from $11 million to $5.75 million, and customs duties are 4 percent of the value of the dutiable imports. The value of the imports fell because the U.S. parent's $5 million expense payment (and an accompanying 5-percent markup for the cost-plus foreign related party) was no longer included in the import value. Partially offsetting decreased customs duties, U.S. tax revenues would rise by $156,400--a 6-percent increase. This rise would result from the U.S. parent's income before taxes increasing by almost $500,000. U.S. income before taxes rose because customs duties (which are a deductible expense) went down and so did the U.S. parent's overall payment to the foreign related party. The overall payment declined because the U.S. parent did not have to pay the 5-percent markup that would have gone with the $5-million payment if the payment were made directly to the foreign related party. Because the additional U.S. tax was smaller than the loss in customs duties, the U.S. government would lose about $54,000. Foreign government: Mexico's direct tax revenues from the maquiladora would decrease by 25 percent--from $350,000 to $262,500. This decrease results from the maquiladora receiving less in direct revenue from the parent. Although we did not obtain the views of Mexico's tax officials on the reduced tax revenues from the maquiladora, we believe that their response to the revenue effect would be in part determined by the significance of the other benefits of the maquiladora program, such as its role as a source of manufacturing employment, foreign exchange, and foreign technology. Corporation: The combined savings in customs duties and foreign income taxes are greater than the additional U.S. income tax liabilities. As a result, corporate net profits (U.S. parent and maquiladora) would increase about $140,000--from $5.64 million to $5.78 million. We were not able to estimate the total revenue loss to the U.S. government from the practice of making payments on behalf of foreign related parties. In order to do so, we would need to know the extent to which U.S. parent companies make payments on behalf of their foreign related parties and the extent to which foreign parent companies make payments on behalf of their U.S. related parties. The extent of the payment practices by these two groups could not be ascertained from the few cases that so far had been audited by the IRS, which involved mostly Mexican maquiladoras. In addition, according to the November 1993 House of Representatives report on NAFTA, the tariffs on U.S. imports from Mexico would be reduced over 15 years with the approval of NAFTA. Further, we do not know the extent of businesses' use of direct payments in other countries whose imports will not be affected by NAFTA since this information had not been collected by the executive branch at the time of our review. -------------------- \9 The illustration does not represent a specific taxpayer. However, according to an IRS official, the assumptions used in this example reflect the characteristics raised in the IRS audits. OPTIONS FOR RESOLVING INCONSISTENCY ------------------------------------------------------------ Letter :6 There are two general options available to resolve the inconsistency in the valuation definitions--multilateral renegotiation of the Customs Valuation Code of GATT or unilateral amendment of either section 1059A of the Internal Revenue Code or section 402 of the customs legislation (19 U.S.C. �1401a). Both options have advantages and disadvantages. Under the GATT option, the executive branch could attempt to renegotiate the duty valuation provision to reconcile the difference in valuation definitions. Following agreement, Congress would then enact the revised provision into customs legislation. This option has the advantage of reconciling the difference within the GATT structure and avoiding unilateral actions that would likely be viewed by other GATT members as violations that could encourage retaliation. Among the disadvantages of this approach are that it could be time consuming, and there is no guarantee of agreement. Under one alternative of the legislative option, section 1059A could be amended to reconcile the duty valuation difference. A new subsection would specifically disallow adjustments for amounts paid by an importer for operating expenses that are not reflected in customs valuation. Thus, a taxpayer could not make adjustments to cost basis for an expense that did not qualify as an assist and was not reflected in duty value. Appendix V provides the legal citation and legislative language for this change. Under the other alternative, section 402 of the customs legislation could be amended in one of two ways. One way would be to amend the definition of the term "transaction value" or "computed value" found in section 402 to specifically include those expenses paid on behalf of the foreign related party but not reflected in the customs valuation.\10 The other way would be to amend the definition of the term assist found in section 402(h)(1) to specifically include these expenses.