Incoterms_® and Commercial Contracts

Executive Summary

In order to determine how much duty is owed on a particular import, Customs authorities need to determine: (1) the origin of the product, to determine whether it is eligible for duty reduction under a regional trade agreement or a preferential arrangement; (2) its classification, to determine the applicable duty rate; and (3) its value if, as in most cases, the duty rate is expressed as a percentage of the value of the goods.

Rules of Origin are used both for preferential (regional trade agreements and preferential arrangements) and non-preferential purposes, such as country-of origin marking. The purpose is to determine whether goods that originate in Country A, are processed in some fashion in Country B, and then exported to Country C, are products of Country A or Country B. There are a number of different bases for rules of origin: (a) specified change of tariff heading in Country B; (b) “substantial transformation” in Country B; (c) amount of value added in Country B; and (d) specified manufacturing operation in Country B.
For Classification purposes most countries use the Harmonized Commodity Description and Coding System (HS), which is administered not by the WTO, but by the World Customs Organization (WCO) based in Brussels. The HS system breaks down products into more than 1,200 four-digit headings and more than 5,000 six-digit subheadings. Individual countries can further break down the subheadings into their own eight-digit (for tariff purposes) and 10-digit (for statistical purposes) classifications.
The WTO Agreement on Valuation sets out a hierarchy of values to be used to value imported goods. The preferred value is the transaction value, which is normally the price paid by the importer to the exporter. The Agreement sets out a series of other values that can be used where transaction value is not available, where for example the transaction value may be affected by a relationship between the importer and the exporter.

Many countries allow the establishment of special customs zones where imported materials can be processed without being subject to duty, which is only payable when and if the finished product is brought into the customs territory.

* Daniel Cannistra is a partner in the Washington, DC office of Crowell & Moring.

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Many countries require imported goods to be marked with their country of origin, for consumer information. The GATT sets out some fairly straightforward rules, basically to ensure that the marking requirements are not too stringent and do not damage the goods.

In 2013 the WTO adopted the Agreement on Trade Facilitation, the only significant multilateral agreement to come out of the Doha Round. The Agreement is designed to streamline customs procedures and to make them more transparent. It entered into force in early 2017.

Two important global customs issues that remain to be addressed are the overlap (and in some cases inconsistencies) between valuation concepts for tax and customs purposes, and the customs treatment of digital products.

Global supply chain security programmes, operated under a Framework developed by the WCO, offer privileges, such as expediting processing, to private businesses that offer a high degree of security in their supply chain operations.

Finally, the Chapter discusses the importance for companies engaged in international trade to set up Customs compliance programmes. Not only will these help to avoid inadvertent violations, which can result in significant penalties, but their existence may lead the authorities to take a more lenient view when violations do occur.

1.0 Introduction

Most of the world’s sovereign nations have their own customs agencies to control the importation and entry of goods. Their primary function is to assess and collect duties on imported items, as well as to ensure that prohibited items, such as drugs and pornography, do not enter the country. Increasingly in the post-9/11 world, they also seek to protect their citizens from terrorist activities, for example by ensuring that cargo shipments do not contain terrorist devices. Because of their revenue-raising function, customs agencies traditionally have been, and often still are, part of a country’s finance ministry. However, in the post-9/11 era some countries consolidated the activities of various border agencies. For instance, in 2002, the United States consolidated the Customs Service (which had been part of the Treasury Department) and the Bureau of Immigration and Naturalization (which had been part of the Department of Justice) into a new agency, US Customs and Border Protection (CBP), which itself is part of the Department of Homeland Security. Similarly, in 2003, Canada consolidated the Canada Customs and Revenue Agency, Citizenship and Immigration Canada, and Canadian Food Inspection Agency into the Canada Border Services Agency (CBSA).

In this chapter we first discuss the means by which customs authorities assess the amount of duties due on imports. We then discuss various programmes that allow reduction or refund of import duties, such as foreign trade zones and drawback schemes. Next, we describe the GATT rules on country-of-origin marking. We then describe the Trade Facilitation Agreement, an agreement reached by WTO Members in 2013 (and entered into force in early 2017) that is designed to streamline customs procedures, which are very cumbersome in many developing countries. Next, we review two global trade issues – the tension between taxation and customs, and whether the value of software embedded in physical goods, such as computers, should be subject to duty. We then describe programmes that are designed to ensure the safety and security of global supply chains. Finally, we discuss the importance of compliance programmes.

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2.0 Duty Assessment

In order to determine how much duty (if any) is due on a particular import, the Customs authorities must make several determinations:

1. The origin of the goods, to determine whether the MFN duty rate is applicable, or if the item is eligible for a lower or zero rate under a regional trade agreement or a preferential trade arrangement;
2. The classification of the item, which is necessary to determine the rate of duty; and
3. The value of the item, which is needed to determine the amount of duty if, as in most cases, the duty rate is a percentage of value (ad valorem).

2.1 Rules of Origin

According to a Canadian Trade Minister, “Rules of origin are very, very complex. You don’t want to know about them. They are terrible things to deal with.”¹To give a sense of their complexity, the recently concluded Trans-Pacific Partnership (TPP) contains thousands of separate rules of origin – one for virtually every tariff heading and subheading – which take up over 200 pages of the agreement.²Unfortunately, however, rules of origin play a critical role in international trade, and have become increasingly important with the burgeoning of free trade agreements.

