Can a Chinese factory sell to its own U.S. company at any price?

No. Related-party prices must be arm's length, meaning what unrelated parties would agree in similar circumstances. The IRS can adjust under IRC §482 and add a 20% or 40% penalty on the resulting underpayment, and Chinese tax authorities also review whether export prices are reasonable.

Can the customs value differ from the purchase price in the books?

For income tax, inventory cost can't exceed the customs value. Under IRC §1059A, goods imported from a related party can't carry a higher inventory cost than their customs value. Declaring a low value and booking a high cost doesn't work; use one price for customs, books, the return and Form 5472.

Does the U.S. subsidiary report its purchases from the Chinese factory on Form 5472?

Yes. A U.S. corporation 25% or more foreign-owned files one Form 5472 per foreign related party with its Form 1120 each year, including inventory purchases, loans, interest and service fees. Each missed, incorrect or unsupported form starts at a $25,000 penalty.

How much profit should the U.S. subsidiary earn?

There's no single number. It depends on the functions the U.S. company performs and the risks it bears, measured against the operating margins of comparable independent distributors. A subsidiary that loses money every year or earns far below comparables is the most likely to be adjusted.

Chinese Factory to U.S. Subsidiary: §482, 5472 and §1059A

When a Chinese factory supplies Wayfair through its own U.S. subsidiary, the number that matters most isn't the base cost Wayfair pays. It's the price the subsidiary pays the factory. Set it high and U.S. profit falls, duty rises and China's profit grows; set it low and the reverse happens. The IRS can move the price to arm's length under IRC §482, and under §1059A the U.S. company's inventory cost for income tax can't exceed the value declared to customs. The purchases also go on Form 5472 every year. So set the price before the first entry is filed, and use one set of numbers for both countries and both agencies.

Why many factories use a U.S. subsidiary

Wayfair is a retailer that buys from suppliers: you set a base cost, Wayfair sets the retail price and pays within 60 days of your invoice, and orders must ship from a North American warehouse or Wayfair's CastleGate. A small factory can supply directly through its Chinese company. At volume, with U.S. warehouses, staff and other platforms, most set up a U.S. C corporation that imports, holds inventory and invoices Wayfair. It pays 21% federal corporate tax and, with foreign ownership of 25% or more, files Form 5472 with its Form 1120 every year.

Now the same goods are sold twice: the factory sells to the subsidiary (a related-party sale), and the subsidiary sells to Wayfair (an arm's length sale). Wayfair sets the second price; you set the first. That's the transfer pricing question.

What the price changes: a worked example

Example (hypothetical numbers, to show the method): the subsidiary sells $2,000,000 a year to Wayfair at base cost. The 5% damage allowance is $100,000; ocean freight and delivery $100,000; CastleGate storage and fulfillment $120,000; ads and platform fees $50,000; U.S. staff, office and accounting $80,000; duty is assumed at 25% of the customs value. The factory's production cost is $900,000.

At a purchase price of $1,000,000: duty is $250,000. Subsidiary profit is $2,000,000 less $100,000, $1,000,000, $250,000, $270,000 and $80,000, or $300,000, a 15% operating margin, with $63,000 of federal tax at 21%. The factory earns $100,000.

At $1,200,000: duty is $300,000. Subsidiary profit drops to $50,000, a 2.5% margin, with $10,500 of federal tax. The factory earns $300,000.

Raising the price by $200,000 cuts U.S. profit by $250,000, of which $50,000 is extra duty. State taxes, exchange rates and the exact Chinese tax are left out.

Which price is right? The arm's length standard

Look at what the U.S. company does and which risks it bears. In this structure the subsidiary is a distributor: it clears customs, warehouses goods, handles Wayfair purchase orders, manages returns and damage, and bears inventory write-downs and the 5% allowance. Independent distributors doing that work typically earn a steady, ordinary profit. A U.S. subsidiary that barely breaks even or loses money year after year while the factory earns a lot is the classic IRS adjustment.