\11 Appendix VI provides the legal citation and legislative language for these changes. If either section 402 alternative were enacted, these expenses would have to be taken into account in determining customs value, thereby increasing the dutiable value of the imported merchandise for customs purposes. If such expenses were not included by the importer in the customs valuation of the imported merchandise as required, inclusion of these expenses in cost basis could be disallowed and IRS could make adjustments. While either the section 1059A option or the section 402 option could reconcile the differences in duty value definitions, they are not without disadvantages. They would be considered a violation of GATT and could provide the impetus for some form of retaliation by other GATT members. No estimates are available on the specific revenue impact of adopting either of these alternatives. -------------------- \10 A change to the definition of the term transaction value would not apply to imported merchandise that is appraised on the basis of deductive value or computed value rather than transaction value. \11 A change to the definition of the term assist would not apply to imported merchandise that is appraised on the basis of deductive value rather than transaction or computed value. VIEWS ON THE ALTERNATIVES ------------------------------------------------------------ Letter :7 We obtained views on the legislative options from IRS and Customs officials and private sector representatives, including trade associations and businesses. In response to our inquiry on legislative options, IRS' Office of Chief Counsel concluded in a January 7, 1993, letter that the issue addressed in the technical advice memorandum is not a tax problem. Rather, it believed that the problem is with customs valuation that results from a loophole in customs legislation. The letter concluded the issue should be resolved by amending customs law. The letter also noted two potential problems with amending section 1059A to eliminate the differences in valuation between IRS and Customs. First, an amendment to section 1059A would mean that the issue would not be resolved in all cases, since section 1059A applies only in related party transactions. Second, if section 1059A is amended as proposed without a corresponding change to customs laws, taxpayers would have to overpay customs duties to avoid an income tax problem. See appendix VIII for the text of IRS' comments. In a letter dated January 21, 1993, Customs addressed whether an amendment to the customs law relating to dutiable value would violate GATT. The letter notes that the valuation system that Customs and our major trading partners use to appraise imported merchandise was negotiated during the Tokyo Round of multilateral negotiations within GATT. The resulting valuation agreement, the Customs Valuation Code, is now found in 19 U.S.C. �1401a. Customs' letter concluded that the two alternatives for amending 19 U.S.C. �1401a would in fact violate GATT. According to Customs, the amendatory language would place the U.S. valuation legislation in conflict with the Customs Valuation Code. See appendix IX for the text of Customs' comments. Private sector representatives, including trade associations and businesses, generally opposed any U.S. legislative amendment that would change their current business practices. Their main reasons for objecting were that the amendment would be a violation of GATT, and they were concerned that U.S. firms might be placed at a competitive disadvantage from retaliation by GATT members. AGENCY COMMENTS ------------------------------------------------------------ Letter :8 IRS, Treasury, Customs, and the Office of the United States Trade Representative (USTR) provided comments on the report. The four agencies did not agree on a common approach to resolving the problem of the inconsistencies in valuation definitions. The full texts of their comments appear in appendixes X through XIII. IRS commented that a formal IRS-Customs Policy Board was chartered during the latter part of 1992 to identify issues to be commonly addressed, provide oversight and guidance for the formulation and development of major initiatives, identify and address barriers that impede cooperation between IRS and Customs, and do other tasks. IRS also commented that it has signed a formal working agreement with Customs providing for mutual assistance and the exchange of information that could be helpful in potential section 1059A issues, and it emphasized the problems with the application of section 162 of the Internal Revenue Code to disallow deductions for the expenses or reallocate them to the foreign related party. We believe that improving the exchange of information between the two agencies could, if done systematically and on a worldwide basis, reveal the extent of the practice of making direct payments on behalf of a foreign related party. However, IRS and Customs would still not have the legal means to resolve the issues raised by the practice of making direct payments. Regarding the possibility of using section 162 as a substitute for section 1059A, we have determined that the IRS district office that was pursuing this option is no longer doing so. The report has been revised to reflect this. Regarding the method of valuation observed in the maquiladora cases, IRS incorrectly stated that in all these cases duty was imposed on the basis