Today, the theme is tariff engineering and, in the manner of a B School case study, we will examine a single product that an importer attempted to enter into the US market as a good qualifying under one of the more popular FTAs, in this case, the DR-CAFTA¹.

What is an FTA and How Long Have They Been Around

A glance at the web page for the Office of the US Trade Representative (USTR), which manages the FTA programs, will show the US has entered into free trade agreements with 20 countries. The word “free” means that goods that qualify will be eligible for duty-free entry into the given country participating in the agreement. These agreements have been popular for the last thirty years. The general purpose of an FTA is to promote trade and investments for the mutual benefit of the parties.

Some of the agreements are between the US and mature trading partners, such as Korea, Singapore, Australia, and Israel, while many promote trade between the US and a developing country partner, such as Peru, Chile, or Colombia.

FTA vs. GSP Program

Just a brief diversion to compare an FTA to a GSP program:

• GSP is a unilateral tariff preference program extended by the US and other developing countries.
• Under its terms, qualifying goods will be entitled to duty-free entry into the country granting the benefit.
• The US program dates to 1975 and has had to be re-confirmed periodically by Congress.
• The GSP program in the US is currently in abeyance.
• Eligibility is denied to certain product sectors generally and to selected products on a per-country basis, and conditioned on meeting a 35% local content test.

Who Benefits from an FTA?

Not only would the partner country as a whole benefit, the primary beneficiaries of an FTA would be the exporter and importer.

Often, the goods will have been made in multiple stages and in more than one country. In such a case, components or portions of the finished good could be made in China or another low-cost producer country and then shipped to the FTA country. Final assembly of the pieces or production of the finished product would take place in that FTA country.

This allows a “best of both worlds” scenario where an exporter could take advantage of the economies of scale of a low-cost manufacturing hub in sourcing its parts or raw materials and still receive the benefit of duty-free entry provided by an FTA treaty.

There is an added benefit if the low-cost materials provider is China. In that case, elimination of Section 301 duties as well as the normal duties is a compelling incentive² to use an FTA partner country as a manufacturing base.

In the case study, this is exactly the dynamic situation present—and FTA eligibility earns the importer a double-win if the requirements are satisfied. For the importer in the study, and for any other importer, the eligibility exercise involves a close examination of the Bill of Materials (BOM). The aim is to see if the cost and/or HTS numbers and origin of any third-country components are sufficiently transformed in the case of a tariff shift requirement or if the value added in the participating country meets a minimum local regional value content threshold.

What is the Eligibility Recipe for Any FTA

Here is a summary of the steps needed to evaluate eligibility of a given product for duty-free status:

1. Start with the HTS number of the product to be reviewed.
2. Refer to the General Note within the HTSUS pertaining to that specific FTA. General Note 29 governs CAFTA-DR eligibility.
3. Refer to the Eligibility requirement, which is usually a mix of several things:
   • Is the article wholly the growth of the subject territory?³
   • Is it imported directly into the US?
   • Is the sum of the cost of processing operations in the subject territory less than x% of the appraised value of each article at the time of US entry?
   • Do the constituent components of the finished good undergo a specific tariff shift inside the subject territory?
4. Consider provisions for the cost of packaging and the application of a de minimis rule covering the negligible presence of non-originating material or a negligible cost of a variable that, if a threshold is not exceeded, does not affect FTA eligibility.

To make this assessment, it is necessary to have an annotated BOM, listing each of the inputs and components involved in the manufacture of the subject merchandise as well as the country of origin, tariff classification, and per-unit cost for such components.

Application: DR-CAFTA FTA Eligibility Requirement

An FTA by the name of DR-CAFTA, signed on August 5, 2004, is an example of an agreement between the US and smaller developing countries. The DR-CAFTA is actually a regional FTA between the US and Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, as well as the Dominican Republic.

Case Study – Expressed in Ruling no. H329045, April 12, 2023

The product imported into the US was a boot, style KFT5094RMA, referred to as the “Pink Fizz” model of a child’s waterproof boot.

The ruling published the entire BOM of the Pink Fizz Boot, only a portion of which is reproduced here for brevity.

Abbreviated Pink Fizz Boot BOM

Cost element totals were as follows:

• DR-CAFTA regional total: $6.224
• Non DR-CAFTA materials total: $1.636
• Adjusted value³ of each unit: $11.35

The finished boots were classified under subheading 6401.92.9060, HTSUS, which provides for a specific type of boot, “waterproof footwear with outer soles and uppers of rubber or plastics….” The tariff number within Chapter 64 of the HTSUS was thus the starting point of the eligibility analysis.

DR-CAFTA Eligibility Analysis

General Note 29(b) begins with FTA boilerplate language qualifying a good as originating if under paragraph (i) it is “wholly obtained or produced entirely in the territory of one or more” of the treaty partners.

Since (i) was not satisfied (usually the case of manufactured goods), we next look at General Note paragraph (b)(ii), which sets forth both the tariff shift and regional value content requirements.

