Are you ignoring a chance to reduce import costs?

Staff -- Purchasing, 2/3/2005

Smart planners are smart because they plan and they plan because they're smart.

This is not a tautology. Rather, planning for delays or increased purchased costs in logistics due to dock strikes, lift shortages or other contingencies is what separates the great procurement professional from the merely good, the "best in class" from the solid B student.

But planning—or management of costs—can only occur when all of the costs are out in the open. Unfortunately, one of the most enduring—but also incorrect—assumptions made by too many purchasing professionals is that they have no control over the amount of customs duties assessed against their imported goods and that the importing buyer has to cede control over the process to the customs authorities.

Both assumptions are wrong, which means that purchasing is ignoring an opportunity to manage the duties, taxes, freight and fees that can represent up to 25% of the total cost of a commodity bought internationally.

So what are you paying now—really?

As a starting point, ask yourself these fundamental questions:

• How much am I paying for the goods?
• How much am I paying for transportation and insurance?
• How much am I paying in customs duties?
• How long does the process take?
• How much initiative have I taken?

In addition, since duty cost burdens of transportation and freight costs are often fully submerged into the cost of goods sold, purchasing professionals often have no idea how much they are paying in duties and associated fees, have no idea of their fully loaded cost and are not in a position to begin to shrink, manage or eliminate the costs of those duties and other add-ons.

For example: In the case of a destination purchase, the seller assumes all of the costs of getting the goods transported and delivered to the destination point selected by the buyer—and all of these costs are passed along to the buyer in a single, undifferentiated bottom-line number. There is no incentive for the seller to look to lower those costs because duty costs are tacked on as additions to the buyer's account.

To add insult to injury, if the seller takes advantage of customs planning opportunities, the seller can pocket the savings and not pass them along to the buyer. So since the duties, fees and associated costs are ultimately paid by the buyer, the buyer must recognize this, plan and act accordingly.

First, purchasing needs to organize its products within a tariff classification database to make the customs entry process smoother and allow them to influence how the product is classified.

(Customs duties are ad valorem in nature, which means that the duty collected will be a function of the product's tariff classification and of its valuation, which serves as the tax basis against which duties are collected. And the importer, in the U.S., is responsible for assigning the proper tariff classification and value to the imported merchandise.)

But to do that, you need to understand tariff laws because often a product might be classifiable under two or more competing provisions, each carrying a different duty rate. And what a company says about its product and how it is described in patent applications or in sales and marketing literature may have a profound impact on tariff classification.

A company may also explore "tariff engineering," i.e., designing a product or putting together a product with the lowest duty rate in mind. That includes knowing where to have the product assembled because the duty rate is related to the assembled state of the imported product and there is a provision in the customs law for articles assembled into a retail set. In other words, the duty rate for all of the articles in the set will be that rate which applies to the article conferring the essential character of the set.

To be sure, this can be a subjective test, but knowing this, an importer may be able to assemble the retail set abroad, rather than after importation, and pocket the savings. The difference in such foreign assembly costs versus the cost of domestic assembly, of course, has to be factored into the equation. The customs notion of a composite machine, with two or more machines fitted together to form a whole, is also useful when considering the importation of machines separately or fitted offshore and imported as a unit. In addition, purchasing professionals must calculate the effect of the country of origin of the goods on any customs duty charge in order to arrive at an in-the-door cost for imported goods.

In many customs jurisdictions, including the U.S., there may be a tiered approach to duty depending upon the origin of the goods. The U.S. has a general column with duties of around 3% to 4%; a special column with rates that are either zero or lowered because of trade preference relations between the U.S. and the country of origin such as a NAFTA country or the Generalized System of Preferences and a column-two rate which applies to those few countries, such as North Korea and Cuba, to whom the U.S. has not extended normal trade relations. These last rates are at the 1930 Tariff Act level, without benefit of any of the tariff reductions taken under the GATT, and often spike to 80% to 90% levels.

In terms of valuation, the purchasing professional's prime concern should be the price paid for the goods. One useful development of the past 20 years: the U.S. and all of its major trading partners have agreed on a hierarchy of methodologies to use that are contained in the World Trade Organization's (WTO) customs valuation law, often termed the Customs Valuation Agreement.

The starting point is "Transaction Value," which is defined as the price actually paid or payable when the goods are sold for exportation. Signatories are left to decide for themselves whether to assess duties on a free on board (FOB) basis, as does the U.S. and Canada, for example, or on a cost, insurance and freight (CIF) basis, as is the case with Mexico and the 25-member European Union. In the latter case, of course, a savings in transport costs will pay an extra dividend in the form of lowered customs duties. This system lends an element of predictability to the process of ascertaining fully loaded costs of goods crossing borders.

Since the Customs Valuation Agreement is largely a function of the price shown in the invoice, it would be an easy matter for a clever buyer and seller to set up off-invoice partial payments for goods. For example, the seller could tell the buyer to pay $95 for the goods but set up a separate $5 invoice for packaging. Or the seller could ask for $95 for the goods, but direct that a $5 payment go to a company set up as an agent by the seller. Indeed, the customs law anticipates these two and three other arrangements (assists in the nature of R&D or engineering work, tooling, dies or molds or materials to be used in the production; royalties and proceeds of subsequent resales) which are in the nature of the "Five Statutory Additions." If amounts in these categories are not already included in the purchase price then they will be added to the declared price in order to make value, which is $100 in the cases above.

There are special rules for related party purchases which parallel the rules that the IRS uses in its transfer pricing reviews. Both agencies want to ensure that the pricing is at arm's length and freed of nonmarket influences.

It is important that customs planning be fully integrated with a company's international tax planning. And, just as with tariff classification, there are planning opportunities in this area as well. For example, if a buyer were able to buy in extended terms and pay interest on the purchase, the interest charge can be nondutiable. If the overseas seller is in a jurisdiction where withholding tax on the interest payments are not a problem because of a tax treaty, the duties can be lowered with no ill tax effect. Also, post-importation costs of erection, installation and maintenance are nondutiable. Thus, it makes sense to separately account for such costs, especially if tax nexus issues were not an issue to the parties.

Mark Neville is a principal with International Trade Counsellors, a law firm focused on customs and international trade law. He may be reached at intltradecounsel@sbcglobal.net