of computed value. These cases involved a mix of transaction and computed valuation. However, we agree with the thrust of the IRS comments that a change in the definition of "transaction value" and the definition of "assist" as it applies to transaction value would not effectively amend the definition of dutiable value used by IRS in all of the audits in question. We have revised the option amending the definition of dutiable value to reflect these concerns. IRS repeated its January 1993 position that it is inappropriate to solve a customs problem through a change in tax law. IRS stated that in the cases that it has seen there has not been an underpayment of federal income tax, and any federal revenue loss in these transactions has been in customs duties. Accordingly, IRS stated that the problem should be solved by modifying the customs laws or regulations, not section 1059A. Treasury stated that a solution to the direct payments practice described in our report is to modify customs law and not tax law and suggested amending the rules with respect to the definition of an "assist" that is dutiable under the customs laws. According to Treasury, the option of amending section 1059A to prevent the evasion of customs duties would lead to two undesirable consequences. First, taxpayers would be obligated to pay more customs duties than is legally required if they wish to avail themselves of deductions for all expenses that normally are deductible as costs of goods sold. Second, if taxpayers do not include such expenses in dutiable value, deductions would be denied for expenses that otherwise are clearly deductible as costs of goods sold. USTR stated it shared Customs' and private sector representatives' concerns that unilateral amendment of section 402 would be inconsistent with GATT's Custom Valuation Code and could result in a GATT challenge and possible retaliation by GATT members. Regarding the GATT renegotiation option, USTR noted the December 15, 1993, date for notifying Congress of the President's intention to enter into an agreement. Because of this time limit, USTR stated it would not be feasible at this stage of the current round of multilateral trade negotiations to introduce for renegotiation as complex an issue as direct payments made on behalf of a foreign related party. It also suggested further economic study of the proposed changes prior to negotiations. Customs commented that it had made the preliminary determination that it could administratively resolve many of the valuation issues identified in the report, but did not explain how the issues will be resolved administratively. Customs also stated that it was willing to work with IRS to determine if differences in their respective statutes' interpretations could be narrowed, and it cautioned that any results would have to be coordinated with USTR prior to beginning what it viewed as a possibly lengthy implementation process. While we cannot determine whether Customs administrative approach will resolve this issue, we support Customs' willingness to pursue jointly with IRS actual audits and legal reviews. We also clarified our report to address Customs' concerns that our discussion of transaction value and computed value could create confusion. After we received the agencies' comments, we met with Customs and IRS officials to obtain their views on the possibility of obtaining additional information to determine the extent of the federal revenue loss caused by the direct payments practice. They cited resource and legal authority constraints for collecting information on a worldwide basis. Customs officials stated that their auditors generally do not have access to tax information unless importers voluntarily provide tax data during a Customs audit.\12 Also, the Customs officials stated that Customs audits are limited to customs matters, such as declarations of value and duty assessments. An IRS official stated that there is currently insufficient evidence of a revenue loss to justify the expenditure of scarce resources to determine the worldwide extent of the practice of making direct payments on behalf of foreign related parties. -------------------- \12 According to the North American Free Trade Agreement Implementation Act report of the Committee on Ways and Means (Report 103-361, Part 1), the NAFTA Implementation Act would permit the IRS to disclose tax information to Customs. CONCLUSION ------------------------------------------------------------ Letter :9 Implementation of section 1059A in those situations that involve direct payments effectively ceased following the issuance of IRS' technical advice memorandum. While we agree with the IRS position that it is inappropriate to use section 1059A to disallow the practice of making direct payments on behalf of foreign related parties, we are concerned by the revenue implications of this practice. The potential federal revenue loss is not known since the executive branch has only done a small number of audits of direct payments practices. Furthermore, Customs and IRS officials cited legal and resource constraints for not determining the full extent of the federal revenue loss. The two general options presented in this report would reconcile the valuation differences, but each has