Rules of origin are used for many purposes. They are an essential component of every regional trade agreement (RTA), since they are used to determine whether a product exported from one RTA party to another “originated” in the exporting country and is therefore eligible for duty-free treatment. They are also used in preferential trade arrangements (PTAs), such as the Generalised System of Preferences (GSP), to determine whether imports originated in a beneficiary country and are therefore entitled to the preferential tariff rate. When used in RTAs and PTAs, rules of origin are referred to as “preferential.” So-called “non-preferential” rules are used for other purposes, such as the administration of tariff-rate quotas, country-of-origin marking, collection of anti-dumping and countervailing duties (which are levied on a country specific basis), government procurement and statistics. The distinction between preferential and non-preferential rules of origin is important in the context of the Uruguay Round Agreement on Rules of Origin, discussed in Section 2.1.2 below.

Many importers fail to take advantage of rules of origin and miss out on RTA duty-free benefits. In some cases, however, particularly where the MFN tariff is low, it may simply not be financially worth their while to take the administrative steps necessary to qualify, which can be quite burdensome.

2.1.1 Bases for Rules of Origin

There is little difficulty in determining origin when a good is wholly the growth, product, or manufacture of a single country. For example, silver that is mined in Canada, made into jewellery in Canada, and exported to the United States would qualify for NAFTA tariff preference as Canadian origin. Fish caught on the high seas are deemed to originate in the country of the vessel’s flag.

The determination of origin becomes more complicated when a good is not produced in a single country, but contains materials or components from one country that are worked on in an intermediate country before being shipped to the final destination. This of course is increasingly the case with the growth of global supply chains. One study has shown that iPhones contain components from Germany, Japan, Korea, and the United States, and that the value added in China, where the components are assembled, is only US$6.50.³There are at least four different approaches to determine[Page68:]origin in this situation. These approaches may vary according to the purpose for which they are being used, and they may produce different results.⁴Sometimes they are combined or provided as alternatives.

2.1.1.1 Change of Tariff Heading

The most-commonly used basis for rules of origin, particularly in regional trade agreements, is the “tariff-shift”, or “Change of Tariff Heading” (CTH) method, which provides a unique rule of origin for each article according to its customs classification (see Section 2.2 below). Under this approach, origin is conferred on the intermediary country if the components undergo a specified change of tariff heading (usually at the four-digit level but sometimes at the six-digit level). The vast majority of rules of origin in modern regional trade agreements are based on CTH, though in some cases RTAs provide for “regional value content” (see Section 2.1.1.3) as an alternative. The following is from a typical CTH rule from the Transpacific Partnership (TPP):

271012-2710.20 [PETROLEUM-BASED PRODUCTS]

[Origin is conferred by a] change to a good of subheading 2710.12 through 2710.20 from any other heading, except from heading 22.07 [which covers ethanol].

The change of tariff heading and sub-heading approach, while potentially complex, has the advantage of providing business with a reasonable degree of certainty, and is the preferred approach for the harmonisation of non-preferential rules of origin which is called for under the Uruguay Round Agreement (see Section 2.1.2 below). However, it can be used as a means of restricting trade, as illustrated by the following:

TOMATO KETCHUP

Tomato paste, an ingredient of tomato catsup (or “ketchup” as it is usually called), is classified under HS 2002.90, while tomato catsup is classified under HS 2103.20. Under the US/Canada Free Trade Agreement – the predecessor to the North American Free Trade Agreement (NAFTA) – conversion to Chapter 21 [Miscellaneous Edible Preparations] from any other chapter conferred origin. US ketchup manufacturers used tomato paste imported from Chile. Since the paste was converted from Chapter 20 into Chapter 21 in the United States, the ketchup was entitled to duty-free treatment in Canada. However, the rule was changed in NAFTA to provide that conversion from outside Chapter 21, except from 2002.90, conferred origin. Now to qualify for duty-free treatment, manufacturers must use NAFTAorigin tomato paste. It was probably no accident that Mexico is a major supplier of tomato paste. The share of US imports of tomato paste from Chile dropped sharply, while that from Mexico expanded.⁵

Business should pay close attention to the drafting of rules of origin when regional trade agreements are being negotiated. As the Tomato Ketchup example illustrates, rules of origin can easily be used in subtle ways to restrict trade. The auto industry, for one, has had a particularly keen interest in rules of origin in RTAs.⁶

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2.1.1.2 Substantial Transformation

A second common type of rule of origin is based on the substantial transformation of the product in question. The issue here is whether the merchandise has undergone a change in “name, character or use” in the intermediate country. This test is used by the United States to determine country of origin for marking purposes. It is a rather subjective test, and can lead to unpredictable results, as shown in the example below.

FISH

Koru North America v United States⁷involved fish caught in New Zealand’s Exclusive Economic Zone⁸(EEZ) by fishing boats chartered by a New Zealand company and flying flags of New Zealand, Japan and the Soviet Union. The fish were frozen, de-headed and de-tailed on the ships, then landed in New Zealand for inspection, after which they were shipped to Korea where they were filleted. The fillets were exported to the United States. The importer argued that they should be labelled as the product of New Zealand, but the US Customs Service ruled that as they were caught on the high seas (EEZs are not part of territorial waters), they should be labelled according to the flags of the vessels, i.e., New Zealand, Japan and the Soviet Union. On appeal, however, the Court disagreed with both and held that as the fillets had been “substantially transformed” in Korea, Korea was the country of origin.

