Many non-US-manufactured products are still trapped under the US long-arm jurisdiction of the Export Administration Regulations (EAR).1 Whether or not foreign-made products incorporating US-origin content or manufactured from US-origin technology, machines or plants is now a primary consideration of major international technology and telecommunications companies because of the expansion of export prohibitions over the last decade.
When does a non-US-made product incorporating US-origin components or technology escape the technical jurisdiction of the EAR? One important published exemption from EAR control (or from being subject to the EAR) involves a concept known as the “second incorporation rule,” which will be described herein as the “second incorporation principle.”
The US Department of Commerce, Bureau of Industry and Security (BIS) published a redacted advisory opinion clarifying the application of the EAR to foreign-made products incorporating other foreign-made products with US-origin content. In particular, BIS issued written guidance permitting foreign manufacturers to disregard US-origin content incorporated by others into foreign-made products that are, in turn, incorporated into their product. This permits foreign manufacturers to apply more easily the de minimis exemption from US reexport control under the EAR. Israeli companies with operations in the United States should be aware of the technical jurisdiction of the EAR.
US controls on reexports of US-origin products
The US Department of Commerce controls shipments of commercial and dual-use products and technology. These controls are authorized by the Export Control Reform Act of 2018 and implemented by the EAR. The Department of Commerce has published a list of controlled products and technology (the Commerce Control List) in the EAR. Items on this list are controlled principally for reasons of national security, foreign policy, missile technology proliferation, nuclear, chemical and biological weapons proliferation and anti-terrorism. Depending on the classification of an item on the list and the country to which it is being shipped, an item may be exported or reexported without a license (NLR), under a license exception, or with an export license.
The US Department of State controls exports of items which at the time of export, are designated as military and included on the US Munitions List (USML). These controls are authorized by the Arms Export Control Act and are administered by the Directorate of Defense Trade Controls (DDTC) within the US Department of State under the International Traffic in Arms Regulations (ITAR). Other US government agencies control the transfer of more specialized items such as nuclear materials and technology. There is no de minimis exemption for incorporated USML content in foreign-made products. Therefore, the de minimis exemption described herein is limited to EAR-controlled items.
The EAR applies to exports of commodities, software and technical data (items) from the US to foreign countries and to reexports from one foreign country to another. In addition, it applies to shipments from one foreign country to another of foreign-made products that incorporate more than 10 percent or 25 percent US origin parts, components or materials by value, depending on the country of ultimate destination. The EAR may not impose a prior licensing requirement on the reexport of a foreign-made product incorporating US-origin content, but if so, the de minimis exemption may provide relief from such a requirement.
The EAR de minimis exemption
If the foreign-made item incorporates less than the de minimis level of US content, the foreign-made item (commodity, software or technical data) is considered outside the scope of the EAR.3 US-origin incorporated content that is hardware, software (including source code) and technology must be analyzed separately in applying the de minimis exemption.
The EAR de minimis exemption is not available to exempt foreign-made products from reexport control under the EAR. The following foreign-made products remain subject to EAR reexport control jurisdiction:
- Computers to certain destinations with an “Adjusted Peak Performance” exceeding specified levels and containing certain US-origin controlled semiconductors (other than memory circuits) or high-speed interconnect devices.
- Encryption technology incorporating US-origin encryption technology (Export Control Classification Number (ECCN) 5E002).
- Gas turbine technology described in parts of ECCN 9E003.
- Certain foreign-made military commodities.
- Certain spacecraft-related items (ECCN 9×515) and items formerly included on the USML (600 series).4
Additional catch-all controls may further restrict the activities of US citizens and US residents abroad, primarily related to proliferation of weapons of mass destruction and missiles. However, a non-US-manufactured item that incorporates US-origin EAR controlled content equal to or below the de minimis threshold is not subject to the EAR. Regulations administered by the US Department of the Treasury, Office of Foreign Assets Control (OFAC) may restrict the transactions and reexports by US-owned or controlled entities notwithstanding the EAR de minimis exemption.5
Calculation of de minimis content
In order to apply the de minimis exemption, one must determine the ECCN of each US-origin item incorporated into a non-US-made product. Then, a determination must be made whether the US-origin item is “controlled” for reexport to the new country in the form received. For example, if a German-made router incorporates a US-origin integrated circuit classified for export under ECCN 3A001 and also incorporates several US-origin integrated circuits classified for export under ECCN 3A991 and a power supply that is EAR99, and the router is to be exported to China, you only need to count the value of the ECCN 3A001 item as US-origin controlled content. This is because the ECCN 3A991 integrated circuits and the EAR99 power supply may be exported to China from the US without a license. If the cost of the ECCN 3A001 integrated circuit was USD200 and the sale price of the router was USD1 thousand, the percentage of controlled US content would be 20% and the router (with its incorporated content) would be eligible for export from Germany to China under the de minimis exemption.