major disadvantages. Multilateral renegotiation of the Customs Valuation Code of GATT would be time consuming with no guarantee of agreement. Unilateral amendment of either tax or customs legislation would be viewed as a violation of GATT. Furthermore, the four executive branch agencies associated with this issue do not agree on what legislative approach should be used to reconcile the valuation differences. Treasury and IRS oppose amending the tax code and prefer amending section 402 of customs legislation. Customs and USTR oppose amending section 402 of the customs legislation and do not state an opinion on amending tax law. Also, under current conditions the executive branch and Congress do not have the information necessary to determine the extent of federal revenue losses due to the payments practice, and IRS has been left without the use of section 1059A in those situations involving direct payments on behalf of related parties. RECOMMENDATION ----------------------------------------------------------- Letter :10 We are not making a recommendation in this report. --------------------------------------------------------- Letter :10.1 As agreed with your office, unless you publicly announce the contents of this report earlier, we plan no further distribution until 30 days after the date of this letter. At that time, we will send copies of the report to the Secretary of the Treasury; the Commissioners of IRS and Customs; the United States Trade Representative; the Director, Office of Management and Budget; and other interested parties. We will also make copies available to others upon request. If you or your staff have any questions concerning matters discussed in this report, please contact me on (202) 512-5407. Major contributors to this report are listed in appendix XIV. Sincerely yours, Jennie S. Stathis Director, Tax Policy and Administration Issues OBJECTIVES, SCOPE, AND METHODOLOGY =========================================================== Appendix I Our objectives were to (1) provide information on IRS' implementation of section 1059A of the Internal Revenue Code and on specific cases in which it was used as identified in the IRS Commissioner's Quarterly Report; (2) provide information on IRS' July 10, 1992, technical advice memorandum on the applicability of section 1059A; (3) develop an illustration of the likely impact on U.S. revenues of the practice of allowing U.S. taxpayers to make payments on behalf of their foreign related parties; and (4) develop legislative language to make IRS and Customs valuation definitions consistent with each other. To provide information on IRS' implementation of section 1059A and the IRS technical advice memorandum, we interviewed IRS and Customs officials at their respective national offices and IRS field personnel in Austin and San Antonio, Texas. The IRS September 1991 Quarterly Report identified six IRS audits involving section 1059A issues. We discussed development and disposition of the section 1059A issues in five of the six cases with cognizant IRS officials. Upon examination, we found that the sixth case had been erroneously reported as having a section 1059A issue. We discussed four other section 1059A cases not identified in the report. We also discussed the impact of the technical advice memorandum on the existing cases and the future development of section 1059A issues in IRS audits. We constructed a specific illustration to show the possible impact on U.S. revenues, foreign tax revenues, and corporate revenues of the situation discussed in IRS' technical advice memorandum (see app. VII). We did not have sufficient information to generalize from the eight audits involving section 1059A issues to obtain an aggregate estimate on U.S. revenues. In order to develop legislative language, our Office of General Counsel reviewed the IRS technical advice memorandum and developed language to amend legislation to address the valuation difference identified in our work. We also discussed the potential overall impact of amending legislation with IRS and Customs officials and with private sector representatives. We did not perform a revenue estimate of the impact of adopting the alternatives. TEXT OF SECTION 1059A ========================================================== Appendix II IRC 1059A. LIMITATION ON TAXPAYER'S BASIS OR INVENTORY COST IN PROPERTY IMPORTED FROM RELATED PERSONS (a) IN GENERAL.-- If any property is imported into the United States in a transaction (directly or indirectly) between related persons (within the meaning of section 482), the amount of any costs-- (1) which are taken into account in computing the basis or inventory costs of such property by the purchaser, and (2) which are also taken into account in computing the customs value of such property, shall not, for purposes of computing such basis or inventory cost for purposes of this chapter, be greater than the amount of such costs taken into account in computing such customs value. (b) CUSTOMS VALUE; IMPORT.-- For purposes of this section-- (1) Customs value.