Customs Value in Related-Party Transactions: Royalties and Transfer Pricing

In a transaction between related parties, the customs value is determined by the invoice price only if the importer shows that the relationship between the parties did not influence it. This is set out in Section 132(b)(4) of the Customs Ordinance. If Customs believes the price was influenced, it must notify the importer and hear its arguments, and only then move to another valuation method. In addition, royalties paid to the brand owner are included in the value when their payment is a condition of the sale of the goods, under Section 133(a)(3).

The Ordinance starts from the "transaction value": the price actually paid or payable for the goods when sold for export to Israel, plus the amounts listed in Section 133 (Section 132(a)). This method applies only to goods imported for commercial use (Section 133I). When it is rejected, the subsequent methods are applied in the order set out in Section 130.

Who Is a Related Party for Customs Purposes

Section 129 defines "special relationships" through a closed list of situations. Among them: a person who holds 5% or more of the voting rights or shares in each of the parties, directly or indirectly; a party that controls the other; two parties controlled by a third party; an officer in the other party's business; and family members. Control means a legal or practical position that enables one to restrain or direct the activities of the other.

A sole distributor, sole agent or sole concessionaire is not considered a related party merely because of the exclusivity. They fall within the definition only if one of the listed situations applies to them.

How to Prove the Price Was Not Influenced

The relationship between the parties does not, in itself, invalidate the price. Under Section 132(b)(4)(b), the transaction value is deemed uninfluenced if the importer proves that it closely approximates one of three test values: the transaction value of identical or similar goods sold for export to Israel to unrelated importers, a value determined by the selling price in Israel (Section 133D), or a computed value based on production cost and profit (Section 133E).

Royalties and License Fees

Section 133(a)(3) adds to the value royalties and license fees "related to the goods" that the importer must pay, directly or indirectly, as a condition of the sale of the goods. The same section also adds assists that the importer supplied to the manufacturer free of charge or at a reduced cost, such as molds, components and design work performed outside Israel (Section 133(a)(2)).

The Supreme Court interpreted this condition in CA 5885/13 Maroidex v. State of Israel. The importers in that case paid overseas manufacturers for branded clothing and, separately, paid royalties to the trademark owners, who neither owned nor controlled the manufacturers. Customs demanded 12% duty on the royalties as well. Customs' appeal was largely dismissed. Royalties are included in the value when their payment is a condition of the sale of the goods for export to Israel, whereas royalties that are a condition only of the sale in Israel after importation are not included. To decide the matter, the Court examined the wording of the agreements and the parties' actual conduct.

In a transaction between related companies, the documents that decide the dispute are the purchase agreement, the license agreement and the group's pricing policy. Section 134 empowers the Director to issue regulations requiring anyone connected with the importation to provide information, books and documents concerning the purchase, importation and sale of the goods. From there, the process looks like this:

1. Customs notifies you that, in its view, the relationship influenced the price. Section 132(b)(4)(c) requires it to give you an opportunity to present your arguments before it rejects the transaction value.

2. You present a test value under one of the three routes in Section 132(b)(4)(b), supported by documents: invoices to unrelated importers, selling price lists in Israel, or cost and profit data from the manufacturer.

3. If the transaction value is rejected, Customs moves to the methods in Section 130 in order: identical goods, similar goods, selling price in Israel, computed value. At your request and with the approval of the Customs collector, the computed value may be applied earlier.

4. Customs issues a written notice of the value and the method by which it was determined. Under Section 133H, you may also request a written breakdown of the calculation.

For example, an Israeli company imports goods from its parent company for $100,000 and pays the parent an additional 8% in brand royalties, without which the parent will not sell it the goods. The transaction value will be $108,000 before freight and insurance. If the duty rate on the goods is 12%, the duty will rise from $12,000 to $12,960.

When the demand arrives at the moment of release and you dispute it, you can release the goods and continue the dispute by paying "under protest". An explanation of this route and the applicable deadlines is available in the article Goods Detained by Customs.

A review is especially important when the purchase price is set within the group rather than through negotiation. These are the situations that arise in valuation audits:

• There is a license or franchise agreement separate from the purchase agreement, and the royalties are calculated as a percentage of sales of the imported products. Here you need to examine whether the payment is a condition of the sale for export, under the Maroidex test.

• The transfer price is set according to a transfer pricing study prepared for income tax purposes. Customs examines the price under Section 132 and compares it with one of the test values set out there, so a study accepted by the Income Tax Authority does not guarantee that Customs will accept the value.

• The parent company grants a year-end discount or credit. Under Section 132(e), a discount granted after the goods have been released from customs control does not reduce the value. An upward year-end adjustment requires examining whether the declared value must be updated.

• You supplied the manufacturer with molds, components or design without paying for them in the transaction price. Their apportioned value is included in the value under Section 133(a)(2).

Information on representation before customs valuers in such audits is available on the page Classification of Goods and Customs Valuation.

This practice area is handled at the firm by Adv. Udi Assa, who worked from 2011 to 2022 in the Legal Department of the Customs and VAT Division at the Israel Tax Authority headquarters.