Reexporters beware: The Bureau of Industry and Security (BIS) recently published an Advisory Opinion on second incorporation which articulates a “discrete products” test and other caveats that appears to substantially narrow the applicability of the second incorporation principle when compared to earlier published guidance. Foreign companies that apply second incorporation principles in their US de minimis content calculations should carefully examine the Advisory Opinion (see http://www.bis.doc.gov/policiesandregulations/advisoryopinions/second_incorporation_rule_advisory.PDF) and the newly articulated tests, and adjust their calculation procedures accordingly.
What is de minimis calculation and second incorporation? The US Export Administration Regulations (EAR) assert jurisdiction over international movement of foreign manufactured items containing EAR controlled US content exceeding certain de minimis thresholds, notably 10% or 25% US content depending on the destination. The second incorporation principle is used in determining what should be considered US content for purposes of de minimis calculation. Say a US manufactured subcomponent is exported from the US to a foreign manufacturer who incorporates it into a component made outside the US, i.e. the first incorporation. That foreign manufacturer then sells that component to another foreign manufacturer, who then incorporates that component into a higher assembly, i.e. the second incorporation. The principle of second incorporation generally holds that the US subcomponent would lose its identity for purposes of a de minimis calculation to determine if the EAR has jurisdiction over the foreign made higher assembly.
BIS states it has long recognized the concept of second incorporation, but we first heard of it after it was presented at a BIS Update conference several years ago. The policy seemed plausible given that “US origin content” is undefined in the de minimis rules. However, as second incorporation is not described in the EAR, many foreign manufacturers were hesitant to rely on the verbal BIS advice. Some of the more diligent manufacturers mine deeply for all US subcomponent values, no matter how many incorporation layers down. It was not until BIS published guidance on its website, in the form of a March 2008 “reexport controls” webinar, that even the more skeptical de minimis bathers felt secure enough to dip their toes into the second incorporation pool. The webinar guidance gave some assurance that the water was fine. It recognized the concept of second incorporation as described above, with the caveat that US content that is ineligible for de minimis, like certain encryption items and the now infamous QRS11 sensor, never lose their identity no matter how many times they were incorporated. You can still find the reexport controls webinar guidance on BIS’ website at http://www.bis.doc.gov/seminarsandtraining/webinars.htm.
The Advisory Opinion published on BIS’ website on January 6, 2010, was in some ways welcome in that it publicly affirms that the second incorporation concept is no mirage. Yet the guidance makes it look far less appealing to foreign manufacturers by introducing another more complex caveat: a “discrete products” test as to when second incorporation principles can be applied in de minimis calculation. Essentially, BIS now states that second incorporation principles can only be applied if the first incorporation component is a discrete product, as opposed to a component that is viewed by BIS as part of a single overall manufacturing process. The Advisory Opinion does not so much provide a concrete definition of a discrete product as it articulates factors that indicate that an item is a discrete product and factors which indicate that an item is not.
For those who need to apply this test, you should read over the discrete product factors in the ruling. Suffice it to say, many foreign made components no longer appear to qualify for second incorporation treatment, such as non-purchased components, components purchased by or from related companies, purchases of most custom components, or purchases of components where the purchaser has some say over the subcomponents. A foreign company trying to systematically implement this test in their compliance programs would now have to take an additional de minimis calculation step: sort out the discrete from the non-discrete products, and include in their calculation the US subcomponents of the non-discrete products. Practically speaking, it might be easier to just count in all the US subcomponent content in the calculation.
The Advisory Opinion includes one more caveat that calls into question whether you can apply second incorporation principles even to components that otherwise meet the discrete product test. In the ruling, BIS reminds that when applying second incorporation the de minimis calculator should bear in mind the overall purpose of second incorporation: “to minimize the burden” on those who buy components that “typically have little or no means to determine how much, if any, US origin content those foreign made” components contain.
Does that mean that the foreign manufacturer should include all known US subcomponents within a discrete product in their de minimis calculation? If they do not know but have some means to obtain US subcomponent data in a discrete product, must they try to obtain the data and include it in their calculation? And if they did not try to obtain the data, could they be held accountable for any unidentified US subcomponent information they could have obtained if they only had asked? If the answer to all these questions is “yes”, the second incorporation pool may well contain a biohazard. It effectively would be reduced to a miniscule savings clause: You would only be safe in excluding from calculation unidentified and de minimis eligible US subcomponents only in discrete products and only after the foreign manufacture did at least a semi-vigorous shake down of their often uncooperative and clueless suppliers and sub-suppliers for the data.
Given that the most recent Advisory Opinion at a minimum articulates more subtlety, complexity and limits on the use of the second incorporation principle than the more encouraging previously published public guidance, some wonder if BIS would be better off doing what the Advisory Opinion requestor appears to have raised in their request: amend the EAR to directly include the concept. BIS could define second incorporation concept and/or better define “US origin content” in the context of de minimis calculation. That will give a clearer and more consistent signal as to whether a foreign manufacturer should jump in or jump out of second incorporation. Otherwise, conscientious reexporters will likely to continue to find themselves on uncertain and potentially shifting policy grounds in applying second incorporation concepts.