-- The term "customs value" means the value taken into account for purposes of determining the amount of any customs duties or any other duties which may be imposed on the importation of any property. (2) Import. -- Except as provided in regulations, the term "import" means the entering, or withdrawal from warehouse, for consumption. (See figure in printed edition.)Appendix III JULY 10, 1992, IRS TECHNICAL ADVICE MEMORANDUM ON THE APPLICABILITY OF SECTION 1059A PUBLISHED AS PRIVATE RULING 9301002 ========================================================== Appendix II (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.)Appendix IV IRS FORM 5472, INFORMATION RETURN OF A 25% FOREIGN-OWNED U.S. CORPORATION OR A FOREIGN CORPORATION ENGAGED IN A U.S. TRADE OR BUSINESS ========================================================== Appendix II (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) OPTION FOR EXCLUDING FROM TRANSFER PRICE CERTAIN OPERATING EXPENSES OF FOREIGN MANUFACTURER PAID DIRECTLY BY IMPORTER UNDER SECTION 1059A =========================================================== Appendix V Sec. 1. LIMITATION ON COST OF PROPERTY IMPORTED FROM RELATED PERSONS (a) IN GENERAL.-- Section 1059A (related to basis or inventory cost in property imported from related persons) is amended by adding at the end thereof the following new paragraph: "(c) REGULATIONS.-- The Secretary shall prescribe such regulations as may be appropriate to carry out the purposes of this section, including regulations allowing adjustments where customs pricing rules differ from appropriate tax valuation principles. Such regulations may not, however, allow adjustments for amounts paid directly or indirectly by the importer for operating expenses of the manufacturer which are not included in customs valuation. The explanation of this provision in the report accompanying the legislation could provide a list of examples of what expenses should be considered operating expenses. The following is a list of examples. 1. Rent on foreign related party's office equipment 2. Depreciation on the foreign related party's auto 3. Landscaping 4. Janitorial supplies 5. Office supplies for the foreign related party 6. Business expenses for the foreign related party 7. Foreign related party's electric bill 8. Safety/medical expenses of the foreign related party 9. Foreign related party's telephone bill 10. Foreign related party's postage expenses 11. Removal of trash 12. Legal fees of the foreign related party 13. Classified advertising of foreign related party 14. Executive development 15. Travel and entertainment expenses 16. Professional dues and subscriptions 17. Charitable contributions 18. Consulting fees 19. Expenses attributable to conversion of currencies OPTIONS FOR INCLUDING IN DUTIABLE VALUE CERTAIN OPERATING EXPENSES OF FOREIGN MANUFACTURER PAID DIRECTLY BY IMPORTER ========================================================== Appendix VI OPTION 1: ------------------------------------------------------ Appendix VI:0.1 Sec. 1. CERTAIN EXPENSES TO BE INCLUDED IN DEFINITION OF "TRANSACTION VALUE" (a) IN GENERAL.-- Section 402(b)(1) of the Tariff Act of 1930, as amended by the Trade Agreements Act of 1979 (19 U.S.C. 1401a(b)), is amended by adding after subparagraph (E) the following new subparagraph: "(F) any amounts for operating expenses paid directly or indirectly to the manufacturer by the importer as purchase price for the imported merchandise." (b) CONFORMING AMENDMENTS.-- (1) Subparagraph (D) of section 402(b)(1) is amended by striking "and" at the end thereof. (2) Subparagraph (E) of section 402(b)(1) is amended by striking "." and inserting ";and". (3) Section 402(b)(1) is amended by striking "(A) through (E)" where it appears and inserting "(A) through (F)". (c) EFFECTIVE DATE.-- The amendment made by this section shall take effect upon enactment of this Act. Sec. 1. CERTAIN EXPENSES TO BE INCLUDED IN DEFINITION OF "COMPUTED VALUE" (a) IN GENERAL.--Section 402(e) of the Tariff Act of 1930, as amended by the Trade Agreements Act of 1979 (19 U.S.C. 1401a(e)(1)), is amended by adding after subparagraph (D) the following new subparagraph: "(E) any amounts for operating expenses paid directly or indirectly to the manufacturer by the importer as purchase price for the imported merchandise." (b) CONFORMING AMENDMENTS.-- (1) Subparagraph (C) of section 402(e) is amended by striking "and" at the end thereof. (2) Subparagraph (D) of section 402(e) is amended by striking "." and inserting ";and". (c) EFFECTIVE DATE.-- The amendment made by this section shall take effect upon enactment of this Act. OPTION 2: ------------------------------------------------------ Appendix VI:0.2 Sec. 1. CERTAIN EXPENSES TO BE INCLUDED IN DEFINITION OF "ASSIST" IN DETERMINING TRANSACTION OR COMPUTED VALUE (a) IN GENERAL.-- Section 402(h)(1) of the Tariff Act of 1930, as amended by the Trade Agreements Act of 1979 (19 U.S.C. 1401a(h)(1), is amended by redesignating subparagraphs (B) and (C) as subparagraphs (C) and (D) and inserting after subparagraph (A) the following new subparagraph: "(B) The term "assist" also includes any amounts for operating expenses paid directly or indirectly to the manufacturer by the importer as purchase price for the imported merchandise." (b) EFFECTIVE DATE.-- The amendments made by this section shall take effect upon enactment of this Act. The explanation of the provision in the report accompanying the legislation could provide a list of examples of what expenses should be considered operating expenses. The following is a list of examples. 