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Psst, Tax Professionals:
Customs Duties are an Indirect Tax

Mark K. Neville, Jr.

From time to time there is speculation about whether the U.S. should adopt a national sales tax, such as a Value Added Tax (VAT). As many will already know, the U.S. is the only major economy without such a tax regime. We can leave aside the question whether the non-progressive nature of a VAT is politically unacceptable in the U.S., a country where a significant portion of the population pays no income tax. But by referring to a VAT the door is opened to a discussion of indirect taxes more generally.¹

At the federal level we already have an indirect tax regime—excise taxes on some selected products, such as spirits and sport fishing gear. We can guess that most tax practitioners will be aware of even if not familiar with these federal excise taxes.

But there is a need to raise the level of awareness in the ranks of tax professionals to that other federal indirect tax—customs duties. The relevance of such an increased awareness is certainly perceived if the taxpayer is an importer of tangible products. After all, imported products will attract a duty, this topic being the subject of most of the discussions presented in this column. But we can see that even “indirect importers”—those companies who buy the goods in the U.S. from companies who had imported them—should be aware of the impact of customs duties. This is especially because, as an indirect tax, the prevailing effect is that the cost of the duty will be passed along to the customer. This is the concept of the “forward shift” of such taxes.

Another familiar notion is that a product exported from one country will become an import in another country. As a result, a tax professional working for or advising an exporter should be cognizant of the customs duty impact on that product. The importer in the foreign market may be the exporter itself, in those countries such as the U.S. which allow non- resident importations, or an affiliate. Customs planning and compliance should be of concern to the exporter. But there may be a similar concern even for exports to and the corresponding imports by a third-party buyer. That is the case where the exporter may advise the foreign buyer in a way that lowers the buyer’s costs, e.g., in providing the proper tariff classification, carrying a lower duty rate, or in furnishing information that supports the eligibility for a free trade agreement duty-free treatment. At the same time, the exporter may be called upon to provide false documents—such as a double invoice scheme—to lower the buyer’s duty and VAT obligation at the time of import. Such an endeavor should be avoided at all costs. Not only would such false documentation subject the U.S. exporter to liability in the foreign market, it would raise U.S. compliance issues as well.

By now you should have deduced that the audience for this piece are the tax professionals amongst us, specifically to make the point that customs duty planning and compliance deserve a spot in the overall tax advisory function whenever tangible goods are involved. The traditional focus of the tax professional was on federal or state income tax. Beginning in the 1990s we started to see that the state and local taxes (SALT) were demanding attention and the result is that there is now a mature practice area that is centered on sales tax levies. That concentration is even more justified in this e-commerce environment.

In very much the same fashion, there has been something of an awareness that customs duties can take a bite out of an importing company’s above the line revenue. For those taxpayers who are aware of this some customs planning strategies may bring those costs down. But the first step is the access to the data which shows what the annual customs duty bill will be. In this day of data analytics and supercharged ESP systems and access to the customs data in the Customs and Border Protection system via the Automated Commercial Environment (ACE) there is no excuse for not digging out those costs rather than leaving them deeply buried within transportation or logistics expenditures. Once measured, those costs can be managed.

That last point is an important one to grasp. Many professionals make the mistake in assuming that customs duty costs are fixed and that the only question is how much of that cost can or must be absorbed vs. being passed along to customers. With that mindset, it hardly makes sense to find out what those costs are because, from that approach, nothing can be done about them after they have been ascertained.

But the reality is that, true to their indirect tax roots, as you will see below, we often find that customs duties may be lowered through astute planning strategies.

Why Should Tax Professionals Care?

The first answer to note here is that customs duties are taxes. It is usually well to begin at the beginning. With customs duties, that takes us back to the Tariff Act of 1789. From that starting point until the coming of the income tax in 1913, it was customs duties that provided the bulk of revenues for the federal government. While the major share of federal revenues nowadays comes from income tax, and individuals’ tax payments at that, the customs duty share of $100 billion (in 2022) is a small but significant revenue source for the federal government.