In establishing the proper relative values to assign US-origin content, use the actual cost to the non-US manufacturer unless it is not reflective of fair market price. If it does not reflect fair market price because of special arrangements, then a value reflecting the fair market price where the non-US product is being produced should be used. For the non-US-made product value, the actual sale price should be used unless it does not reflect the fair market price that would normally be charged to unaffiliated customers in the same foreign market. Again, if this is the case, then the fair market price that would normally be charged to unaffiliated customers in the same foreign market should be used instead.
“Controlled” content: What is controlled?
US-origin content must be “controlled” to the country of ultimate destination before it must be counted as US content under the de minimis rule. If any of the US-origin content can be exported or reexported to the new country of ultimate destination under a License Exception published in the EAR, or without a license, then it may be disregarded as US content. For example, aircraft avionics classified for export under ECCN 7A994 may be exported to any country except to terrorist designated/embargoed countries (Groups E:1 and E:2) (Cuba, North Korea, Iran, and Syria). Therefore, such content need not be counted when performing a de minimis calculation on a foreign made aircraft destined for all but the E:1 and E:2 countries. On the other hand, if the export of the non-US product is to an E:1 or E:2 country, all or most of such content must be counted and the lower de minimis threshold applies (10%). The rule operates on a sliding scale that becomes very strict for the E:1 and E:2 countries. The prime example of just how strict the rule becomes is when applying the rule to a reexport to Syria. At present, all items subject to the EAR (with limited exceptions) require a license for export or reexport to Syria. Therefore, in the aircraft example above, all US-origin content on the aircraft, including carpeting that may be classified for export under EAR99 must be included in the calculation, thereby raising the percentage of US-origin content.
Certain information or technical data are never subject to EAR controls. These include the following categories of information and may be excluded from any de minimis calculation:
- Publicly available technology and software (except encryption)6
- Technology or software outside the US that includes less than a de minimis amount of US commingled technology or software (except encryption)7
- Items controlled by other government agencies (eg, munitions, nuclear materials)8
- Publications (including newspapers and periodicals), printed books, pamphlets, etc.9
What is “incorporated”?
An item is “incorporated” in the foreign-made item if it is:
- Essential to the functioning of the foreign equipment
- Customarily included in sales of the foreign equipment and
- Reexported with the foreign produced item.
In addition, US-origin software may be “bundled” with foreign-produced hardware and may be treated the same as an incorporated component within the hardware de minimis calculation. Software may be “bundled” with the foreign-produced product if it is reexported together with the product and is configured for the product, but is not necessarily physically integrated into the product. If US-origin software is not “bundled” with or incorporated into a foreign-made hardware product, or incorporated into a foreign-made software product, then it is not eligible for the de minimis exemption.
Second incorporation principle
The second incorporation principle has long been an unwritten policy of BIS when applying the de minimis exemption to foreign manufactured products incorporating US-origin content.
The published opinion is a double-edged sword: On one hand, it provides concrete guidance for non-US manufacturers to use in the application of the second incorporation principle, but, on the other, it outlines a “discrete product” test to limit its application in certain cases.
The advisory opinion was published on the BIS website on January 6, 2010 and is dated September 14, 2009. BIS clarified in the advisory opinion that:
“The second incorporation principle generally states that US-origin components that are 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 (ie, after the second foreign incorporation).”
BIS further noted that the principle may be employed only if a first incorporation has actually been completed, which results in a foreign-made “discrete product.” BIS further clarified that the US-origin components must be incorporated into a first discrete product before a second incorporation can occur. Until the second incorporation occurs, the original first product must be analyzed with all of its US-origin content for the purpose of EAR reexport controls.
As outlined above, before the second incorporation principle can be applied to exempt prior incorporated US-origin content, the content must be contained in a “discrete product.” BIS outlined the following facts that would weigh in favor of a “discrete product” determination:
- The product was purchased in an arm’s length transaction and
- The product is regularly sold by itself, either as a stand-alone product or as an identifiable replacement for a particular product.
Alternatively, BIS noted that 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. BIS used avionics equipment as an example of discrete products that are secondarily incorporated into aircraft. Aircraft manufacturers often have no visibility into the US-origin content incorporated into foreign manufactured avionics devices that are incorporated into their aircraft.
Foreign manufacturers are directly affected by this principle
The second incorporation principle is aimed squarely at the interpretational problems that non-US companies encounter when purchasing foreign-made products for their manufacturing operations. As such, the principle permits foreign manufacturers to apply the EAR de minimis exemption with reasonable certainty. This may allow many foreign-manufactured products to be more easily released from export controls under the EAR.
Unfortunately, the advisory opinion also raises questions in certain transactions, particularly among affiliated companies. For a stand-alone manufacturing operation, which is not a part of a larger group of affiliated companies, the second incorporation principle may be applied in a straightforward way, ie, all non-US-origin products may be treated as non-US content. However, where affiliated companies share resources and information, knowledge of the US-origin content in another company’s product may disqualify the product from being treated under the second incorporation principle as a “discrete product.” Whether a non-US-origin component can be declared by a non-US manufacturer as a “discrete product” will depend on the facts and circumstances in each case. Documenting the analysis and resulting decision can provide a “safe harbor” from possible future inquiries from US export control authorities.