Navigate the first sale rule and transfer pricing effectively | Baker Tilly
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Navigate the first sale rule and transfer pricing for cross border success
March 14, 2025 · Authored by Sid Paruthi, Ravi Ganapathy
In today’s globalized economy, multinational corporations (MNCs) continually seek strategies to optimize import costs while complying with tax regulations. Two key mechanisms at work in this area are the First Sale Rule (FSR) and transfer pricing rules.
While the FSR helps companies reduce customs duties, transfer pricing regulations govern profit allocation across jurisdictions. The interplay between these two frameworks can create valuation mismatches, leading to heightened scrutiny from both tax and customs authorities.
Overcome challenges associated with managing cross-border trade costs with insights into the FSR, its impact on customs valuation, and its interaction with transfer pricing regulations.
Understanding the first sale rule
The FSR allows importers to declare a lower customs value by using the price from an earlier transaction in a multi-tiered supply chain, rather than the final resale price. This is particularly useful in scenarios where goods pass through intermediaries before reaching the U.S.
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The FSR is an opportunity for importers to reduce customs duties.
In a 1996 General Notice, published as T.D. 96-87, U.S. Customs and Border Protection (CBP) identified three key conditions that must be satisfied for an importer to declare a lower customs value:
Bona Fide Sale. A legitimate sale must occur between the manufacturer and the intermediary.
Arm’s-Length Transaction. The manufacturer and intermediary must negotiate under market conditions without influence from related-party relationships.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
Irrevocable Commitment for Exportation. At the time of the first sale, the goods must be destined for the U.S. and not for resale elsewhere.
To support a FSR claim, companies must provide documentation, such as purchase orders, invoices, contracts, proof of payment, and other relevant records, that establish how the parties interact in the supply chain.
By meeting these conditions, importers can reduce customs duties by basing the customs value on a lower first-sale price, leading to significant cost savings.
Transfer pricing and customs valuation: A mismatch?
While the FSR lowers import costs, transfer pricing rules ensure profits are fairly allocated across related entities in different jurisdictions.
The key challenge is the potential valuation gap:
For customs purposes, a taxpayer wants to declare a lower import value — $80 instead of $100 — to minimize duties.
For tax purposes, the same taxpayer wants to record a higher cost of goods sold (COGS) — $100 instead of $80 — to reduce taxable income.
This discrepancy often leads to regulatory scrutiny from both customs and tax authorities, requiring companies to adopt robust documentation and compliance strategies.
U.S. Customs has historically challenged the use of the FSR when transactions involve related middlemen.
Key reasons for rejection include:
Failure to demonstrate a bona fide sale between the manufacturer and intermediary.
Middleman doesn’t take title to the goods, raising questions about its role in the transaction.
Flash title transfers where title is passed momentarily without the middleman holding risk.
Shared business addresses between the manufacturer and middleman indicating potential non-arm’s length dealings.
Middleman failing to insure goods leading to doubts about economic substance.
Lack of complete documentation proving transaction structures, payment flows, and profit allocation.
The IRS enacted Section 1059A of the Internal Revenue Code (IRC) to address the valuation of imported goods from a related party, preventing mismatches between customs and income tax reporting when applying the FSR. Section 1059A specifically prohibits companies from claiming a higher inventory value for tax purposes than the customs value declared upon importation.
Section 1059A allows adjustments to inventory cost that aren’t included in the initial customs value, such as freight charges, insurance, assembly costs, and post-importation services. The IRS has clarified that if valuation differences result from the correct application of the FSR, they don’t violate Section 1059A.
Given the focus on related-party transactions, the IRS and CBP have the right to scrutinize whether the transaction is at arm’s length, ensuring that the relationship didn’t influence pricing, as required under Section 482 of the Internal Revenue Code.
To mitigate these risks, companies must provide transfer pricing studies, financial statements, and detailed transaction records that support the legitimacy of the middleman’s role. Transfer pricing study becomes very pertinent to ensure that intercompany transactions reflect arm’s length pricing.
This involves a two-step approach:
Assessing the functions performed, risks assumed, and assets employed by related parties.
Conducting a comparability analysis to benchmark related-party transactions against similar ones between unrelated companies.
First sale rule application: Volkswagen of America, Inc. V. United States
A landmark case illustrating the FSR is Volkswagen of America, Inc. v. United States, 277 F. Supp. 2d 1364 (CIT 2003). This case provides a real-world application of how a company leveraged the FSR to reduce customs duties while demonstrating compliance with U.S. customs law.
Volkswagen of America (VW USA) imported automobiles into the U.S. through a multi-tiered transaction involving its parent company, Volkswagen AG (VW AG), in Germany, which sourced vehicles from an independent manufacturer. The key issue was whether VW USA could declare the lower price VW AG paid to the manufacturer — FSR — as the customs value, rather than the higher resale price VW USA paid to VW AG.
FSR application and outcome
Under 19 U.S.C. § 1401a(b), U.S. customs law requires imported goods to be valued based on the transaction value, which is the price actually paid or payable for the goods when sold for exportation to the United States. However, if multiple sales occur before importation, the importer may use the lower first sale price, provided it meets the criteria established in CBP T.D. 96-87 (1996).
The Court of International Trade (CIT) acknowledged that related-party transactions could qualify for the FSR if they met arm’s-length and bona fide sale conditions.
However, rather than issuing a definitive ruling in favor of Volkswagen, the court remanded the case for further fact-finding, requiring Volkswagen to provide additional evidence that the manufacturer-to-VW AG sale was a bona fide sale for exportation to the U.S. and that the pricing reflected arm’s-length terms.
The decision emphasized the burden of proof on the importer to substantiate compliance with FSR requirements before using a lower customs valuation.
Next steps
The FSR is an opportunity for importers to reduce customs duties by using the price from an earlier transaction in a multi-tiered supply chain. However, as seen in cases like Volkswagen of America, Inc. v. United States (2003), CBP imposes strict conditions to ensure that the first sale price reflects an arm’s-length transaction and that each party in the supply chain assumes real economic risks.
This is where transfer pricing documentation becomes critical. A robust transfer pricing study provides the necessary comparability analysis, functional analysis, and financial documentation to demonstrate that related-party transactions meet arm’s-length standards and comply with both customs and tax regulations.
It helps prove that:
Manufacturer-to-intermediary sale is a bona fide transaction
Pricing reflects market conditions
The middleman plays a legitimate economic role rather than acting as a conduit to lower import duties
Without comprehensive transfer pricing documentation, importers risk having their FSR claims rejected, potentially leading to higher customs duties, increased tax liabilities, and regulatory penalties.
By integrating transfer pricing principles into FSR compliance, companies can ensure regulatory alignment and leverage their global supply chain strategy effectively.
