Classification refers to the category the product fits into under the Harmonized Tariff Schedule. The Schedule is published by the U.S. International Trade Commission ("USITC"). It was adopted by Congress as part of the Omnibus Trade and Competitiveness Act of 1988.

System Structure

The merchandise classification system is like a pyramid, beginning at the Section level, such as vegetables, textiles, vehicles, and so forth, and then going on to the Chapter level, with articles such as tin items, aircraft, furniture, and so on. Within each Chapter, Headings are further organized by level of processing or by function or use. Subheadings further define products into various categories.

The first six digits of the tariff number are standardized by the Customs Cooperation Council, an international organization located in Brussels. Additional subheadings, from the seventh to the tenth digit, are available to individual countries to further make divisions for duty purposes or for purposes of quotas or statistical tracking.

These breakdowns are subject to nationally and internationally promulgated rules of interpretation. Indeed, by far the vast majority of rulings issued by Customs deal with classification questions. Rulings are issued pursuant to regulation. More recent rulings can be purchased from Customs on microfiche or floppy disks.

Section and Chapter notes are subject to General Rules of Interpretation. The notes are found at the Star-l of the Harmonized Tariff Schedule. These rules are designed to resolve classification issues when the same products are seemingly classified under more than one heading.

The rules provide that the heading to be used is the one providing the most specific description of the imported product or, for combinations of materials or multiple functional products, the heading for the material, component, or function which provides the "essential character" of the product. If nothing else, the heading last in numerical order of the Harmonized System prevails.

The classification decided by Customs can greatly affect the rate of duty applied. For example, for years lavatory modules for use in commercial aircraft were imported by commercial aircraft manufacturers as HTSUS 8803.30.00104 (other parts of airplanes). Customs reclassified the modules as HTSUS 9406.00.8090 (prefabricated buildings). The result was an increase in duty from duty free to a duty of 5.7 per cent. Only after a protest was filed was Customs convinced that the original classification was correct.

One area in which classification is particularly significant is the treatment of merchandise as finished or unassembled. Certain items may fall under different tariff rates, may be under a quota, or may be subject to dumping duties, depending on whether the item is a component or completed article.

Harmonized Tariff Schedule General Rules of Interpretation 2(a) states generally that the tariff description of an article must refer to an article as incomplete or unfinished if the incomplete or unfinished article has the essential character of the complete or finished article.

An example was in the news a few years ago. Certain flat panel electronic computer displays typically used in laptop computers were subject to an antidumping duty of approximately 63 per cent when imported into the United States from Japan. This level of duty made it almost prohibitive to import these panels. However, if the same panels were imported into Canada and assembled into laptop computers there, they could enter the United States as laptop computers under a different classification and tariff schedule. Under certain circumstances they could enter as Canadian goods and thus be subject to the Free Trade Agreement with Canada, greatly reducing the duty that would be paid. The result was a rush of computer companies setting up laptop assembly plants in Canada or various other countries.

The goal of NAFTA is to eliminate all customs duties on all goods originating in Canada, Mexico, or the United States over a transition period. Now that NAFTA has become effective, it will have a tremendous impact on all aspects of Customs law and practice. To begin with, it will remove all tariffs among the three countries under various timetables, depending on the sensitivity of the particular import. About half of all Mexican tariffs were eliminated on the effective date of the agreement, with the rest to be eliminated over five or 10 years or, in a very few cases, 15 years. Since Mexican tariffs are about two-and-a-half times the U.S. tariff rates, this will have a major impact on trade between the two countries. Canada's rates have already been reduced by the U.S.-Canada Free Trade Agreement and have been further reduced under NAFTA.

VALUATION

U.S. Customs law is derived from the valuation code of the General Agreement on Tariffs and Trade ("GATT"). Both the GATT code and the U.S. application focus on the use of "transaction value" as the basis for Customs Valuation

"Commercially Realistic" Transaction Value

United States law has developed a detailed definition of transaction value. The basic premise is that imported merchandise is to be valued on the commercially realistic basis of the price paid or payable. When the importation is the result of a sale between unrelated parties in the normal course of business, the dutiable value is established as the selling price or "transaction value." Transaction value is by far the most frequently used method of valuation.

Transaction value means the price actually paid or payable for the merchandise when sold for exportation to the United States. This price must be increased to reflect packing costs, selling commissions, "assists" (something provided by the buyer, the value of which has to be added into the selling price), royalties or license fees, and the proceeds of any subsequent resale that accrue directly or indirectly to the seller if they are not already included. Additions to the price actually paid or payable create many disputes in Customs law. It is an area in which creative analysis can be very helpful.

Alternative Methods

Sometimes, however, valuation cannot be decided by transaction value. This includes sales between related parties in which the price is not chosen on an arms-length basis, or the absence of a sale, such as a shift of inventory from one location to another.