This paragraph is satisfied if:

“the good was produced entirely in the territory of one or more of the parties to the Agreement, and—

• each of the nonoriginating materials used in the production of the good undergoes an applicable change in tariff classification specified in subdivision (n) of this note; or
• the good otherwise satisfies any applicable regional value content or other requirements specified in subdivision (n) of this note;
• and the good satisfies all other applicable requirements of this note”

We are directed to apply the tariff shift rule found in General Note 29:

“A change to … tariff item 6401.92.90 … from any other heading outside headings 6401 through 6405, except from subheading 6406.10, provided that there is a regional value content of not less than 55 percent under the build-up method.” (emphasis added)

Note here that the specific eligibility rule is a hybrid. There is both a tariff shift and RVC requirement in play. The tariff shift test was satisfied because an inspection of the BOM showed that the boot components from outside the DR-CAFTA were from outside subheading 6406.10. The eligibility rules require additionally that the boot satisfy a 55% regional value content requirement (RVC).

RVC Calculation

To determine the RVC, apply the formula:

1
RVC = ((VOM)/AV) x 100

• VOM: Value of the originating materials or local content.
• The BOM should reflect the origin of the material and not merely where it was sourced.
• Good practice requires the manufacturer to obtain a manufacturer’s certificate to support the local origin of every material item comprising the BOM.

From ruling no. H329045:

• Adjusted value of each boot: $11.35
• CAFTA-DR local cost component (VOM): $6.224

Calculation:

1
RVC = $6.224 / $11.35 ≈ 54.873%

As a result, CBP concluded that the boot failed the RVC test and did not qualify for preferential treatment under the rules of DR-CAFTA.

In my view, this result can only be regarded as a colossal failure in tariff engineering. At the risk of sounding like I am second guessing the importer’s team, my advice is to never cut it so close. We can tell that they tried to just meet the 55% RVC test and came up short. This is a pass/fail test – CBP does not hand out B’s. In this case a Fail means that the boot is subject to the full duty rate of 37.5% and, on top of that, the 7.5% List 4A Section 301 China duties are in play.

Using driving as an analogy, this is like a family about to cross the desert and passing up a “Last Chance Gas” sign thinking it can save .50 a gallon on the other side of the desert. If you run out of gas in the desert, the consequences can be dire and the safer advice is to gas up before attempting a desert crossing. By the same token, the safer course of action for our importer of pink boots was to provide a buffer and beef up the value of the local DR content before asking CBP for a ruling on DR-CAFTA eligibility.

A Second Chance: Ruling no. H332383, October 16, 2023

There is a happy ending for this importer after all. Although in life we often get only a single chance, it had another bite at the FTA apple here. CBP allows an importer to request a reconsideration or to file a second ruling request when circumstances change.

In this case, we can assume the importer did the only sensible thing and called in its team of tariff engineers. After they stopped pointing fingers and tossing pink boots at each other from across the conference table, they changed the sourcing of a single key component sufficiently to tip the scale and exceed the 55% RVC requirement.

The issue was resubmitted to CBP on May 1—just days after the April 12 date of the first ruling. By comparing the BOM in each of the two rulings, we can see precisely where the sourcing was changed.

For this second bite at the apple, there were some minor changes in values of some Chinese materials, but the big move was an importer shift in the sourcing of a single item: Thread was shifted from China origin at $0.103 per unit to the DR at a per unit cost of $0.194. That alone boosted the VOM.

• The first ruling hung on a thread (pun intended), and the result was changed in this second ruling.
• As a result of the shift in thread sourcing, the VOM was increased by $0.194 from $6.224 to $6.418, while the total adjusted value remained constant at $11.35.

While the thread cost was increased by $0.091, the duty savings alone was $5.10. Since the FTA eligibility rule was satisfied, the merchandise processing fee (MPF) was also lifted.

As a result of this single shift in the BOM, the subject Pink Fizz Boot qualified for duty-free entry under DR-CAFTA. The RVC was satisfied by a whisker. The new calculation placed the RVC at 56.5%. In the exporter’s boardroom, harmony reigns, hostilities have ceased, and the pink boots with a shiny FTA certificate can be displayed on their shelves.

Final Thoughts

I have been a trade attorney since prat-falling Chevy Chase was mocking Gerald Ford and have counselled many dozens of importers on tariff engineering projects that take advantage of a trade regime or tariff preference program such as an FTA or GSP.

It is easy to say that when engaged in tariff engineering matters, a trade professional must have all his ducks lined in a row. But what does this mean in practical terms? By the end of the project, the trade specialist/lawyer will necessarily be on a first name basis with many in the importer’s trade team—their import department, many times their broker, the CFO or equivalent, even internal teams that prepare power point presentations on the manufacturing facility, product flow, and marketing. All of these may play a role because in presentations to CBP, spreadsheets, brochures, and power point slides are often useful in explaining how a product is assembled and it is not useful to rely solely on narrative explanation.

For me, the key takeaway was the fact that the company had not built into the program a sufficient cushion. Lesson: sometimes you can be too cute in a pencil sharpening exercise.

I hope this case study has given you insights into the complexity of satisfying FTA requirements and the decisions made to satisfy them.

This article was originally published in the Journal of International Taxation in November 2024

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