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.  Major divisions and subdivisions *
* of the text, such as Chapters, Sections, and Appendixes, are           *
* identified by double and single lines.  The numbers on the right end   *
* of these lines indicate the position of each of the subsections in the *
* document outline.  These numbers do NOT correspond with the page       *
* numbers of the printed product.                                        *
*                                                                        *
* No attempt has been made to display graphic images, although figure    *
* captions are reproduced. Tables are included, but may not resemble     *
* those in the printed version.                                          *
*                                                                        *
* A printed copy of this report may be obtained from the GAO Document    *
* Distribution Facility by calling (202) 512-6000, by faxing your        *
* request to (301) 258-4066, or by writing to P.O. Box 6015,             *
* Gaithersburg, MD 20884-6015. 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. 
ï¿½1401a).\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.  ï¿½1401a).  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.  ï¿½1401a. 

Customs' letter concluded that the two alternatives for amending 19
U.S.C.  ï¿½1401a 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