2.1.1.3 Value Added

A third approach to determining the origin of a product is to specify that origin is conferred on the intermediate country when a specified percentage of the value of the final product (Regional Value Content, or RVC) is added there. For example, under the US/Israel Free Trade Agreement goods are deemed to be of Israeli origin if 35% of the final value is added in Israel. The United States applies the same rule in its Generalised System of Preferences and African Growth and Opportunity Act programmes.

RVC is often calculated using one of two methods: transaction value or net cost. These involve subtracting out the value of all non-originating materials from the total value or cost of the good. Many rules offer the choice, but some require that the net cost method must be used, which by excluding profit prevents importers from artificially marking up profit to qualify goods for RTA benefits under the transaction value method.

In some rules in modern RTAs, origin can be conferred either by CTH or by RVC, as in the following example of a product-specific rule of origin from the TPP:

8516.40⁹ [ELECTRIC SMOOTHING IRONS]

[Origin is conferred by a] change to a good of subheading 8516.40 from any other heading; or No change in tariff classification required for a good of subheading 8516.40, provided there is a regional value content of not less than:

(a) 35% under the build-up [net cost] method; or

(b) 45% under the build-down [total value] method.

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2.1.1.4 Specified Manufacturing or Processing Operation

Yet another approach is to require that a particular manufacturing or processing operation take place in the intermediate country in order to confer origin. For example, under the North American Free Trade Agreement, in order for television equipment to qualify as NAFTA-origin, eight out of every nine printed circuit assemblies included in the equipment must be produced in a NAFTA country.¹⁰

2.1.1.5 NAFTA Rules of Origin

The complexity of rules of origin is illustrated by NAFTA, which contains more than 11,000 different rules of origin for products by tariff classification, dozens of special rules that apply to certain products, and numerous exceptions, which must be examined to complete an origin analysis for tariff preference purposes. For example, some rules require a tariff shift for all non-originating components (i.e., components from outside the NAFTA region); other product-specific rules allow for, or require, use of a NAFTA regional value content (RVC) analysis (e.g., vehicles); some rules allow for use of either tariff shift or RVC (e.g., certain chemicals); and some rules look to the volume (weight) of NAFTA or non-NAFTA content in the finished product (e.g., certain juices), or whether a particular process (e.g., chemical reaction) or manufacturing operation has occurred in a NAFTA country.

More recent RTAs use the CTH approach predominantly, although as noted above, the TPP in many cases allows RVC as an alternative.

2.1.2 The Agreement on Rules of Origin

The Uruguay Round Agreement on Rules of Origin was designed to produce a harmonised system of rules of origin, but only for non-preferential rules. WTO Members would continue to be free to use whatever rules they chose for RTAs and PTAs. The Agreement specified that the preferred basis for the harmonised rules would be Change of Tariff Heading, and called for completion of a harmonised system of origin within three years. The WCO established a committee to work with the WTO on this project. In 2002 the committee referred a number of controversial “core issues” to the WTO Committee on Rules of Origin, which however was unable to resolve them. Work stopped in 2007, and it is unclear whether it will be restarted.¹¹

2.2 Classification

Nearly all customs issues arise from the classification of the product. While on its face the classification of a product may appear to be a simple administrative task, this is not always so. For example, there is a classification code in Chapter 87 of the international customs classification system (described in the next subsection) that provides for “parts and accessories of motor vehicles.” However, certain automobile brake parts are classified as pumps (Chapter 84), certain automobile seats are classified as furniture (Chapter 94), and certain electric door locks are classified as locks (Chapter 83).

2.2.1 The Harmonised System

As explained in Section 2.2 of Chapter Two, every country maintains a tariff schedule setting forth the duty rates applicable to imports, item-by-item. In order to determine the duty rate applicable to a particular import, the customs authorities (and the business community) must determine under what category in the schedule the product is classified. Virtually every country in the world uses a common framework to classify imports, the Harmonised Commodity Description and Coding System (HS), which was adopted in 1988. It is administered not by the WTO, but by the Brussels based World Customs Organization (WCO). The WCO has 180 members, which account for 98% of world trade.

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THE WORLD CUSTOMS ORGANISATION

The WCO began life in 1952 as the Customs Cooperation Council (CCC), which was set up to supervise and provide interpretations of the Brussels Tariff Nomenclature (BTN), a tariff classification system developed after World War II for use in Europe. The BTN began to be used by other countries, and in 1988 was adopted as the International Convention on the Harmonised Commodity Description and Coding System (HS Convention). In 1994 the CCC changed its name to the WCO.

