Neville Peterson LLP: Customs and International Trade Law

M E M O R A N D U M
To: Clients and Friends of the Firm
From: Neville Peterson LLP
Re: Duty Drawback under NAFTA
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INTRODUCTION

     This Memorandum describes the impact of the North American Free Trade Agreement (NAFTA) on United States duty drawback laws and regulations. As discussed below, NAFTA effected substantial changes in the drawback regime, beginning January 1, 1994, and will continue to effect such changes into the 21st Century.

     In light of these significant changes, companies will want to examine their sourcing and distribution strategies to determine how best to minimize Customs duty expenditures and maximize drawback recoveries under NAFTA.

BACKGROUND

     NAFTA provides for the gradual reduction and elimination of United States, Canadian and Mexican Customs duties for qualifying products manufactured in the signatory countries. The United States and Canada will phase out all duties on each other's products by January 1, 1998. Under NAFTA, tariffs on North American trade involving Mexico will be eliminated by the year 2008.

     Under United States law, "drawback" in the form of a refund of 99 percent of customs duties paid generally is available under four principal scenarios:

(1) Direct identification manufacturing drawback [19 U.S.C. Section 1313(a)] is a refund of duties paid on imported goods which are used to manufacture in the United States articles which are exported;

(2) Substitution manufacturing drawback [19 U.S.C. Section 1313(b)] is a refund of duties paid on imported, duty paid goods when other foreign or domestic goods of the "same kind and quality" are used in the manufacture of articles that are exported;

(3) Direct identification same condition drawback/unused merchandise drawback [19 U.S.C. Section 1313(j)(1)] is a 99% refund of duties paid on imported goods which, within three years, are exported without having been used in the United States, save for the performing of certain incidental operations;

(4) Substitution same condition drawback/unused merchandise drawback [19 U.S.C. Section 1313(j)(2)] is a 99% refund of duties paid on imported goods when other "commercially interchangeable" domestic or foreign goods are exported.

NAFTA will affect each of these types of drawback in different ways.

NAFTA'S DRAWBACK PROVISIONS

     Under the CFTA, the United States would have ceased paying manufacturing duty drawback in respect of goods exported to Canada on and after January 1, 1994. Direct identification same condition drawbacks/unused merchandise drawbacks would continue unchanged, while the treatment of substitution same condition drawback/unused merchandise drawback was unclear. NAFTA's drawback provisions are generally similar to those of CFTA, but differ in some very important respects.

     The United States ceased paying manufacturing drawbacks in respect of goods exported to Canada on or after January 1, 1996. This represented a two year "reprieve" from the CFTA's drawback sunset date. Furthermore, the United States will continue paying manufacturing drawback in respect of goods exported to Mexico until January 1, 2001.

     Even after those "drawback sunset" dates are reached, NAFTA will permit limited payments of drawback pursuant to what might be termed the "NAFTA Drawback Program". Under NAFTA, direct identification same condition drawback/unused merchandise drawback will continue unchanged, while substitution same condition drawback/unused merchandise drawback will be eliminated).

     We now consider the fate of various forms of United States duty drawback under the NAFTA:
     (1) Direct identification manufacturing drawback can be claimed on third-country imports in the same manner as present with respect to goods exported to Canada before January 1, 1996 and goods exported to Mexico until January 1, 2001. Thereafter, payments of manufacturing drawbacks will be limited to an amount equal to the lesser of the United States external tariff or the NAFTA internal tariff, as noted above.

Example: After the NAFTA "drawback sunset" sunset date, A U.S. company imports third-country parts and pays duty thereon. The company then uses the parts to manufacture articles. The articles are exported to Mexico. The U.S. company would be eligible to claim drawback in the amount of either the U.S. duty paid or the Mexican duty paid, whichever is less.

(2) Substitution manufacturing drawback can also be claimed with respect to third-country imports, as noted above.

Example: After the "drawback sunset" date, a U.S. company imports third-country parts and pays duty thereon. The company then uses commercially interchangeable, domestic-origin parts to manufacture articles. The articles are exported to Mexico. The U.S. company would be eligible to claim drawback in the amount of either the United States duty or the Mexican duty, whichever is less.

(3) Direction identification same condition drawback/unused merchandise drawback can be claimed under the NAFTA in the usual manner. The amount of the refund would be 99 percent of the duty paid. However, Customs has taken the position that 19 U.S.C. Section 1313(j)(1) claims will be processed in the traditional manner only where the goods are not changed in condition by operations performed in the United States. Where the goods are changed in condition (i.e., subjected to the expanded list of incidental processes authorized under the Customs Informed Compliance and Modernization Act of 1993, Customs takes the position that drawback recoveries are subjected to the NAFTA drawback program "cap".

Where third-country imports are commingled with North American products, a drawback claimant is required to implement an inventory system to determine the origin of goods for same condition drawback purposes.

Example: A Canadian company imports 50 widgets from a third country and pays duty thereon. The widgets are commingled in inventory with commercially interchangeable widgets of U.S. origin. The company then exports to Mexico 50 widgets from inventory. The company could claim same condition drawback only if has adopted an inventory management system approved under the NAFTA Uniform Regulations, to be adopted by the parties.

     Many United States firms which import duty paid goods, and subsequently export them, use substitution same condition drawback programs, in order to be spared the effort and expense of tracing each lot of fungible merchandise back to a particular import entry. Since the NAFTA commingling provisions by their terms apply only when originating and non-originating goods are commingled, it does not appear that these provisions would apply where two or more lots of non-originating (i.e., foreign) goods are commingled.