What are typical duties in the U.S.? The answer is it depends. It is true on an overall basis that the average duty rate is in the 3- 4% range after the reductions from the 1930 Tariff Act levels. Those reductions arose in the successive rounds of multilateral tariff negotiations under the General Agreement on Tariffs and Trade (the GATT) and the World Trade Organization (WTO). While some duties are rated free— e.g., furniture, toys, pharmaceuticals, civil aircraft parts—other product sectors spike to over 30% (certain apparel) or have significant duties (food, footwear). As a result, income tax professionals who might be ready to dismiss customs duty planning because the duty is thought to be of lesser consequence than the “effective rate” of income tax should be encouraged to rethink that. And especially because these are above the line expenses. All of this means that customs duties are taxes and they may be significant. Why would tax professionals not be interested in managing that exposure?

Who should be responsible for monitoring customs duty obligations?

Here we find that the assignment of responsibility will vary from one company to the next. Some companies will place this functional area within the tax department, which is fitting given its status as an indirect tax. Other companies will place the function within a line reporting to the legal department, which is appropriate given the challenge of the importer’s legal responsibilities.²

High performing companies will typically avoid giving the customs function to the transportation or logistics function, because the focus in those departments is more on the “fast” and “cheap” movement of goods across borders rather than a movement that is also legally correct. As a result, in these companies there is a tendency to override concerns about compliance. That is a mistake because out-of-compliance customs transactions can cost the importer dearly.

One indication of the tax professionals’ responsibilities for customs duties is that the Big 4 and other accounting firms have trade and customs functions housed within the international tax function.

Compliance Obligations

Starting with the Customs Modernization Act of 1993 (the Mod Act) the U.S. Congress has placed the responsibility for complying with a myriad of statutory obligations on the shoulders of the importer of record. The long-accepted response of “my broker takes care of that” when asked how the importer will ensure the correct tariff classification, for example, was thrown out. Instead, the Mod Act requires that the importer must own that responsibility. The importer must demonstrate that it has an institutional capability to discharge that tariff classification and other responsibilities.

One way to do that is to show it has adequate internal controls, e.g., that it has a process and procedures manual and that the staff has had adequate training. A smart company will have sufficient internal expertise, in the same way that the tax function is typically staffed internally by professionals with public accounting experience. That in-house tax professional approach should work as a model for internal staffing here, with the company looking for credentialed professionals. Such credentials could include status as ex-CBP officers, licensed customs brokers and ex-Big 4 or law firm staffers. The goal is to have a Best-in-Class roster of internal employees who are able to effectively team with trusted outside advisors such as-lawyers, accountants and brokers. For the latter group, their expertise is strongest in the customs clearance process, with lawyers and accountants being better positioned to handle more complex assignments such as prior disclosures, customs valuation questions and duty drawback. In any event, a high- performing company will want to manage the broker function, closely reviewing entries in real time and allowing for timely corrections to be made via Post Summary Corrections (PSCs).

Ideally, the importer, assisted by outside advisors as necessary, will want to compile a “tariff classification database.” Annotated to show the reasons for the classification being assigned, e.g., rulings, case law, Explanatory Notes, the database will be organized on a Stock Keeping Unit (SKU) basis and provided to the broker with instructions to the broker to write the entries using those assigned HTS numbers. That is one way to mitigate the chances of errors and to ensure consistency in tariff treatment.

Once the right team is in place and the compliance responsibilities have been met, the tax professional will turn to planning opportunities, the challenge to lower the effective tax rate being built into his or her DNA.

Planning Opportunities

As is the case with many taxes, as already noted, opportunities for custom duty savings may present themselves. The first goal is to eliminate duties entirely.

Duty Elimination

Origin will determine whether the imported products will enter the U.S. with no duty. In one strategy this will be as a result of eligibility for a Free Trade Agreement (FTA), such as the USMCA or the Australia-US FTA. There are almost 20 such FTAs at the present time, with the obvious benefit being a savings on customs duty and on the Merchandise Processing Fee (MPF) for qualifying imports. For those companies with an eye for exports, the advantage lies in duty free access to partner country markets, such as Canada, Mexico and Australia in the two examples just cited.

GSP

Another origin-based, duty elimination program is the Generalized System of Preferences (GSP), which allows for duty free entry into the U.S. for goods that qualify. The GSP is a unilateral tariff preference program that benefits certain Beneficiary Developing Countries (BDCs) if the importer can show that the goods were produced with a 35% local origin. Note that there are some regional programs as well, such as the Caribbean Basin Initiative (CBI).

