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Sourcing From China Suffers Another Blow

After four years of bad news for China sourcingtariffs and rumors of tariffs, allegations of forced labor on an almost unfathomable scale, the risk getting drawn into political crossfire—it might seem that there aren’t many shoes left to drop. Hopes that 2021 might bring a ‘return to normal’ were challenged on March 1, not by political developments or another explosive human rights exposé, but by a U.S. court ruling calling into question the viability of “first sale” for companies sourcing from China—and Vietnam too, for good measure.

If not reversed on appeal, the decision by the U.S. Court of International Trade (CIT) in Meyer Corp. U.S. v. United States imperils the use of first sale, and could increase the customs duty expense of sourcing apparel from these countries by an average of 10 to 15 percent.

Much depends not only on how the case fares if appealed, but on how U.S. Customs and Border Protection (“CBP”) decides to apply the decision to other importers. At a minimum, though, the risk associated with utilizing first sale has shifted. Companies that rely on first sale for China and Vietnam sourcing should take additional steps to mitigate the risk of exposure for additional customs duties and penalties.

First sale is widely used by apparel importers as a tried-and-true method of reducing tariff liability. If the necessary conditions are satisfied, an importer is able to value goods for customs purposes on the basis of an earlier sale in the chain of transactions leading to importation. The classic example is a three-tier transaction involving a factory (for instance, in China), a middleman (say, in Hong Kong) and a U.S. importer.

The U.S. customs value statute—that is, a law passed by Congress and signed by the president—says that an importer can value goods for importation on the basis of the price actually paid or payable “when sold for exportation to the United States.” Several decades ago, enterprising importers and their innovative customs counsel realized that this language could be interpreted to mean not just the price paid by the U.S. importer, but any earlier sale in the chain of transactions leading to importation.

These importers pressed their case in court, and the courts agreed. The landmark case from the Court of Appeals for the Federal Circuit laid out the basic requirements for first sale, which have been repeated in many subsequent court cases, and dozens of customs rulings since. In common recitation, there are three elements.

As mentioned above, the value statute specifies that a transaction value must involve a “sale for exportation,” so that’s element No. 1. Goods sold in a valid first sale must be clearly destined to the United States at the time the sale takes place.

John Foote
John Foote courtesy

The other two “elements” of first sale aren’t actually unique to first sale; they’re simply reiterations of requirements that apply to the use of any sales price as a customs value. If you want to declare a sales price as a customs value—whether it’s a first sale, a last sale, or something in between—it must be a “bona fide sale” that occurs at “arm’s length.” Those are elements No. 2 and No. 3.

The CIT began its opinion in Meyer with the eyebrow-raising assertion that a company seeking to utilize first sale must satisfy four elements, not just three. New to the mix in 2021? An importer must also prove that the proposed first sale price is “absent any distortive nonmarket influences.”

The idea is that in a non-market economy (an official status conferred on China and Vietnam under U.S. law), non-market influences could result in artificial depression of prices for any number of reasons—because the production of cotton is subsidized, because factories take a government payment to employ certain workers, or because polyester manufacturers don’t have to pay market rates for rent or utilities, just to name a few examples. The decision in Meyer now suggests that an importer must have some proof that the first sale values it wishes to use are not influenced by these types of distortions. The CIT frames this both as a new, fourth stand-alone requirement for first sale, and as a previously unexplored dimension of the arm’s length rule.

Where did this new legal requirement sprout from? Turns out, it was there in that seminal Court of Appeals decision all along. That court held in 1992 that: The manufacturer’s price constitutes a viable transaction value when the goods are clearly destined for export to the United States and when the manufacturer and the middleman deal with each other at arm’s length, in the absence of any non-market influences that affect the legitimacy of the sales price.

For whatever reason, that final “requirement” was simply overlooked for decades. Though this paragraph has often been quoted by CBP in rulings on first sale, it has seldom, if ever, been recognized as a legal element requiring supplemental documentation or proof. Yet in an era where everyone is looking at China trade a little bit differently, everyone, it seems, includes U.S. courts.

So where does this leave apparel and footwear importers, which rely on first sale for more than $5 billion in annual imports?

Let’s hit the good news first.

For starters, first sale has not been abolished. The customs value statute hasn’t been changed, and a sale for exportation to the United States, if it meets the requirements applicable to any transaction value, should be an acceptable customs value, regardless of your politics. Moreover, there are both legal and practical arguments that could limit the impact of the decision in Meyer.

That said, whether the case is appealed or not, all importers relying on first sale should reevaluate their first sale programs in light of this case. Even in ordinary times, first sale programs require active maintenance and consistent self-auditing to avoid devolving into risky monstrosities. With a new legal requirement in the mix, importers should be proactive in assessing their exposure, and developing a strategy for compliance and risk reduction.

John Foote is a partner in the international trade practice at Kelley Drye & Warren LLP in Washington, D.C.  Views expressed are his own.