Qualifying Products for Duty Free Entry Under the Generalized System of Preferences (GSP)
This Memorandum considers the requirements for obtaining duty free entry of merchandise into the United States under the Generalized System of Preferences (GSP). We also explain herein how companies manufacturing abroad can review their manufacturing cost records to determine whether their products satisfy the GSP’s “35% value added” requirement.
II. The Generalized System Of Preferences (GSP): Background
Under its Generalized System of Preferences (GSP)[currently codified at 19 U.S.C. Sections 2461-2466], the United States extends unilateral duty-free treatment to certain products manufactured in designated “beneficiary developing countries” (BDCs).
GSP-eligible goods are designated by the letter “A” in the “Special” duty rate column of the Harmonized Tariff Schedule of the United States.
Each year, the President reviews the GSP to determine whether certain products should be deleted from, or added to, the list of GSP-eligible articles, either generally or from particular countries.
There are two principal ways in which a product may be dropped from the GSP-eligible list.
First, if in any calendar year the entered value of a GSP-eligible article from a particular beneficiary country exceeds a dollar value known as the “competitive need limitation”, the President is authorized to terminate GSP treatment for the product, from that country, effective at the beginning of the next “GSP year”. However, governments and industries may petition the President to “waive” the competitive need limitation for certain products, permitting continued GSP treatment.
Second, products may be dropped from the GSP program, either completely or with respect to a particular BDC, upon petition by a domestic interested party, such as a United States manufacturer or trade union engaged in production of a like or directly competitive article.
III. GSP Eligibility Criteria
In order for an eligible article manufactured in a BDC to qualify for duty-free entry into the United States under the GSP, the following conditions must be satisfied:
(1) The product must be “substantially transformed” in the BDC into a new and different article of commerce, which is “grown, produced or manufactured” in the BDC;
(2) The sum of (1) the cost of materials originating in the BDC, plus (2) the “direct cost of processing operations” performed in the BDC must equal at least 35% of the dutiable value of the article upon importation into the United States; and
(3) The merchandise must be “imported directly” into the United States from the BDC.
At the time of entry, the importer must make a claim for GSP treatment on its Customs entry forms, and must present a “Form A” Certificate of Origin. [Presentation of the "Form A" may be waived if the District Director of Customs is satisfied that the merchandise is a product of the BDC].
For good order’s sake, we examine each of these requirements separately below.
A. “Substantial Transformation”
Since GSP was enacted in 1975, the Customs Service’s position was that eligible articles must undergo a “substantial transformation” in a BDC in order to qualify for duty-free entry under GSP; however, no such condition appeared in the GSP statute. In Madison Galleries, Ltd. v. United States, 870 F. 2nd 627 (Fed. Cir. 1989), the United States Court of Appeals for the Federal Circuit ruled that “substantial transformation” was not required under the GSP statute.
Responding to the Madison Galleries decision, the Customs and Trade Act of 1990 amended the GSP to require specifically that eligible articles be “a new and different article of commerce which has been grown, produced or manufactured” in the BDC. Customs has interpreted this amendment as imposing a “substantial transformation” requirement, and has administered the statute accordingly.
An extensive discussion of “substantial transformation” is beyond the scope of this memorandum. However, the Customs Service makes “substantial transformation” determinations on a case-by-case basis, applying judicial precedent and the agency’s administrative rulings on “substantial transformation” issues rendered under other statutory regimes.
B. “Thirty-Five Percent” Requirement
To qualify for duty-free treatment, GSP-eligible articles must also satisfy the GSP’s “35% requirement”. Specifically, the sum of (1) the cost of BDC-origin materials, plus (2) the “direct cost of processing operations” performed in the BDC, must equal at least 35% of the appraised value of the finished product for United States Customs duty purposes. The test can be represented by the following formula:
Cost of BDC materials) + (“Direct cost of processing operations” in BDC)
Dutiable value of imported product
> = 35%
It is helpful to consider each element of the formula separately.
1. Cost of BDC Materials
BDC-origin materials which may be counted against the GSP’s “35% value added” requirement include all materials appearing in, or consumed in the production of, the finished product.