1. Rent on foreign related party's office equipment 2. Depreciation on the foreign related party's auto 3. Landscaping 4. Janitorial supplies 5. Office supplies for the foreign related party 6. Business expenses for the foreign related party 7. Foreign related party's electric bill 8. Safety/medical expenses of the foreign related party 9. Foreign related party's telephone bill 10. Foreign related party's postage expenses 11. Removal of trash 12. Legal fees of the foreign related party 13. Classified advertising of foreign related party 14. Executive development 15. Travel and entertainment expenses 16. Professional dues and subscriptions 17. Charitable contributions 18. Consulting fees 19. Expenses attributable to conversion of currencies MAQUILADORA CASE ========================================================= Appendix VII In this appendix we develop a numerical illustration of two related parties--a U.S. parent company and its Mexican related party (maquiladora). The U.S. parent would purchase the foreign related party's goods and also pay a portion of the foreign related party's expenses. The model shows how the combined profits of both related parties increase when the U.S. parent makes payments on behalf of the foreign related party. If the U.S. parent pays expenses on behalf of its foreign related party, it will pay less for the product itself when imported from the foreign related party. Because the product costs less, U.S. Customs duties will be less. However, the practice of paying foreign expenses may also result in higher overall income taxes because U.S. income taxes may be higher. In the numerical illustration we assumed that (1) a U.S. parent had a Mexican maquiladora under a cost-plus contract that paid 5 percent of total cost; (2) total maquila expenses were $20 million, of which $10 million were duty-free and $10 million were dutiable expenses incurred in Mexico; (3) the U.S. parent was able to pay half of the amount of dutiable expenses ($5 million) on behalf of the maquiladora and deduct the same amount for U.S. tax purposes; (4) the maquiladora did not declare dividends; (5) the Mexican corporate income tax rate was 35 percent; (6) the top U.S. corporate income tax rate was 34 percent; and (7) the customs duty rate on the maquiladora's imports was 4 percent.\1 The first assumption reflects the situation of a maquiladora that functions as a cost center, not as a profit center. While wage costs are lower in Mexico than in the United States, the Mexican corporate tax rate (35 percent) is greater than the top U.S. corporate tax rate (34 percent). Thus, the U.S. parent would not necessarily have an incentive to report a high level of taxable income in Mexico. The second assumption reflects the fact that many U.S. imports from the maquiladoras benefit from U.S. tariff provisions that allow manufacturers that assemble or process U.S. components abroad for reexport to the United States to pay duties only on that portion of the product's value that is added abroad, not on the product's final value. Using the above figures, in table VII.1 we compared a baseline situation in which the parent and the maquiladora pay their respective expenses with a situation in which the U.S. parent pays half of the dutiable expenses ($5 million) of the maquiladora. Table VII.2 presents the detailed results of the baseline in which the two related parties pay for all their respective expenses. Table VII.3 presents the detailed results of the case in which the U.S. parent makes a $5 million payment on behalf of the maquiladora. The results of our comparison show that when the parent pays half of the maquiladora's dutiable expenses, overall U.S. government revenues would decrease about 2 percent of the baseline's revenues; and the sum of the parent and the maquiladora's net incomes would increase by about 2.5 percent over the baseline's combined net income. The following are the specific revenue results shown in table VII.1: U.S. government: U.S. revenues from customs duties would decline $210,000--from $440,000 to $230,000. This is because the value of the imports on which the duties are due dropped from $11 million to $5.75 million and customs duties are 4 percent of the value of dutiable imports. Table VII.1 How Profits Increase and Government Revenues Decrease if U.S. Parent Pays $5 Million of Foreign Related Party's Expenses U.S. parent pays $5 Baseline million Change ------------------------- -------- ------------- -------- U.S. government Duties $440,000 $230,000 ($210,00 0) U.S. tax 2,570,40 2,726,800 156,400 0 Total U.S. revenues 3,010,40 2,956,800 (53,600) 0 Foreign government Foreign tax 350,000 262,500 (87,500) Net income of two related parties U.S. parent 4,989,60 5,293,200 303,600 0 Foreign related party 650,000 487,500 (162,500 ) Combined net income 5,639,60 5,780,700 141,100 0 ------------------------------------------------------------ Source: Tables VII.2 and VII.3. The value of the imports fell because the U.S. parent's $5- million expense payment (and an accompanying 5-percent markup for the cost-plus foreign related party) were no longer included in the import value. See