Every WCO member uses the HS classification system as the basis for its tariff schedule, although the system of course does not set the actual duty rate. Thus, for example, each country will classify oranges in subheading 0805.10, though the duty itself will vary. The classification of a product is also a key factor in determining whether it is subject to tariff-rate quotas, embargoes, anti-dumping or countervailing duties, or other restrictions. WCO members meet several times each year to discuss updates to the next version and to resolve classification disputes, and modify the HS system every five years to take account of new products and technological developments. The WCO provides rulings where there is a dispute between two countries as to the proper classification of an item, but unlike the WTO, it has no enforcement powers. The WTO itself rarely adjudicates classification issues, but has done so on a few occasions where the classification by the importing country results in a duty that is higher than the bound rate for the classification favoured by the exporting country.¹²

The Harmonised Tariff System (HS) is a progressive commodity identification system, describing simple items such as live animals in the early chapters (Chapter 1), and more complex products in later chapters (e.g., optical instruments in Chapter 90). It is divided into 22 Sections, 97 chapters (two digits), over 1,200 headings (four digits), and more than 5,000 subheadings (six digits). The following text box provides an example:

While each WCO member is required to use the six-digit code prescribed by the HS (when setting its own duty rate), it may if it wishes, break each subheading down into its own unique eight- and ten-digit classifications. It may use the eight-digit codes for tariff purposes if it wishes to charge different tariffs on items falling within the same six-digit code. The further break out into ten-digit codes is used simply to gather detailed statistical information.

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HS EXAMPLE WITH EIGHT AND TEN-DIGIT BREAKOUTS

To continue the example in the preceding text box, the US tariff schedule breaks down Item 090210 into two eight-digit items, 0902.10.10, Flavoured Green Tea (6.4% tariff), and 0902.10.90, “Other” (duty-free). These are each further broken into ten-digit items to distinguish between organic and nonorganic green tea, for statistical purposes.

Most jurisdictions have mechanisms that allow importers to seek HS classification opinions in advance. This is helpful to businesses for planning purposes.

2.2.2 Headnotes and General Rules of Interpretation

The HS contains headnotes to each section and chapter that are designed to help Customs officials to classify a product. It also includes six General Rules of Interpretation (GRI), the most important of which are GRIs 1, 2 and 3.

GRI 1 states that classification shall be determined according to the terms of the headings and any relevant section or chapter notes. The individual headings of the HS of the United States provides for either specific named goods (eo nomine provisions, such as “imitation jewellery” of heading 7117) or goods used for certain named purposes (use provisions, such as “Machines and apparatus of a kind used solely or principally for the manufacture of semiconductor boules or wafers, semiconductor devices, electronic integrated circuits or flat panel displays” of heading 8486). When goods meet the terms of more than one heading, the various Section and Chapter Notes are used to decide which is correct. Nearly all classification determinations can be made using only GRI 1.

GRI 2, known as the “Doctrine of the Entireties”, provides in part that an incomplete or unfinished article is classified as the article itself if it has the “essential character” of the article itself. This rule is designed to prevent importers from avoiding duties on finished products, which are often higher than on components, by simply omitting a few parts at the time of importation. To use a hypothetical example, suppose that the duty on finished bicycles is 20%, and on bicycle parts only 10%. Under GRI 2 an imported bicycle kit that contained all the parts of the bicycle except for a few fasteners, would be classified as an unfinished or incomplete bicycle, subject to the 20% rate. The outcome might be different, however, if, say, the frame, saddle and handle bar were imported in one shipment and the wheels in another. In another example, light trucks are classified under subheading 8704.21.00, carrying a 25% duty in the United States. Diesel engines of such vehicles are classified under subheading 8708.20.20, at 2.5%. If the motor vehicle was shipped without the engine, it would still be dutiable at 25% if Customs and Border Protection considered that it had the “essential character” of a light truck. But the engine, when shipped separately, would be dutiable at the lower rate of 2.5%.

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THE TOYOTA CASE

Toyota Motor Sales U.S.A Inc. v United States¹³was a high-profile case involving the Doctrine of the Entireties (GRI 2) in which hundreds of millions of dollars were at stake. In an attempt to avoid the 25% duty on light trucks, Toyota imported the trucks without the truck beds, which were attached after importation, and claimed that the trucks should be classified either as “chassis” carrying a duty of 5%, or as “other” motor vehicles, at 2.8%. Based on the fact that the truck beds accounted for only 10% of the total cost of the trucks, and took only 20 minutes to attach after importation, the Customs Service classified the trucks as “unfinished” trucks and charged the 25% duty. The ruling was upheld on appeal.

An importer that is importing all or almost all the components for a product that is being assembled in the United States should determine whether it can save duty by bringing in the components in separate shipments

GRI 3 provides that where an article falls within more than one heading, it will be classified under:

• The most specific description;
• The material or component that provides its “essential character”;
• The last equally applicable heading.

Consider, for example, the classification of an iPod. An iPod is a media player that records, stores, and plays music and video content and displays video images and text information on a screen incorporated into the device. It is marketed, sold, and used as a music player as well as a video player. Sound recording and reproducing apparatus are classified in heading 8419, while video recording and reproducing apparatus are classified in heading 8421. The terms “sound recording and reproducing apparatus” and “video recording and reproducing apparatus” are equally specific. It is hard to say whether the “essential character” is as a music player or a video player, so that a customs official might well fall back to the default position and classify an iPod under heading 8421 because that heading is last (i.e., highest) of the headings under consideration.

2.3 Valuation

The final step in assessing the amount of duty owed is the determination of value where, as in most cases, the duty rate is expressed as a percentage of value^.14Article VII of the GATT established a few basic valuation rules, most importantly that the value of imported goods should be based on their “actual value”, and not on the value of goods produced in the importing country or on arbitrary or fictitious values. However, Article VII left a good deal of discretion to countries as to how to determine “actual value”.