The usual method. For distributors the common approach is the comparable profits method (CPM): find independent distributors in similar businesses, look at their range of operating margins, and work back to a purchase price that puts the U.S. company inside the range. Whether 15% or 2.5% is reasonable in the example has to be shown with comparable data, not instinct.

The contract has to match reality. The purchase agreement should state the price or formula, delivery terms, when title and risk pass, who bears damage, and any year-end adjustment. Conduct must follow it: if the contract puts risk in the U.S., the factory can't be the one absorbing damage.

Careful with year-end adjustments. Some companies true up the price at year-end to hit a target margin. That can change declared customs values, so handle it with your customs broker and file post-entry corrections where needed.

Why customs value has to line up: §1059A

Under IRC §1059A, for goods imported from a related party, the amount the U.S. buyer includes in inventory cost can't exceed the customs value. In other words, if you declare $1,000,000 to customs to save duty, you can't book $1,200,000 as inventory cost for income tax. You can't have it both ways.

The other direction has its own cost: a higher customs value means more duty, and while income tax cost can follow it, the IRS can still argue under §482 that the price is too high and U.S. profit too low. The sensible approach is one price with one rationale, used for customs, books, the tax return and Form 5472.

Reporting on Form 5472

A U.S. corporation 25% or more owned, directly or indirectly, by a foreign person is a reporting corporation. It files one Form 5472 per foreign related party with its Form 1120. Purchases of inventory from the Chinese factory are reported, as are loans from the factory, interest, service fees and expenses paid on the company's behalf. Each failure to file, incorrect filing or failure to keep records starts at a $25,000 penalty.

A foreign-owned single-member LLC also files pro forma Form 1120 plus Form 5472, but for income tax it is disregarded, so the profit analysis above doesn't carry over. It only works like a C corporation after a Form 8832 election to be taxed as one.

Penalties and documentation

Penalties. Underpayments from a §482 adjustment can draw the IRC §6662(e) accuracy penalty: 20% when a price is substantially misstated or the net annual adjustment exceeds the lesser of $5,000,000 or 10% of gross receipts, and 40% in more serious cases.

Documentation that avoids them. Contemporaneous transfer pricing documentation that existed when the return was filed, and is provided within 30 days of an IRS request, can avoid these penalties. A small company may not need a full report, but it should have the purchase agreement, a description of the pricing method, comparable company data and calculations, and customs entries and invoices.

The China side. Chinese tax authorities also review whether export prices are reasonable, and related-party transactions have reporting requirements in China. Keep the same position on both sides of the same transaction, or both countries may adjust and the same profit gets taxed twice.

Bringing profit home

Dividends from the U.S. subsidiary to the Chinese parent are subject to 30% withholding, generally reduced to 10% under the U.S.-China treaty when the parent is a Chinese tax resident and provides a Form W-8BEN-E. In the $1,000,000 example, distributing the full $237,000 after-tax profit means $23,700 withheld. The subsidiary files Forms 1042 and 1042-S by March 15 of the following year. Profit kept in the U.S. for growth bears no withholding.

Timeline

Before the first entry: settle the structure, sign the purchase agreement, set the price and customs value.

Monthly: book from Wayfair invoices and deduction details, cost inventory and duty by unit, and watch the U.S. company's margin.

Year-end: compare with the comparable range, adjust if needed, and handle customs consistently.

April 15 of the next year: Form 1120 plus Form 5472; with dividends, Forms 1042 and 1042-S by March 15.

The full Wayfair supplier picture, entity comparison and a three-way comparison table are in the Wayfair supplier guide; filings for foreign-owned subsidiaries are in the U.S. subsidiary guide; Form 5472 details are in the Form 5472 guide. Complex pricing work can go to a paid consultation; to start with a quick conversation, book a free 15-minute call or add WeChat YCLUSA.