the customs duties listed in tables VII.2 and VII.3. Partially offsetting decreased customs duties, U.S. tax revenues would rise by $156,400--from $2,570,400 to $2,726,800 as table VII.1 shows. This rise would result from the U.S. parent's income before taxes increasing from $7.6 million on table VII.2 to about $8 million on table VII.3. U.S. income before taxes rose because customs duties went down as did the U.S. parent's overall payment to its foreign related party. The overall payment declined because the U.S. parent did not have to pay the 5-percent markup that would have gone with the $5-million payment if the payment were made directly to the foreign related party. Because the $156,400 in additional U.S. taxes was smaller than the $210,000 loss in customs duties, the U.S. government would lose net revenues of $53,600. Table VII.2 Maquiladora's Baseline Case Foreign related U.S. Combined party parent results ------------------------ ---------- ---------- ---------- Revenue $21,000,00 $30,000,00 $30,000,00 0 0 0\a Cost of goods sold 20,000,000 21,000,000 20,000,000 \a Other expenses 0 1,000,000 1,000,000 Payments made on 0 0 0 behalf of foreign affiliate Customs duties 0 440,000 440,000 (4% x dutiable imports)\b Income before taxes 1,000,000 7,560,000 8,560,000 Taxes (35% in Mexico, 350,000 2,570,400 2,920,400 34% in the United States) Net income $650,000 $4,989,600 $5,639,600 ------------------------------------------------------------ \a The combined results net out the intercompany transactions. \b Dutiable imports are equal to the value of imports ($21 million) minus the value of duty-free components ($10 million). Thus, dutiable imports are $11 million and duties are $440,000. Source: GAO. Foreign government: As shown in the foreign related party columns in tables VII.2 and VII.3, Mexico's tax revenues would decrease by $87,500--from $350,000 to $262,500. This decrease results from the foreign related party receiving less in direct payments, or revenue, from the U.S. parent. Corporation: Corporate net profits (U.S. parent and maquiladora) would increase by $141,100--from $5,639,600 to $5,780,700. An analysis of the financial statements in table VII.2 follows. Foreign related party's results: Customs duties are determined by duty rates set by law and the dutiable value of imports. A portion of the value of goods imported into the U.S. may be duty-free if the final goods have incorporated some U.S.-made components. We assumed that the goods made in Mexico have incorporated $10 million worth of U.S.-made components, which would be exempt from duty. Thus, of the $20-million maquiladora expenses, $10 million were duty-free and $10 million were dutiable expenses incurred in Mexico. The Mexican maquiladora operated under a cost-plus contract that provided a markup rate equal to 5 percent of total cost. Thus, the maquiladora's maximum revenues would be $21 million, which is the sum of cost of goods sold ($20 million) plus 5 percent of cost of goods sold ($1 million). The foreign tax rate was 35 percent; thus the maquiladora's tax payments and net income would be $350,000 and $650,000, respectively. U.S. parent's results: The U.S. parent would import the full production of the maquiladora ($21 million), pay a U.S. Customs duty rate of 4 percent ($440,000), and incur additional expenses of $1 million in the United States. After subtracting all expenses from final sales to unrelated customers ($30 million), the U.S. parent's taxable income would be $7,560,000. The U.S. tax rate is 34 percent, so the U.S. parent's tax payments and net income would be $2,570,400 and $4,989,600, respectively. Combined results: The combined results of the two related parties were obtained by adding up the revenues and expenses of the maquiladora and the U.S. parent and netting out the intercompany transactions. Specifically, the maquiladora's revenues ($21 million) would not be included in consolidated revenues, and the U.S. parent's imports ($21 million) would not be included in consolidated expenses. Table VII.3 provides the figures that would result if the U.S. parent pays $5 million of the maquiladora's expenses. Our analysis of the changes in the financial statements follows the table. Table VII.3 U.S. Parent Pays $5 Million of Foreign Related Party's Expenses Foreign related U.S. Combined party parent results ------------------------ ---------- ---------- ---------- Revenue $15,750,00 $30,000,00 $30,000,00 0 0 0\a Cost of goods sold 15,000,000 15,750,000 15,000,000 \a Other expenses 0 1,000,000 1,000,000 Payments made on behalf 0 5,000,000 5,000,000 of foreign related party Customs duties (4% x 0 230,000 230,000 dutiable imports)\b Income before taxes 750,000 8,020,000 8,770,000 Taxes (35% in Mexico, 262,500 2,726,800 2,989,300 34% in the United States) Net income $487,500 $5,293,200 $5,780,700 ------------------------------------------------------------ \a The combined results net out the intercompany transactions. \b Dutiable imports are equal to the value of imports ($15.75 million) minus duty-free components ($10 million). Thus, dutiable imports are $5.75 million and duties are only $230,000. Source: GAO. Foreign related party's results: The U.S. parent would pay $5 million on behalf of the maquiladora. Thus, the maquiladora's expenses would be $15 million instead of $20 million. Because of this decrease in expenses, the maquiladora's revenues would also decrease because the maquiladora's revenues are tied to its costs.