The Uruguay Round Agreement on Customs Valuation (CVA)¹⁵provides much more detail, including a hierarchy of methods for determining “actual value” in order to ensure that each country applies the same rules to value imported products, thus helping to create business certainty. Although a WTO Agreement, the CVA established a Technical Committee under the auspices of the WCO, which oversees interpretation and implementation of the CVA and provides advisory opinions.

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2.3.1 Transaction Value

The preferred method of valuation is “transaction value.” This term is defined as the “price actually paid or payable” for imported merchandise “when sold for export”.¹⁶Typically, this value is the sales price paid by the buyer to the seller for the imported product. It is greatly preferred by Customs authorities, since the value can normally be determined from the commercial invoice or other documents filed at the time of entry. Transaction value is used in the vast majority of cases.

ADDITIONS TO TRANSACTION VALUE

A number of additions must be made to the sales price, to the extent they are not already included:

• Packing costs incurred by the buyer;
• Any selling commission incurred by the buyer;
• The value, apportioned as appropriate, of any “assist” (i.e., tooling, parts, design work and the like supplied by the buyer to the seller free of charge);
• Any royalty or license fee that the buyer is required to pay, directly or indirectly, as a condition of the sale; and
• The proceeds of any subsequent resale, disposal, or use of the imported merchandise that accrue, directly or indirectly, to the seller.

The importing country may include ocean freight and insurance in the transaction value, but this is optional. The United States allows the deduction of both inland and ocean freight and insurance from the transaction value, whereas the EU does not.

THE FIRST SALE RULE

Imports may be bought and sold a number of times prior to exportation. For example, a manufacturer may sell an import to a middleman (in the same or a different country), who in turn sells the merchandise to an importer. The customs value is usually the price the importer paid for the merchandise. However, in the case of a series of sales, the importer may choose to use a sale that occurred earlier in the chain (which is likely to have been at a lower price) as the basis for declared customs value. The option is known as the First Sale rule and is available in many, but not all, jurisdictions, including the United States, but not the EU.

2.3.1.1 Royalties and Licence Fees

Multinational business relies on a wide-range of agreements to manage international distribution and intellectual property rights. These agreements frequently concern exclusive distribution rights, the use of brand names and marking rights and the right to use propriety formulas. The right to use these intellectual property rights is typically compensated in the form of royalty and license fees. Customs valuation issues often arise when these payments are made across borders, as many customs jurisdictions have taken the position that royalty and license fees should be added to the value of any physical product that is imported. This, in turn, has the effect of applying customs duties on royalty and license fees.

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The CVA requires inclusion in Transaction Value of royalties and licence fees that are “related to the goods being valued that the buyer must pay … as a condition of sale of the goods being valued.”¹⁷In considering whether royalties or license fees are “related to” the goods being valued, the key considerations are:

• Why the fees were paid, that is, what in fact the payee receives in return for the payment;
• How the activity covered by the fees relate to the imported goods;
• From and to whom the fees were paid; and
• The terms surrounding the fees and where the activity associated with the fees takes place.

In determining whether the fees must be paid “as a condition of sale”, the issue is whether the goods could have been purchased without payment of the fees. Different countries have interpreted these provisions in different ways. As a general matter, however:

• Fees are likely to be included in transaction value where the parties are related, whereas fees paid to a third-party licensor are not likely to be included;
• Patent fees related to the production of the imported item are likely to be included; and
• Royalties related to the distribution of the goods in the importing country are not likely to be included.

Importers should pay careful attention to structuring their royalty and licence fee arrangement in a way that maximises the chances that they will not be subject to duty.

2.3.2 Other Valuation Methods

In certain circumstances importers may not be able to use the transaction value method. For example, there is no transaction price where the importer takes the product on consignment, sells it on behalf of the exporter, and pays the exporter the price it receives, less a commission. “Most importantly, transaction value cannot be used where the exporter and the importer are related and cannot establish that a bona fide sale at an acceptable arm’s length price occurred.”¹⁸

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RELATED PARTY TRANSACTIONS

US Customs and Border Protection has explained how it determines whether related party transactions are at arm’s length:

“Customs will examine the manner in which the buyer and seller organise their commercial relations and the way in which the price in question was derived in order to determine whether the relationship influenced the price. If it can be shown that the price was settled in a manner consistent with the normal pricing practices of the industry in question, or with the way in which the seller settles prices with unrelated buyers, this will demonstrate that the price has not been influenced by the relationship. In addition, Customs will consider the price not to have been influenced if the price was adequate to ensure recovery of all costs plus a profit equivalent to the firm’s overall profit realised over a representative period of time.”¹⁹

Other factors may be relevant as well.

