An important objective of deal teams is to uncover risk, especially when it has the potential of hurting the bottom line or causing reputational damage postacquisition. In a world of ever-growing risks, deal teams have been adding seats to the due diligence table in recent years, including information technology and environmental, social, and governance (ESG) infrastructure. It’s probably time to start pulling a seat up to the table for trade compliance as well.
Over much of the past two decades, U.S. companies engaged in international trade have been buried with new regulations from the 40-plus federal agencies that have at least some jurisdiction over import and export activity, largely thanks to a dozen new free trade agreements, post-9/11 supply chain and national security measures, and increased enforcement on product safety and compliance. Additionally, the duty liability for U.S. companies has significantly increased as a result of growing protectionism, especially with the punitive tariffs imposed on Chinese-originated goods in 2018. Any deal team evaluating an acquisition target that is actively engaged in international trade, especially if the target heavily relies on foreign suppliers, should apply a critical eye toward the company’s efforts to comply with the various import and export laws and regulations as part of its due diligence scope.
Importers of record are required to exercise “reasonable care” with respect to declaring the correct tariff classification, value, and rates of duty at the time of entry. Importers who fail to exercise reasonable care might incur penalties and can be subjected to inquiries and audits by U.S. Customs and Border Protection (CBP). Companies that export goods are obligated to comply with the export administration regulations (EARs) and can face not only penalties, but also civil and criminal prosecution. Many small- to medium-size companies are often unaware of their obligation to comply with import and export laws and regulations, as well as the lengthy five-year statute of limitations.
A growing number of private equity firms are starting to include trade compliance as part of its due diligence scope, with good reason. Following are five common trade compliance errors that can result in penalties and other regulatory enforcement action.
- Lack of internal controls. Companies that lack internal expertise, written procedures, and resources often rely heavily on third parties such as customs brokers, freight forwarders, and even foreign suppliers for tariff classifications, licensing determinations, recordkeeping, and other trade compliance matters, often with disastrous results.
- Wrong tariff classifications. Classifying goods under the wrong tariff classification is a violation of 19 U.S.C. 1592 and can subject the importer to penalties. However, because the rate of duty is tied to the tariff classification, misclassifying might also result in underpayments or overpayments of duty. Companies that classify their own goods or have outsourced classification to competent specialists such as a trade attorney or consultant, are less likely to run into trouble than those that simply rely on the tariff classification the foreign vendor included on its commercial invoice. It is considered a best business practice for companies to keep and maintain their own harmonized tariff schedule database capturing part numbers or SKUs, product descriptions, tariff classifications, and other supporting information.
- Undervaluation of imported goods. Imported goods are appraised using a hierarchical basis of appraisement, beginning with the transaction value of merchandise that accounts for about 85% of imported goods and is defined as the “price actually paid” or “payable plus certain statutory additions.” A limitation to using transaction value is the related-party transaction where there is an absence of an arm’s-length relationship and the foreign seller and the U.S. importer or buyer are related. While a transfer pricing policy can help alleviate concerns about whether the relationship between the parties influenced the price, it alone is not dispositive and the circumstance of sale and whether a reasonable profit is earned by the seller could carry more weight. When the transaction value of merchandise is unacceptable, another – often more complicated – basis of appraisement must be used, such as deductive or computed value. Additionally, importers often are unaware that they must declare the so-called “statutory additions” when they are furnished free of charge or at a reduced rate, directly or indirectly, to the foreign supplier. For example:
- Materials, parts, and components
- Tooling, dies, and molds
- Certain engineering, design, and research and development work
- Packaging and crating
- Certain licensing fees and royalties
- Proceeds to the seller upon subsequent sale
- Unsubstantiated preferential duty claims. Importers that use free trade agreements, special trade programs, or even certain preferential duty provisions under the tariff schedule are required to present evidence that the imported goods are eligible on demand by CBP. This could include certificates of origin, as well as various other certificates, statements, and declarations set forth under the regulations. Typically, importers are granted a 30-day period to present such evidence. However, if the importer is unable to substantiate its claim, it can be assessed a duty liability and can be subjected to further scrutiny by the CBP and additional penalties.
- Export violations. Companies that export goods are obligated to comply with the EARs, including determining whether their product is subjected to any licensing requirements and evaluating whether the consignee has been designated by the U.S. government as a denied party for receiving U.S. exports. While violations might result in possible penalties, companies have faced civil as well as criminal prosecution for failing to comply with U.S. export regulations over the years, causing not only financial harm, but even reputational damage. Products that have a dual use, meaning a civilian as well as military application, are particularly risky and have been the source of various enforcement actions over the years.