The “cost” of BDC-origin materials, for purposes of the GSP’s “35% requirement” is defined in the Customs Regulations as:
(i) The manufacturer’s actual cost for the materials;
(ii) When not included in the manufacturer’s actual cost of the materials, the freight, insurance, packing and all other costs incurred in transporting the materials to the manufacturer’s plant;
(iii) The actual cost of waste or spoilage (material list), less the value of recoverable scrap; and
(iv) Taxes and/or duties imposed on the materials by the beneficiary developing country . . . provided they are not remitted upon exportation.
10 C.F.R. Section 10.177 (c)(1).
Thus, if a Philippine manufacturer purchases a Philippine-origin component at a price of $10, ex-factory, and incurs nonrefundable taxes of $1.00 and transportation costs of $1.00, the component is considered to have a value of $12.00 for purposes of the GSP calculation.
1a.”Double Substantial Transformation”
Also vitally important to understanding GSP is the concept of “substantially transformed constituent materials”, also known as “double substantial transformation”. This concept recognizes that many manufacturing operations involve multiple steps, and that in certain cases non-BDC-origin materials may be “substantially transformed” in a BDC into a new and different article of commerce (a “substantially transformed constituent material”). If such a material is then subjected to a second “substantial transformation”, resulting in a product which is exported to the United States, then the cost or value of the “substantially transformed constituent material” may be counted against the GSP’s “35% requirement”.
An example will help to illustrate the concept. Assume that a fax machine manufacturer company buys United States-origin parts having a value of $10.00, delivered to a Thailand plant. The Thai plant then assembles these parts and materials to produce a wire harness for a fax machine, incurring direct assembly costs of $15.00. The “wire harness” can fairly be said to be a “substantially transformed constituent material” of Thai origin. If the wire harness is then subjected to a second “substantial transformation,” resulting in a new and different article of commerce, (for example, assembly with other components to make a fax machine), then the value of that “substantial transformed” constituent material ($10 + $15 = $25) may be counted as the cost of a “Thai” component, and applied to the GSP’s “35% requirement”.
It must be stressed that a “substantially transformed material must be an independent and identifiable article of commerce. It is not sufficient if the article is merely an intermediate step in the completion of an article, without any intrinsic commercial identity. See, e.g., The Torrington Company v. United States 8 CIT 150 (1984) aff’d, 764 F. 2nd 1563 (Fed. Cir. 1985): . . it is not enough to transform substantially the non-BDC constituent materials into the final article, as the material utilized to produce the final article would remain non-BDC material. There must first be substantial transformation of the non-BDC material into a new and different article of commerce which becomes “materials produced”, and these materials produced in the BDC must then be substantially transformed into a new and different article of commerce. . . . .
See also, Azteca Milling Co. v. United States, 890 F. 2nd 1150 (Fed. Cir. 1989)(GSP treatment denied where alleged “substantially transformed constituent material” had no independent commercial identity or use per se.)
2. “Direct Costs of Processing Operations”
Not all costs of manufacturing goods in a BDC are included in the “direct cost of processing operations” for GSP purposes. Rather, 19 C.F.R. Section 10.176 defines the term “direct cost of processing operations” to include only:
. . . those costs either directly incurred in, or which can be reasonably allocated to, the growth, production, manufacture or assembly of the specific merchandise under consideration. Such costs include, but are not limited to:
- All actual labor costs involved in the growth, production, manufacture or assembly of the specific merchandise, including fringe benefits, on-the-job training, and the cost of engineering, supervisory, quality control and similar personnel:
- Dies, molds, tooling and depreciation on machinery and equipment which are allocable to the specific merchandise;
- Research, development, design, engineering and blueprint costs insofar as they are allocable to the specific merchandise;
- Costs of inspecting and testing the specific merchandise; and
- Costs of inspecting and testing the specific merchandise.
Among the type of costs which Customs has held are included in the direct cost of processing operations [to the extent they can be directly attributed or allocated to production] are the following:
- Direct salaries of production employees
- Vacation pay
- 25% bonus mandated by national law
- Christmas bonus
- National social security taxes
- Employee housing funds
- Federal payroll taxes
- State payroll taxes
- Nursery taxes
- Attendance bonuses
- Travel expenses
- Tuition reimbursements
- Cafeteria subsidies
- Transportation subsidies
- Sport team subsidies
- Group insurance premiums
- Cost of inspections and inspection supervision,
- Product testing costs
- Energy costs
- Depreciation on production machinery
- Development and design costs
- On-job training costs
- Engineering, quality control and supervisory personnel
- Property costs.