The CVA sets forth a hierarchy of alternative values to be used if transaction value cannot be used:²⁰

• The transaction value of identical merchandise, which is usually based on another sale to either the same or a different purchaser that has been accepted by the customs authorities. The sale must be “identical in all respects” except that “[m]inor differences in appearance will not preclude otherwise conforming merchandise from being considered ‘identical.’”
• The transaction value of similar merchandise, i.e., merchandise that is “like the merchandise being appraised in characteristics and component material, and commercially interchangeable with the merchandise being appraised.” Sales of identical or similar merchandise are typically difficult to find, and usually importers must look to the deductive or computed value method if they cannot use the transaction value method. Adjustments to the value are allowed if they are based on substantial evidence.
• The deductive value, which is the price at which the importer sells the goods to an unrelated customer after importation of the goods, with deductions made for a number of items including post-importation transportation costs, duties and taxes, value-added, commissions, general expenses and profit.
• The computed value is the sum of the costs and expenses incurred in producing the good, including cost of materials, labour, any assists and profit. The importer can elect to use this method in preference to deductive value.
• If none of the above methods can be used, then the authorities may, as a fallback method, use a reasonably adjusted version of one or more of the above methods to derive a value.

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2.3.3 Prohibited Values

The CVA provides that certain values may not be used in the valuation of imports.²¹

These include:

• The price of goods produced in the country of importation;²²
• The price of goods on the domestic market of the country of exportation;
• The price of goods for export to third countries;
• Minimum values;²³and
• Arbitrary or fictitious values.

2.3.4 Other Important Provisions

Determination of value, and therefore calculation of the amount of duty owed, can take time, particularly if transaction value cannot be used. If the goods are not released pending the value determination, the importer will be saddled with inventory costs. Article 13 of the CVA therefore gives the importer the right to take possession of the goods before the duty has been assessed, though the authorities may (and normally do) require some sort of guarantee (bond) to ensure payment of the duties when they are finally assessed.

Bonds cost a small percentage of the value of the goods, and can usually be provided by Customs brokers.

Other CVA provisions designed to protect importers include the requirement that the authorities protect confidential information, that importers have the right to appeal without penalty to a judicial authority, and that importers have the right to be informed of the customs value of imported goods and the method of valuation used.

3.0 Duty Deferment and Mitigation Programmes

3.1 Customs Zones

The utilisation of duty deferment programmes is critical to managing border taxes in connection with warehouse and global manufacturing activities. Duty deferment programmes are available for use in most countries. Although the programmes vary in scope, countries typically allow the establishment of special customs zones, which designate areas within the geographic limits of a country that for border tax purposes operate as if they are located outside the customs territory of the importing country.²⁴ There are around 3,500 such operations in 135 countries, and 174 in the United States.²⁵

Most countries allow warehouse facilities, manufacturing or repair operations and distribution operations to be housed in these customs zones. They are particularly advantageous for a manufacturing operation where the duty on the imported parts is higher than that on the finished product (“inverted tariff structure”). The importer can import the parts duty-free, and pay duty on the foreign content of the finished product at the lower rate when it is imported into the customs territory (or of course no duty at all if it is exported). Industries such as autos and petrochemicals take advantage of this situation. At least seven international auto companies operate in Foreign Trade Zones in the United States.²⁶Customs zones provide additional benefits, such as reduced administrative costs and expedited border clearance. However, they do involve significant start-up and running costs, including the provision of physical security.

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In some countries customs zone operations have to be carried out in a specifically designated location, usually near a port. However, in the United States any manufacturing operation can be designated as a subzone affiliated with a particular Foreign Trade Zone (FTZ), wherever it is located. Manufacturers that rely on imports for a significant portion of their inputs should consider whether it would be worthwhile to establish an FTZ subzone.

3.2 Import Duty Mitigation Programmes

Many countries operate programmes that allow the refund of duties under certain circumstances or reduce the amount of duty due on importation. These include duty drawback and repaired goods return programmes. For example, under duty drawback programmes the importer can recover all or most of the duty paid on imported items where they are re-exported, either in the form in which they were imported or as components of a completed item, or unused. Some countries do not charge duty on the full value of imported goods when they are re-imported after being sent abroad for repair under warranty, but only on the value of the repair.²⁷Finally, some countries may only charge duty on the value of the assembly operations performed abroad in certain circumstances.²⁸

4.0 Country-of-Origin Marking

The governments of many countries require imported goods to be marked with their country of origin. This is done to inform consumers of where goods have originated. Individuals may prefer not to purchase products from a particular country because they disagree with its politics (many people avoided buying South African products during the apartheid era) or they are concerned that the product may not be safe. Or they may prefer to buy domestic products out of a sense of patriotism.

Article IX of the GATT lays down some fairly simple requirements applicable to country of- origin marking (COM). Laws and regulations governing COM must be applied on a most-favoured-nation basis. Difficulties in applying COM rules should be minimised, and the rules should not seriously damage the products or materially reduce their value. Marks of origin should be allowed to be attached at the time of importation, so that unmarked goods do not need to be returned to their country of origin. Finally, penalties should not be imposed where a violation of the rules is unintentional.

5.0 The Agreement on Trade Facilitation

Customs procedures, particularly in many developing countries, are outmoded and inefficient. Automation is lacking and procedures are slow and cumbersome. There is a lack of transparency and predictability, and often no effective right of appeal from decisions by customs officials. Border facilities are often out-dated, and documentation excessive. It has been estimated that inefficient customs procedures can contribute to as much as 15% of trade transaction value.²⁹A survey conducted in the Asia-Pacific indicated that customs procedures were viewed as a more serious trade impediment than restrictive regulations or tariffs.³⁰

The Agreement on Trade Facilitation, adopted at the Bali Ministerial Conference in 2013 (the only significant multilateral agreement to emerge so far from the Doha Round), is designed to address these issues. The Agreement entered into force in early 2017.

