With little fanfare, the US Department of Commerce’s Bureau of Industry and Security (BIS) recently placed on its Advisory Opinion Web site an advisory opinion dated September 14, 2009 on what it calls the “Secondary Incorporation Rule.” This rule addresses a key question that many a non-US company has had in trying to figure out whether its foreign made products are subject to US export controls because they contain more than de minimis US content (either 25 percent generally or 10 percent for certain US embargoed or sanctioned countries). See BIS Advisory Opinion here.

Let’s take an example. Suppose British company A produces aircraft landing gear in England, using US parts and components to do so. These US parts and components account for 50 percent of the ex factory price of the landing gear to German company B.

German company B produces an airplane in Germany using parts and components that are both United States in origin and European in origin, including the British landing gear. Counting only the US-origin equipment, the US content is nine percent, but if the US content of the landing gear is added to that, the total US content is 11 percent, rendering the aircraft subject to US export controls for purposes of export or transfer to US embargoed and sanctioned countries.

What should the German company B do?

As in many things export controls-related, even with the BIS new Advisory Opinion on the “secondary incorporation rule”, the answer is, gather more information to see if the secondary incorporation rule applies. Here’s why.

According to the Advisory Opinion, the secondary incorporation rule:

generally states that US-origin components [ ] 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). This principle may be employed only if a ‘first’ incorporation has actually been completed, resulting in a foreign-made discrete product. In other words, the US-origin components must be incorporated into a ‘first’ discrete product before a ‘second’ incorporation can occur, and the level of US-origin content in the ‘first’ discrete product must be considered until that product’s ‘second’ incorporation is complete.

BIS explains that the purpose of this rule 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, US-origin content those foreign-made products contain.

This all sounds promising so let’s apply it to British company A’s landing gear and German company B’s aircraft. If the British landing gear is a first discrete foreign-made product and the German aircraft is the second discrete foreign-made product, then we have reached the “secondary incorporation” for the German aircraft and the British landing gear is treated as wholly British for purposes of the de minimis calculation, rendering a nine percent figure. In short, due to the secondary incorporation rule, the aircraft not subject to US export controls under the Export Administration Regulations.

But what is a “discrete” product anyhow? BIS explains that:

[w]hether a particular foreign made item incorporating US-origin items is a discrete product depends on the facts of a particular case, and it is helpful to keep the purpose of the second incorporation principle in mind when evaluating a particular situation. 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 B purchased a 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 US-origin components of that recorder would not need to be taken account of when determining the amount of US 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 B helped A design a flight data recorder specifically for a B aircraft or chose the components that were to go into the recorder, then those actions by B would be indications that the flight data recorder is not a discrete product.

What does that mean when applied to our British landing gear manufacturer A and its German customer B?

Well, if A and B are affiliated companies and A sells the landing gear to B at a transfer price, it means that there may be at least some question whether the landing gear is a discrete product as it may not have been sold at an “arm's-length” price. In addition, if A and B are unaffiliated companies but B assists A to design the landing gear for its aircraft (since the landing gear will undoubtedly have to work with B’s aircraft), there may be a question as to whether the landing gear is a discrete product. So non-US manufacturers cannot apply the Secondary Incorporation Rule blindly based on the country of origin of the parts and components particularly in cases where: their non-US parts supplier is an affiliated company, or where they work together with that non-US parts supplier to design the parts in question.

Moreover, the Secondary Incorporation Rule does not apply to parts to which the Export Administration Rule expressly says the de minimis rule does not apply, such as for foreign made commercial primary or standby instrument systems and aircraft that integrate QRS11-00100-100/101 Micromachined Angular Rate Sensors. Nor does it apply to parts and components subject to the International Traffic in Arms Regulations (ITAR). Moreover, when contemplating sales to US embargoed and sanction countries, such as Cuba, Iran, and Sudan, non-US companies should also examine the Asset Control Regulations of the Office of Foreign Assets Control (OFAC) of the US Department of Treasury, which contain different de minimis and other legal provisions.

This does not mean that the Secondary Incorporation Rule is not useful. It is in fact a clearly written and defined safe harbor to non-US manufacturers who are doing their best to understand when US export controls apply to their foreign-made products and when they do not. It just needs to be used with some caution and open eyes as to its limitations.

Should you have any questions, please contact the Arent Fox attorney with whom you work or a member of Arent Fox’s International Trade Practice Group.

Kay C. Georgi
georgi.kay@arentfox.com
202.857.6293