When transaction value is not available, the dutiable value is decided by applying one of four alternate methods of valuation. These are, in order of preference:

• Transaction value of identical merchandise, that is, the value based upon the price for identical merchandise charged by the same manufacturer in a direct sale to an unrelated U.S. customer at about the same time;
• Transaction value of similar merchandise based upon a price of nearly identical commercially interchangeable merchandise produced by the same manufacturer;
• Deductive value derived from the price at which the article is ultimately sold in the United States less items such as included international freight, duties, charges, and certain commissions; and
• Computed value, which is derived by building up the manufacturer's actual costs for labor and materials plus the general expenses and profit usually realized by the manufacturer.

Many methods are available to reduce duty liability by controlling valuation. Many of these include "unbundling" or separately invoicing for various nondutiable costs.

The cost of transporting the imported merchandise within the country of exportation, if included in the price paid to the seller, can be excluded from dutiable value under certain circumstances. The general rule is that foreign inland freight is deemed nondutiable if it is separately invoiced and the charges occur after title to the merchandise has transferred. A direct means of avoiding duty on foreign inland freight is to make the purchase on an ex-factory basis with the freight arranged for by an agent acting for the buyer, as both the freight and the cost of the buyer's agent are not part of the Customs value.

Some transactions provide for interest payments. If done carefully these interest payments are not part of the Customs value. Interest would not be dutiable when the interest charge is identified separately from the price paid or payable for the goods, the financing arrangement is written, and the buyer can prove that the goods are sold at the price declared and the claimed rate of interest does not exceed the prevailing rate of interest in the country where the financing is provided.

Compensation paid by a buyer to a seller for delivery and inspection services is not part of the dutiable charge for the goods. Sometimes, Customs has treated this as a buying commission that would not be dutiable.

In many transactions the buyer deals with a go-between, rather than the original producer of the imported merchandise. By careful planning, the buyer can avoid paying duty on the middleman's markup. One way to do this is to argue that the sale from the manufacturer to the go-between was a sale "for exportation to the United States." This price paid would be the "price paid or payable for exportation to the United States" in the words of the statutory definition for transaction value. Thus, the buyer pays duty on this amount and not on the larger amount charged by the go-between to the importer.

Another possibility is to provide that the go-between act as the importer's purchasing agent or buying agent. The commission paid to the buying agent is not dutiable. This would require a written agency agreement which ensures that the agent is not vested with responsibilities for the manufacturer's failure to deliver. It must be clear that the buying agent is a legitimate buying agent.

COUNTRY OF ORIGIN

some statutes administered by Customs depend upon the determination of the country of origin:

• Marking requirements by Customs and other federal agencies;
• Qualification for free trade agreements such as NAFTA and the agreement with Israel;
• Application of dumping or quota issues; or
• The application of appropriate duty status such as Generalized System of Preferences, Most Favored Nation, or Caribbean Basin Initiative.

The traditional rule used in Customs has been to decide whether the processes in the particular country involved is a "substantial transformation," whether an existing product has been changed into a "new and different product." However, because of the unworkability of this standard in the modern trade environment, the international move has recently been to look also to the valuation of the work done in the particular country to decide whether that country becomes a country of origin. Thus, NAFTA applies a far more complex analysis for country of origin than the old "substantial transformation" test.

Differing Approaches

Some products to be sold in both the United States and the EEC must have different markings, depending upon the country in which the product is to be sold. For example, U.S. Customs has long held that the assembly of an integrated circuit chip into a package which includes electrical leads and protective material, and the chip, is a substantial transformation which changes the raw semiconductor chip produced in country X into a new and different product which has to be marked with the country of assembly as the country of origin. The EEC holds that the country where the electronic circuitry is laid down on the semiconductor substrate is the country of origin. Subsequent integration operations do not change the semiconductor chip's nature.

This lack of international uniformity adds additional costs and expense to the manufacturing process. Similar problems are created when products from several countries are blended to make a generic product. This has recently been a problem, for example, with orange juice concentrate manufacturers who may use concentrate purchased from five to 10 different countries. The problems of how to do the marking are obvious. The lack of internationally uniformity for country-of-origin criteria is a problem that is important for manufacturers who conduct multinational business operations.

NAFTA will have a tremendous impact on country-of-origin issues. Because entry from Canada and Mexico will be duty free, it becomes very important that the goods imported be from Canada or Mexico. Consequently, the Rules of Origin section is one of the most detailed and complex parts of NAFTA. It follows the Canada-U.S Free Trade Agreement in providing that goods that are wholly from North America (that is, from the United States, Canada, and Mexico) qualify for treatment under NAFTA.

