BIS Guidance On '2nd Incorporation Principle'

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1 Portfolio Media, Inc. 860 Broadway, 6 th Floor New York, NY Phone: Fax: customerservice@portfoliomedia.com BIS Guidance On '2nd Incorporation Principle' Law360, New York (January 19, 2010) -- On Jan. 6, the Bureau of Industry and Security (BIS) of the U.S. Commerce Department published a redacted September 2009 advisory opinion which, in an incremental way, may reduce the downstream burden of U.S. re-export controls. Pressure to Design Out U.S. Content from Foreign-Made Products In a recent speech on the importance of exports to the U.S. economy, Secretary of Commerce Gary Locke cited a troubling quote from the head of a European aerospace industry group, to the effect that the only way to resolve technology access and U.S. government export restrictions was by not including any U.S.-sourced technology in our products. In addition to regulating the actual shipment or transmission of U.S.-origin commodities, software and technology from one foreign country to another, the Export Administration Regulations (EAR) control, among other things, re-exports from abroad of foreign-made items incorporating U.S.-origin materials, parts, components, software or technology. BIS, which administers the EAR, acknowledged the potential downside of such reexport controls in October 2008, stating, Modifying U.S. rules may reduce the pressure to design out U.S. origin items from foreign products, and thereby provide significant benefit to U.S. businesses while enabling BIS to continue exercising appropriate jurisdiction over foreign-made items incorporating controlled U.S. content. EAR De Minimis Rules To a degree, the global reach of the EAR reexport controls is limited by de minimis rules, under which foreign-made items containing no more than 25 percent by value of EAR-controlled U.S.-origin content are generally not subject to the EAR when reexported from abroad to most foreign countries.

2 Foreign-made items containing no more than 10 percent by value of EAR-controlled U.S.-origin content are generally not subject to the EAR when re-exported to Cuba, Iran, North Korea, Sudan or Syria. However, even when the EAR de minimis provisions place a foreign-made item outside the scope of the EAR, Office of Foreign Assets Control (OFAC) restrictions may apply if the item is destined for a U.S.-sanctioned country, individual or entity. Unfortunately, the complexity of the EAR de minimis provisions may undercut their effectiveness in countering the pressure on foreign manufacturers to design out U.S.- origin content. Generally, for example, the EAR de minimis rules only address foreignmade commodities that incorporate controlled U.S.-origin commodities, foreign-made software that is commingled with controlled U.S.-origin software, and foreign-made technology that is commingled with controlled U.S.-origin technology. More complex combinations e.g., a foreign-made machine incorporating U.S.-origin software in many cases are not provided for in the EAR de minimis rules. Although the EAR de minimis allowances were expanded in October 2008 to cover certain re-exports of foreign-made commodities bundled with U.S.-origin software, this bundling allowance is limited to software listed on the Commerce Control List of the EAR for anti-terrorism reasons only or classified as EAR99. New Guidance on Second Incorporation Principle The September 2009 BIS advisory opinion reflects at least some concern about the potential downstream burden of EAR re-export controls. In the opinion, BIS characterized the second incorporation principle as a practice which BIS has historically followed. According to BIS: "The second incorporation principle generally states that U.S.-origin components that are incorporated into a foreign-made discrete product will not be counted in de minimis calculations when the foreign-made discrete product of which they are part is itself incorporated into a subsequent foreign-made item (i.e., after the second foreign incorporation)... "The purpose of the second incorporation principle is to minimize the burden on foreign parties who purchase foreign-made products and typically have little or no means to determine how much, if any, U.S.-origin content those foreign-made products contain." BIS stated that it does not currently plan to amend the EAR to highlight the second incorporation principle, which, in any event, is not expressly set forth in the text of the EAR. The advisory opinion does not define the term foreign party ; nor does the opinion address whether a foreign subsidiary of a U.S. company could be considered a foreign

3 party for purposes of the second incorporation principle, though it does not exclude that possibility. BIS stressed that the second incorporation principle may be employed only if a first incorporation has actually been completed, resulting in a foreign-made discrete product, and added that the level of U.S.-origin content in the first discrete product must be considered until the product s second incorporation is complete. The party requesting the September 2009 advisory opinion had asked BIS for guidance on applying the second incorporation principle in calculating the de minimis ratio of controlled U.S.-origin parts at the aircraft level, and described a scenario in which one company located outside the United States provided avionics equipment, often including U.S.-origin parts, to a civil aircraft manufacturer located outside the United States. Declining to rule on the apparently limited information provided, BIS indicated that whether any particular foreign-made item incorporating U.S.-origin components is a discrete product must be determined on a case-by-case basis. BIS did provide the following criteria and examples on the application of the second incorporation principle: - Evidence that a foreign-made item was purchased in an arm s length transaction or evidence that the item is regularly sold by itself, either as a stand-alone product or as an identifiable replacement for a particular product, would tend to indicate that the item is a discrete product. - For example, if [the foreign aircraft manufacturer] purchased a [foreign-made] flight data recorder regularly sold by itself as a stand-alone product through an arm s length transaction before incorporating the recorder into an aircraft, the U.S.-origin components of that recorder would not need to be taken account of when determining the amount of U.S. content in the aircraft. - Alternatively, if the purchaser of a foreign product in contemplation of further manufacturing operations participated in the design or manufacture of the product or chose the parts that were to go into the foreign product, then that indicates that the foreign-made product was in fact part of a larger manufacturing or production process and therefore not a discrete or completed product when further processing or manufacturing commenced. - For example, if [the foreign aircraft manufacturer] helped [the foreign avionics equipment supplier] design a flight data recorder specifically for [one of the foreign aircraft manufacturer s] aircraft or chose the components that were to go into the recorder, then those actions by [the foreign aircraft manufacturer] would be indications that the flight data recorder is not a discrete product.

4 BIS also stressed that the second incorporation principle could not be applied to U.S.- origin components for which there is no de minimis level under the EAR. For example, there is no de minimis level under the EAR for foreign-made commercial primary or standby instrument systems, automatic flight control systems or aircraft incorporating the QRS11 sensors identified in section 734.4(a)(3) of the EAR. It is also important to note that items subject to the International Traffic in Arms Regulations (ITAR) administered by the U.S. State Department are not eligible for de minimis treatment. Applying the Principle to Foreign Manufacturing Manufacturers utilizing foreign-made products with U.S.-origin content in further production located outside the United States should apply the new BIS guidance on the second incorporation principle with caution, especially since this principle does not appear in the text of the EAR. While not required, probably the safest way to confirm that one foreign-made item to be incorporated into another is a discrete product for purposes of the second incorporation principle is to submit an advisory opinion request to BIS. The request should include details on the following: 1) the first foreign-made item to be purchased (i.e., the proposed discrete product ); 2) the circumstances of its purchase, including whether it is to be acquired in an arm s length transaction and whether it is typically sold as a stand-alone product; 3) the extent, if any, to which the purchaser of the proposed discrete product will participate in its design or manufacture; and 4) the identity of the second foreign-made item in which the proposed discrete product will be incorporated. In addition, advisory opinion requests on the second incorporation principle should confirm that none of the U.S.-origin components incorporated in the proposed discrete product are excluded from the EAR de minimis provisions. --By David M. Dunbar, Katten Muchin Rosenman LLP David Dunbar is a partner in the Washington office of Katten Muchin Rosenman LLP. He advises clients regarding U.S. export laws and regulations, re-export controls and economic sanctions, as well as a wide range of U.S. Customs and Border Protection matters.

5 The opinions expressed are those of the author and do not necessarily reflect the views of Portfolio Media, publisher of Law360.