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The Agreement imposes 37 specific obligations on Members, all designed to streamline the international movement of goods. Key obligations include:

• Transparency, e.g., easy accessibility of information on customs procedures; the setting up of enquiry points; provision of advance rulings;
• The establishment of appeal procedures;
• Pre-arrival processing;
• Single window, i.e., a system under which most or all relevant information can be supplied to the authorities in a single electronic filing;
• Cooperation between relevant government agencies; and
• Establishment of national committees on trade facilitation.

Most developed countries already comply with most if not all of these obligations, and the Agreement is designed principally to encourage developing countries to improve their customs procedures. Each developing country Member is required to divide the obligations into three categories:

• Category A consists of those obligations that will be implemented by the date of entry into force of the Agreement (with a one-year delay for least developed countries (LDCs));
• Category B consists of those obligations that will be implemented after a transition period to be specified by each country. The Category B schedules are to be notified to the WTO by the date of the entry into force of the TFA;³¹and
• Category C consists of those obligations that will be implemented after a transition period and the receipt of technical assistance. The Category C schedules, as well as the capacity building assistance needed, are to be notified to the WTO by the date of the entry into force of the TFA.³²This is the first WTO Agreement in which implementation is conditional upon receipt of technical assistance.

Businesses dependent on the import and export of goods, particularly to and from developing countries, stand to benefit considerably from the implementation of the Trade Facilitation Agreement. Such businesses should consider working through WTO Member governments and trade associations to encourage ratifications. The business community should take steps to monitor and encourage compliance now that the Agreement has entered into effect.

6.0 Global Customs Issues

6.1 Income Tax and Customs Duties

There is a significant overlap between valuation concepts that apply under the customs and tax regimes, but there may be inconsistent results in their application because customs and tax rules often have different objectives. Whereas a tax authority is focused upon the reliability of a transfer price in transactions between related parties, as reflected on an importer’s tax return, a customs authority applies duty charges against the appraised value of the merchandise at the time of entry into a customs territory.

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It is no surprise, therefore, that many importers trading with related parties are confronted with a conflicting choice between two reasonable business objectives: paying as little duty as possible, but also obtaining the largest possible corporate income tax deduction. In pursuing both goals at once, the importer may be exposed to enforcement action by a tax authority that charges the importer with paying too much for imported merchandise (i.e., taking too large a tax deduction), and a customs authority that argues that the same merchandise was undervalued and thus, the duties paid were too little.

Transfer pricing often opposes tax and duty objectives.33 Businesses importing from affiliates must play close attention to transfer pricing issues and may have to seek professional advice from both tax and customs counsel in order to minimise legal risks and deal efficiently (from a business perspective) with transfer pricing issues.

6.2 Digital Products

In the past decade, the line between “goods” and “services” has blurred, especially in the electronics industry, where digital content – be it camera software embedded into a mobile phone or video embedded into a navigation system – defines the value of the physical good. This convergence of goods and services has created difficult issues for trade policymakers who prior to digital convergence neatly packaged trade into goods issues and service issues. Indeed, fundamental questions, such as when – and if – to collect tariffs and taxes on digital products embedded into hardware, remain unsettled.

From a customs perspective, digital convergence has significant implications. For example, if a cellular phone has material costs of US$90 and a retail price in excess of US$400, with a significant portion of the difference attributable to embedded software, the question arises whether customs duties should be assessed on the hardware portion alone or on the full value of the product inclusive of the embedded software.

In 1988 GATT contracting parties approved the practice of valuing carrier mediabearing data or instructions (software) for use in data processing equipment either inclusive or exclusive of the value of the software recorded on carrier media, and this decision has remained in effect.³⁴Not only did this decision leave the “dutiability” of digital products unanswered, it relied on terms that were superseded by technological advances.

The Information Technology Agreement (ITA)³⁵attempted to address digital convergence, at least in the software context. However, the application of the ITA by WTO Members has suffered from significant limitations related to the scope of the Agreement. Many Members, including the United States, limited the scope of the ITA to products classified as traditional “carrier media”, as well as a small number of specifically identified products. As a result, only software on traditional carrier media (e.g., diskettes and CDs) is within the scope of the ITA. Imports of other products incorporating software (e.g., software pre-loaded on the hard drive of a computer) are outside the scope of the ITA because computers are not a “carrier medium.”

The next policy initiative concerning the convergence of good and services was the two-year customs duty moratorium on electronic commerce (“electronic transmissions”) that WTO Members agreed to in 1998. Members subsequently extended the moratorium and it remains in effect.³⁵While effective in eliminating import duties on digital products transmitted electronically, its narrow application did not address convergent electronics.

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Some recent regional trade agreements have begun to address digital convergence in a meaningful way. Namely, a series of recent RTAs – including those to which the United States is a member – contain “electronic commerce” provisions. For example, RTAs between the United States and Central America (Guatemala, El Salvador, Honduras, Nicaragua, Costa Rica and the Dominican Republic), Singapore, Chile, Australia, Peru, Morocco and Bahrain all provide that customs duties will not be assessed on the value of embedded software, regardless of the product in which it is embedded.