Goods containing nonregional materials are also considered North American if the nonregional materials are sufficiently transformed in North America to undergo a specified change in tariff classification. NAFTA has a lengthy appendix that details these specified changes.

Sometimes, the goods have to have a specified percentage of regional content and meet the substantial transformation rules. For example, passenger automobiles and light trucks will need to contain 62.5 per cent North American content to qualify for preferential tariff treatment when the NAFTA rules of origin are fully phased in. In other eases the specified percentage of regional content is sufficient in itself to meet the country-of-origin rules.

In some cases there are specific cost accounting rules required to meet the percentage test. For example, automotive products must use the net cost method (total cost minus royalty, sales promotion, packing, shipping, and some interest costs) with tracing of component parts through the production chain.

As mandated by NAFTA and to promote uniformity, Customs has promulgated new interim marking rules for determining whether a good is a product of a NAFTA country for marking purposes.

STATUS OF ENTRY

Merchandise imported into the United States is not subject for duty until it is officially "entered" for consumption. There are several methods to delay or avoid the entry for consumption and thus either avoids or reduces duty. These include the use of Customs bonded warehouses and foreign trade zones.

A foreign trade zone ("FTZ") is a "restricted-access site, in or next to a Customs port of entry, operated pursuant to public utility principles..." FTZ's are administered by the Foreign Trade Zones Board and may be either general purpose (public) or specialized (private). Customs duty is not due upon entry of the goods into a foreign trade zone but only upon removal from the zone into the commerce of the United States. The duty rate is the lower of the rates for the finished goods after assembling or manufacturing in the zone or for the imported parts and components. Thus if the rate for the finished product is lower than for the imported components, there can be a substantial saving. In addition, there is no duty for scrap or for exported goods, and no duty is due until the goods in question are ready to be sold. Sometimes using a zone can avoid problems with quotas.

The bonded warehouse has a much more limited use, in that manufacturing is not allowed except for export use. The major advantage of a bonded warehouse is for duty deferment. However, if the rate is expected to go down, as, for example, under NAFTA, it may be advantageous to import the goods to a bonded warehouse and then hold them for entry until the lower rate goes into effect.

PENALTIES

Compliance failures, including merely negligent ones, can result in penalties, including:

• Liquidated damages;
• Seizures; and
• Civil Penalties.

Liquidated damages typically result when merchandise is recalled by Customs (under a Notice of Redelivery) and the merchandise is not redelivered. They are assessed against the bond filed at the time of importation.

The Notice of Redelivery is most frequently issued for:

• An improper country of origin marking;
• Pirated copyright merchandise;
• Counterfeit or other trademark violation merchandise;
• Requests for samples or additional examination that is not complied with; or
• Quota or visa requirements or enforcement by Customs or the statute of another agency such as FDA, Consumer Products Safety Commission, or the FTC.

Make Compliance Efforts Known

To avoid substantial damages, if there is going to be a problem with redelivery (and frequently there is, as the goods may be sold or used by the time of the notice), let Customs know and show your efforts to comply. File a timely Application for Relief with Customs setting forth the facts to justify cancellation or reduction of the claim. Customs has guidelines that can lead to reductions to as little as one per cent of the claim, $100, or sometimes, even no damages assessed at all.

Seizures

Customs can seize merchandise introduced into the United States contrary to law. Seizures are normally handled administratively with the filing of a petition for remission. Typically, remission requires removal of the problem that caused the seizure, if possible, or exportation of the merchandise if the problem cannot be corrected. Typically, storage and related costs must also be paid. Again, Customs has published guidelines for remission of seizures that are essential to practice in this area.

Civil Penalties

Most civil penalties are assessed under º592 of the Tariff Act of 1930. This section was amended and additional penalty provisions added by the Customs Modernization Act, passed as part of the NAFTA authorization. These provisions allow Customs to assess penalties for the fraudulent, grossly negligent, or negligent entry or introduction of merchandise into the United States by means of any document, written or oral statement, or act that is material and false or any omission that is material. The maximum penalties that can be imposed depend upon the degree of culpability. In addition, the penalties can be reduced markedly by making a prior disclosure. If you discover a problem with a Customs entry, it is far better to say it than to wait for Customs to possibly find out about it.

Procedure

When customs believes that a º592 violation has occurred, it will issue a pre-penalty notice at the district level. This may be the first time you know of the problem. The problem may also be discovered because of an investigation or audit of your books and records. You should respond to the pre-penalty notice and try to explain why there is no violation. Customs may then either decide that there is no violation or issue a penalty notice. You can then seek mitigation of the penalty or file an offer in compromise. The focus should be on the various levels of culpability and the factors included in the regulations that affect the level of culpability. There is, however, the possibility for a very substantial mitigation of the initial penalty.