- [Wastewater treatment and waste disposal costs]
- [Packing materials]
- [Inland freight]
- [Brokerage fees]
- [Equipment maintenance]
- [Work permit costs]
- [Machinery rental]
- [Repair costs]
- [Driver wages]
- [Building rent]
- [Electroplating costs]
To the extent that these costs are shared by production and non-production-related employees, they can be apportioned, according to generally accepted accounting principles, and the amount attributed to production and related workers for operations counted against the GSP’s “direct cost of processing operations”.
Please bear in mind that the above list is non-exhaustive; any cost which can reasonably be attributed to direct manufacturing or processing operations, using Generally Accepted Accounting Principles (GAAP) can be counted against the “direct cost of processing operations” for GSP purposes.
Section 10.178(b) of the Customs Regulations specifies that cost items are not included in the “direct cost of processing operations” if they:
…are not directly attributable to the merchandise under consideration or are not “costs” of manufacturing the product. These include, but are not limited to:
- Profit; and
- General expenses of doing business which are either not allocable to the specific merchandise or are not related to the growth, production, manufacture or assembly of the merchandise, such as administrative salaries, casualty and liability insurance, advertising and salesmen’s salaries, commissions or expenses.
Cost items which Customs has held not to be included in the “direct cost of processing operations” under the GSP include the following:
- Salaries, fringe benefits, etc. of general managers, personnel managers, accounting and payroll employees;
- Administrative function costs;
- Sales costs;
- Automobile depreciation costs;
- General office expenses;
- Mail and mailroom costs;
- Telecommunications costs
However, some Customs rulings suggest that the last four costs listed above can be counted against the “direct cost of processing operations” if they can be allocated to direct production functions.
Obviously, the best way to evaluate a foreign producer’s GSP potential would be to scrutinize the company’s production cost records on an item-by-item basis.
3. Appraised Value of Imported Merchandise
The sum of the cost of BDC-origin materials and the “direct cost of processing operations” performed in the BDC must be compared with the appraised value of the finished product when imported into the United States. Note that GSP involves a “cost to value” comparison, not a “cost to cost” comparison.
An exhaustive discussion of Customs valuation methods is beyond the scope of this memorandum. However, it is appropriate to note that most merchandise imported into the United States is appraised for Customs purposes according to its “transaction value”, which is defined in Section 402 of the Tariff Act [19 U.S.C. Section 1401a] as the “price paid or payable for the merchandise when sold for exportation to the United States,” plus certain statutory additions. A related party price is acceptable as the basis for “transaction value”, provided certain conditions are met.
There are numerous techniques which importers can use to lawfully minimize the dutiable value of their merchandise, and thus improve their chances of qualifying for GSP treatment. In cases involving related manufacturers and importers, one common technique is for the importer to identify costs on the books of the BDC manufacturer which (1) do not qualify as “direct costs of processing operations” and (2) which, when provided free of charge by the importer to the foreign manufacturer, do not constitute a dutiable “assist”. These expenses can then be shifted to the books of the United States importer, or to the books of a third party, enabling the dutiable value to be lawfully reduced. We would be happy to provide further information concerning such techniques, as required.
C. “Direct Importation” Requirement
In order to qualify for GSP status, eligible products must be “imported directly” from the BDC to the United States. This means that the merchandise may not enter the commerce of another country while en route from the BDC to the United States. Transshipment of the goods through a third country is permissible, provided the goods remain in continuous Customs custody, or do not enter the commerce of that country.
This Memorandum has hopefully served as a general introduction to the GSP, and should allow your company to begin evaluating the GSP potential of its imported products.
Note: The information contained in this memorandum is for general information only, and is not intended as advice or counsel regarding any specific situation. If you have an issue relating to the subject matter discussed in this memorandum, you should consult with counsel or your customs advisers concerning the proper course of action to be followed in your case.
Entire contents copyright 1998 by Neville Peterson LLP.
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