For instance, the US – Singapore FTA expands the definition of “carrier medium” to include “any physical object capable of storing a digital product by any method now known or later developed, and from which a digital product can be perceived, reproduced, or communicated, directly or indirectly, and includes, but is not limited to, an optical medium, a floppy disk, or a magnetic tape.”

In KORUS (the US – Korea Free Trade Agreement), computers with software already loaded are duty free. The value of the software would be included in the computer, but no duties are owed.³⁷

The TPP and the Transatlantic Trade and Investment Partnership (TTIP) do not contain this language. The application of an exemption would instead be governed by: existing RTAs, participation in the moratorium on charging duty for electronic data transfer, or participation in the Information Technology Agreement of the WTO.

7.0 Global Supply Chain Security Programmes

In 2005, the WCO membership adopted the SAFE Framework of Standards to Secure and Facilitate Global Trade (SAFE Framework).³⁸The SAFE Framework sets forth principles and standards designed to act as a deterrent to international terrorism and to promote trade facilitation. The SAFE Framework encourages customs administrations to establish partnerships with the private sector in order to involve it in ensuring the safety and security of the international trade supply chain. The main focus is the creation of an international system for identifying private businesses that offer a high degree of security guarantees in respect of their role in the supply chain. In return these business partners receive tangible benefits such as expedited processing.

The WCO also adopted the concept of the Authorised Economic Operator (AEO):

An AEO is a party involved in the international movement of goods in whatever function that has been approved by or on behalf of a national Customs administration as complying with WCO or equivalent supply chain security standards. AEOs may include manufacturers, importers, exporters, brokers, carriers, consolidators, intermediaries, ports, airports, terminal operators, integrated operators, warehouses, distributors and freight forwarders.³⁹

Annex IV of the SAFE Framework describes the responsibilities of an AEO, and describes the benefits it should receive. An AEO should be able to demonstrate compliance with local customs requirements, have a satisfactory system for management of commercial records, be a financially viable organisation, trade information with the government, and have various types of security procedures in place. An AEO would then receive benefits such as: measures to expedite cargo release, reduce transit time and lower storage costs; access to valuable information; special measures relating to periods of trade disruption or elevated threat level; and priority for participation in any new cargo processing programmes.

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The WCO publishes a yearly compendium of all AEO programmes.⁴⁰As of 2016, there were 69 fully operational AEO programmes in place around the world, and 16 more yet to be launched. This WCO publication also provides a list of all mutual recognition agreements currently in place and under negotiation.

THE CUSTOMS-TRADE PARTNERSHIP AGAINST TERRORISM

The United States has implemented the SAFE Framework through the Customs-Trade Partnership Against Terrorism (C-TPAT).⁴¹

From its inception in November 2001, C-TPAT continued to grow. Today, more than 11,400 certified partners spanning the gamut of the trade community, have been accepted into the programme. The partners include importers/exporters, Canadian highway carriers; Mexican highway carriers; rail and sea carriers; licensed Customs brokers; marine port authority/terminal operators; freight consolidators; ocean transportation intermediaries and non-operating common carriers; Mexican and Canadian manufacturers; and Mexican long-haul carriers, which together account for over 52% (by value) of cargo imported into the United States.⁴²

When an entity joins C-TPAT, an agreement is made to work with CBP to protect the supply chain, identify security gaps, and implement specific security measures and best practices. Applicants must address a broad range of security topics and present security profiles that list action plans to align security throughout the supply chain. C-TPAT members are considered to be of low risk, and are therefore less likely to be examined at a port of entry.⁴³ Any business can apply for C-TPAT at https://www.cbp.gov/ border-security/ports-entry/cargo-security/c-tpat-customs-tradepartnership- against-terrorism/apply.

8.0 Compliance with Customs Laws and Regulations

As can be seen, Customs laws are extremely complicated. Violations, whether deliberate or inadvertent, can result in large fines and even, in cases of egregious fraud, prison sentences.

US PENALTIES FOR CUSTOMS VIOLATIONS

The U.S. Custom Service has established three levels of culpability:

• Negligence: defined as failure to exercise reasonable care;
• Gross Negligence: defined as “actual knowledge or wanton disregard”; and
• Fraud: defined as “voluntarily and intentionally.”

In the case of simple negligence, the penalty is usually between 0.5 and 2 times the duty loss. In the case of gross negligence it is generally between 2.5 and 4 times the loss of duty, and in the case of fraud, it is usually between 5 and 8 times the loss of duty Where no duty loss has resulted from the violation (e.g., where country-of-origin marking is involved), the penalty is based on the value of the goods. See Penalty Flowchart below.

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Companies engaged in importing are therefore well advised to set up a customs compliance programme. Not only will this reduce the chances of inadvertent violations, but the authorities may well view it as a mitigating factor when imposing a penalty. The programme should include detailed rules of record-keeping, training of the personnel involved, and periodic audits to uncover any possible problems.

A company that discovers a potential violation should investigate the facts and take action to prevent future violations. It should also consider whether to make a voluntary disclosure to the Customs authorities, as this is likely to result in a significant reduction in any penalties that may be assessed. With a valid prior disclosure, penalties are waived and the importer need only pay the correct duty. One should be careful regarding the timing of the disclosure and tender of correct import duties because in the United States at least, once the authorities have initiated an audit, an importer may not voluntarily tender unpaid duties without penalty. Instead, the question become the degree of the resulting penalty, not the existence of a penalty.

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