Much Ado about Tariffs: Managing the Impact of Trade Tumult

Much Ado about Tariffs: Managing the Impact of Trade Tumult

Sparked by President Trump’s imposition of additional tariffs on imports of steel and aluminum and many products of Chinese origin, U.S. trade policy dominated news headlines for most of 2018. The tariff announcements caught many companies off guard; prior to the proclamation, many believed that the President’s tariff threats were just a negotiating tactic that he would never see through.

No trade relationship has been more contentious than that of the U.S. and China. The Trump administration levied additional tariffs and legal action against China, alleging its involvement in business malpractice and industrial espionage, and multiple rounds of retaliatory tariffs between the U.S. and China followed. In total, the U.S. imposed tariffs on over $250 billion worth of imports from China in 2018, under Section 301 of the Trade Act of 1974. To date, nearly half of all Chinese goods brought into the U.S. have been subject to additional tariffs, many at a rate of 25 percent, and the remaining at a rate of 10 percent. That rate is expected to rise to 25 percent in the very near future, if ongoing bilateral negotiations fail.

Background on U.S. China trade negotiations

In December 2018, China and U.S. agreed to a moratorium on additional tariffs while trade talks resumed, marking March 1, 2019, as a deadline to reach an accord. This included pausing the scheduled tariff increase from 10 to 25 percent on nearly $200 billion of Chinese goods. The negotiations are also set to try to resolve issues outside of tariffs, including U.S. accusations of Chinese corporate malpractice and espionage. Recently, President Trump said he would not meet with Chinese President Xi Jinping before the March deadline and told reporters at the White House Feb. 12 that he might not stick to a March 1 deadline for deciding whether to raise 10 percent tariffs on about $200 billion in China imports to 25 percent. “We have $267 billion that we were very nice about and we’re not taxing,” he said. “The 10 percent on $200 billion goes up to 25 percent on March 1st. And so far, I’ve said don’t do that. Now, if we’re close to a deal where we think we can make a real deal, and it’s going to get done, I could see myself letting that slide for a little while. But generally speaking, I’m not inclined to do that.” President Trump followed through on February 24 and extended the negotiation deadline beyond March 1, citing "substantial progress" in bilateral talks between the U.S. and China. Amid continued volatility and tariff disruptions, how can companies mitigate the impact of present and future tariffs while positioning their businesses for sustainable, long-term growth?

Regardless of the outcome of the ongoing negotiations, there are several tactics companies can leverage to optimize their approach to tariffs.

Apply for exemptions

Businesses impacted by tariffs on aluminum and steel can apply for tariff exemptions with the U.S. Commerce Department; to date, a little under 50 percent have been approved.  However, for the Section 301 China tariffs, the deadline for filing exclusion requests has passed for the products subject to the 25 percent duties.  For those subject to the 10 percent duties, no exclusion request process has yet been implemented. On February 15, Congress passed a new spending bill to fund the government that included a Joint Explanatory Statement (JES) calling for the USTR to put an exclusion process in place for the List 3 items now dutiable at 10%—similar to the process the USTR adopted for the List 1 and List 2 items that were dutiable at 25% from the get-go. Neither the USTR or Executive Branch are legally obligated to follow the JES, however.

Scrub those tariff codes

When politicians talk tariffs, they’re actually referring to highly specific tariff codes set and standardized by the Harmonized System Committee of the World Customs Organization. Companies need to meticulously review these tariff codes to determine whether they’re correctly applying these highly technical descriptions to their products. This is as much an engineering exercise as a legal one—companies need to evaluate the nitty-gritty details of, e.g., product measurements, material composition, and how the product is used to determine its correct tariff classification. If a company discovers it is improperly applying a tariff code to a product, it can change the tariff code and reap immediate, permanent savings. The company may also be entitled to a retroactive refund on duties paid for about the past 20 months.  While this can be a tedious process, digging into the details of every single product is one of the most effective ways to minimize your tariff liability.

Lower customs valuations

Companies can also reduce their duty liability through legal steps that lower the value of imported items. The U.S. “First Sale Rule” allows importers to declare the value of imported items at a value equal to the factory invoice price in a multi-tiered import transaction. Since goods can sometimes change hands multiple times between a foreign producer and the importer, the price can significantly increase by the time it’s declared to U.S. Customs, so use of this rule can significantly lower an importer’s duty burden.

In addition, ways to legally lower declared customs values exist and can be identified through careful consideration of the various cost elements that make up the unit price of an article.  This is especially true for related party transactions.  My practice pioneered the use of transfer pricing rules to support customs values through multiple Customs HQ rulings over the past 20 years, and encourages companies not to overlook this important aspect of potential duty savings and refunds.

Understand and determine country of origin

The U.S. has many free trade agreements beyond NAFTA that provide reduced or duty-free import of goods from foreign countries. When a good enters the U.S. from another country (except Canada and Mexico), the standard to determine the legal origin of the item is “substantial transformation,” which requires that any processing in a country other than that where the components originated results in an article with a different name, character, or use that those of the starting materials.   As many companies seek to move production out of China to other countries, they should exercise care to address this important standard, especially because simple assembly alone will never confer origin, i.e., if a product assembled in China is disassembled and sent to another country for “re-assembly,” the country of origin is still China.

A wake-up call for deal making

When undergoing a merger or acquisition, companies may neglect to scrub their acquisition’s tariff codes, declared values, trade preference claims, etc. Customs and duties are usually not a priority consideration for executives, because most duty rates (aside from the Section 232 and Section 301 tariffs) are extremely low, or even duty-free; hence, they are not considered “material.”  The current tariff saga with China should be a wake-up call for both buyers and sellers to determine their level of exposure to tariffs and to take a close look at their tariff codes and all other substantive areas that impact duty payments.  Tariff classification, customs valuation, and country of origin should be a normal part of due diligence and risk assessment during any M&A transaction, regardless of whether duties are high or low. Tariff exposure may not ultimately be the deciding factor in a deal’s execution, but it may impact deal terms (exposure) and long-term business planning by the acquirer. Companies that find an otherwise attractive target that has large exposure due to non-compliance with customs and trade rules may adjust their purchase offer or look for ways to decrease risk through alternative procurement or cost-unbundling strategies.

What’s next?

Whether or not an accord is reached in the near future, the safest route for long-term business planning is to act as if tariffs are here to stay. Tariffs will likely always be on the table under the Trump administration, and no guarantees exist that a future administration will shift course if tariffs yield favorable geopolitical results.