     (4) Substitution same condition drawback/unused merchandise drawback is not available for either originating or third-country goods under NAFTA. Furthermore, this type of drawback has been eliminated for exports to the United States and Canada effective January 1, 1994, rather than according to the longer "phase-out" periods provided for other drawbacks.

     The following example is illustrative;

Example: A U.S. company imports goods from a third country and pays duty thereon. The company then exports commercially interchangeable, domestic-origin goods to Canada, paying duty upon their exportation. The company could not claim substitution same condition drawback/unused merchandise drawback.

EFFECT OF NAFTA DRAWBACK SUNSET ON OTHER PROGRAMS

     NAFTA Article 307 requires the elimination or curtailment not only of duty drawbacks, but also of duty deferral schemes. This, temporary in-bond entry schemes will be prohibited in cases where the goods undergo processing while under bond which changes their character, or the duty rate applicable to them.

     One of the major results of the NAFTA drawback sunset provision will be that Mexico will be required to curtail its system of maquiladora bonds, which permits the temporary duty free entry into Mexico of goods for use in the assembly of goods which are then exported (most frequently to the United States, where they are entered with benefits of duty allowances under the HTS subheading 9802.00.80 program, commonly known as the "807" program). Effective January 1, 2001, Mexico will be required to prohibit the use of maquiladora bonds for non-NAFTA-originating components and materials intended for re-exportation to the United States.

     Other duty deferral programs, such as the United States Department of Agriculture's Sugar Re-Export Program (which permits duty free importation of foreign sugar for use in the manufacture of goods for export) were continued after the January 1, 1996 drawback sunset date for Canada, even though this technically violates the terms of NAFTA Article 307.

CONTINGENCY PLANNING: HOW IMPORTERS AND EXPORTERS CAN RESPOND

     There are several ways in which United States importers and exporters might be able to minimize the burdens resulting from the NAFTA drawback changes, particularly the elimination of substitution same condition drawbacks/unused merchandise drawbacks.

     In the long term, companies may be able to minimize the adverse impact of CFTA and NAFTA drawback eliminations by utilizing tariff-advantaged facilities, such as Customs bonded warehouses and Foreign Trade Zones.

     1. Customs Bonded Warehouses

     Foreign goods may be stored in private or public Customs bonded warehouses for up to five (5) years without payment of duty. Duties are payable only when and if the goods are withdrawn from warehouse for domestic consumption. Importers might use bonded warehouses to store commingled goods from several foreign sources, withdrawing goods as needed for consumption in the United States (with payment of external tariff) or for exportation to Canada (subject to payment of Canadian tariffs). The use of a bonded warehouse would eliminate potential for double taxation of foreign goods, and would relieve the importer from the burden of keeping a detailed recordkeeping system to comply with NAFTA requirements relating to drawback.

     Similar benefits would be available as the result of the storage of goods in a Foreign Trade Zone (FTZ) or subzone.

     2. Foreign Trade Zones

     NAFTA's drawback sunset provisions will prohibit U.S. companies from using Foreign Trade Zones to avoid external tariffs on foreign goods which are subsequently exported to Canada and Mexico. Prior to the drawback sunset dates, however, United States companies can receive the full range of FTZ benefits in respect of goods exported to Canada or Mexico. This does not mean, however, that FTZs cannot thereafter be used to obtain United States tariff benefits for goods exported to Canada or Mexico; it only means that duties must be assessed as if the goods were withdrawn from the FTZ for United States consumption. FTZs may still be used to effect tariff reductions.

Example: A United States company imports into a foreign trade zone Japanese components valued at $10,000. If entered directly for consumption into the United States, these components would be subject to duty at a rate of 10% ad valorem, for a total U.S. duty payment of $1,000. However, the company uses the Japanese component in the FTZ to make a product which, when withdrawn from the FTZ for domestic consumption, is dutiable at a rate of 3% ad valorem, and pays duty on the Japanese components at this lower rate ($10,000 x .03 = $300 duty). Thus, the use of the FTZ saves the company $700 in duty.

When the product withdrawn from the FTZ is exported to Canada, the U.S. company cannot claim drawback on the $300 in U.S. duties paid; however, if the product qualifies, it can enter Canada with benefit of NAFTA reduced-duty or duty free status.

     Prior to the NAFTA drawback sunset date, this company might have simply paid the $1000 in duty on the Japanese components, secure in the knowledge that it could recoup 99% of those duties as drawback when goods produced therefrom were exported to Canada. Once the drawback sunset dates arrive, however, it might be in this company's interest to convert its manufacturing facility to an FTZ "subzone". As noted above, such a conversion might help the company save duties on goods which remain in the United States, as well as on goods exported to Canada.

CONCLUSION

     Under NAFTA, the operation of United States duty drawback laws will change significantly. Drawback claims will be gradually limited, with a growing possibility of double taxation of foreign inputs used in North American manufacturing and processing operations. While these changes will in some respects limit the flexibility of United States importers and exporters, companies may in certain cases be able to limit the impact of these changes by shifting sourcing patterns and manufacturing sites, or by utilizing tariff advantaged facilities, such as Customs bonded warehouses and Foreign Trade Zone manufacturing procedures.

     Note: This memorandum is intended for general informational purposes only, and is not given or intended as advice pertaining to any specific case or circumstances. Readers having questions concerning particular situations should consult counsel.

     Entire contents copyright 1998 by Neville Peterson LLP.

     For additional information concerning the subjects discussed in this Neville Peterson LLP background memorandum, please call Martin Neville, John Peterson, Maggie Polito or Arthur Purcell at (212) 635-2730 or George Thompson, Mike Tomenga or Larry Bogard at (202) 861-2959, or e-mail using the mailbox on this Website.

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