\2 The maquiladora's taxable income and Mexican taxes would decrease to $750,000 and $262,500, respectively. U.S. parent's results: The U.S. parent's third-party sales would stay constant at $30 million, but its costs of goods sold would be lower than in the baseline case ($15.75 million compared to $21 million). However, the U.S. parent would be able to include its payment on behalf of the maquiladora ($5 million) as an additional deduction. With respect to customs duties, the U.S. parent's $5 million payment on behalf of the maquiladora would reduce the maquiladora's dutiable components by $5 million plus the 5 percent profit markup ($250,000). As a result, customs duties would be reduced substantially to $230,000 from the $440,000 baseline amount. Combined results: The combined results again net out the intercompany transactions. Although the foreign related party's costs of goods are $15 million instead of the baseline's $20 million, the U.S. parent would pay the other $5 million. This shift of expenses produces an additional combined net income of $141,100 (see table VII.1). (See figure in printed edition.)Appendix VIII -------------------- \1 The illustration does not represent a specific taxpayer. However, according to an IRS official, the assumptions used in this example reflect the characteristics raised in the IRS audits. \2 If the maquiladora's gross profits were not linked to its costs, the payment by the U.S. parent of a portion of the maquiladora's costs would result in higher foreign taxable income and higher foreign taxes. COMMENTS FROM THE INTERNAL REVENUE SERVICE ON AMENDING SECTION 1059A OF THE CODE ========================================================= Appendix VII (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.)Appendix IX COMMENTS FROM THE U.S. CUSTOMS SERVICE ON AMENDING SECTION 402 OF THE CUSTOMS LEGISLATION ========================================================= Appendix VII (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.)Appendix X COMMENTS FROM THE OFFICE OF THE UNITED STATES TRADE REPRESENTATIVE ========================================================= Appendix VII (See figure in printed edition.) (See figure in printed edition.)Appendix XI COMMENTS FROM THE U.S. CUSTOMS SERVICE ========================================================= Appendix VII (See figure in printed edition.) (See figure in printed edition.) (See figure in printed edition.) The following are GAO's comments on Customs' July 27, 1993, letter. GAO COMMENTS ------------------------------------------------------- Appendix VII:1 1. We changed the report to delete the reference to books and records and to state that direct payments on behalf of related parties and the question of whether they were to be included in determining transaction value were the issues at hand. 2. We changed the report to state more clearly that IRS' approach reflected a broader concept of what should be included in transaction value. 3. The change made under comment 1 above addresses this concern. 4. The report notes disadvantages of this option on page 11 and in the characterization of USTR's comments on page 14. (See figure in printed edition.)Appendix XII COMMENTS FROM THE INTERNAL REVENUE SERVICE ========================================================= Appendix VII (See figure in printed edition.) (See figure in printed edition.) The following are GAO's comments on IRS' August 9, 1993, letter. GAO COMMENTS ------------------------------------------------------- Appendix VII:2 1. In addition to the agency comments section describing IRS-Customs working relationships, we have added language on page 8 discussing IRS and Customs working together. 2. Because the relevant IRS district is no longer pursuing the use of section 162 in this context, we have deleted reference to it. 3. Although we do not agree that all of these cases used computed value, we do agree with the comments about the problems with changing definitions. Consequently, we have added the words "computed value" to the customs legislative option on page 11 and added a computed value section to appendix VI. (See figure in printed edition.)Appendix XIII COMMENTS FROM THE TREASURY DEPARTMENT ========================================================= Appendix VII (See figure in printed edition.) (See figure in printed edition.) The following are GAO's comments on Treasury's August 9, 1993, letter. GAO COMMENTS ------------------------------------------------------- Appendix VII:3 1. We note this in our response to IRS comments. MAJOR CONTRIBUTORS TO THIS REPORT ========================================================= Appendix XIV GENERAL GOVERNMENT DIVISION, WASHINGTON, D.C. Jose R. Oyola, Assistant Director, Tax Policy and Administration Issues Lawrence M. Korb, Assignment Manager OFFICE OF GENERAL COUNSEL, WASHINGTON, D.C. Rachel DeMarcus, Assistant General Counsel Shirley A. Jones, Attorney-Advisor PHILADELPHIA REGIONAL OFFICE Linda P. Schmeer, Site Senior Christopher D. Morehouse, Evaluator Douglas Sanner, Evaluator