TIB

Another duty-elimination scheme exists for those products which will be imported only temporarily and then re-exported. These are the Temporary Importation Bond (TIB) provisions.³ One of the primary uses of the TIB program is to allow for repair, alteration or processing in the U.S., with the goods being re-exported after those processes have been completed.⁴ Our European friends will recognize this as the familiar “inward processing relief.” By posting a bond, no duty is due at the time of entry. One catch is that 100% of the goods coming in under that TIB provision must be exported or destroyed. Failure to do so results in a liquidated damage claim, a compliance measure, for a breach of the bond promise to timely destroy or re-export.⁵ That bond is double the duty that would have been due.

Bonded Facility

A final duty elimination result may be attained through use of a bonded facility. Placing the imported goods after entry into a foreign trade zone (FTZ) or customs bonded warehouse (CBW) and then withdrawing them for immediate export will mean that no duty will be required. The goods are never entered into the commerce of the U.S. For those goods that are entered for consumption from the FTZ, the duty is not collected until the goods are taken from the bonded facility. This deferral can be a nice cash flow strategy. Note, too, that goods may be withdrawn from an FTZ on a weekly basis. This may lower the number of entries made, with a resulting savings in MPFs, which are levied on a per-entry basis

. Duty Drawback

If the duty cannot be eliminated altogether, the next best alternative may be to seek a refund of the duty. That thought takes us to the duty drawback program, which is as old as the program of levying customs duty. Under duty drawback, a refund of 99% of the duties paid on previously paid imports will be available upon the export of those goods or merchandise manufactured from them. Drawback is especially attractive for goods imported from China on which Section 301 tariffs of 7.5% to 25% have been levied in addition to the normal duties. Those tariffs are especially onerous for those product sectors whose imports are normally duty free, such as integrated circuits or some furniture. Imagine the impact—free of duty to 25% overnight. That is an eye-opener and many companies who would have had no impetus to assess dutysavings when the duty rate was free or, say, 3%, suddenly became converts to the cause. A 25% tax is enough to attract the attention of most tax professionals. terials in its production so as to qualify for tariff classification in an item number that carries a lower duty is usually referred to as “tariff engineering.” One might surmise that this is akin to sourcing a product from one country vs. another and thereby qualify for a duty-free status, which we saw earlier. Tariff Engineering This brings us to the notion of lowering customs duty. The practice of designing an imported product or using certain materials in its production so as to qualify for tariff classification in an item number that carries a lower duty is usually referred to as “tariff engineering.” One might surmise that this is akin to sourcing a product from one country vs. another and thereby qualify for a duty-free status, which we saw earlier.

Tariff Engineering

This brings us to the notion of lowering customs duty. The practice of designing an imported product or using certain materials in its production so as to qualify for tariff classification in an item number that carries a lower duty is usually referred to as “tariff engineering.” One might surmise that this is akin to sourcing a product from one country vs. another and thereby qualify for a duty-free status, which we saw earlier.

Customs Valuation Strategies

Apart from those two gambits, the importer might choose to engage in planning by looking at the last of the three elements which dictate the duty rate due at importation. For most products this is customs valuation. This is because most customs duties are assessed on an ad valorem basis, meaning the duty rate is applied against the customs value of the imported product.

Getting into customs valuation takes us closest to the point of contact between the tax and customs disciplines. In fact, there is a point of actual intersection when we consider transfer pricing, the price in a sales transaction between related parties or members of a controlled group if you prefer. The customs authorities will reject such a sale price as the basis for a transaction value appraisement if they are not satisfied that the relationship did not influence the price. International tax planning strategies that would raise customs questions, such as separate royalty or license fee payments that may be related to the imported goods, must be carefully considered. Tax professionals may take a lead role here but any strategic decision must be made only with the input of a customs team that is well- prepared to advise on the customs consequences. An example of a failed strategy might be the stripping of nearly all functionality from an importing related party distributor. That plan may justify a lower return for the distributor and lower the tax burden but it may come at the cost of the distributor being cast as a mere facilitating agent and the qualifying sale for export being that in which the buyer is the customer in the country of importation. And, yes, that price is fully marked up, with the result being a higher customs duty bill.

There are potentially many other planning opportunities but space here is limited. Let me close with one that still resonates in the U.S. That is the First Sale for Export doctrine. The strategy will work if there is a series of sales, e.g., the U.S. buyer places an order on a foreign vendor and that vendor then places an order on a factory to fill the U.S. buyer’s order. If the importer has access to the documentation and can show that the factory-to-vendor sale is at arm’s length and that the order was destined for the U.S., then U.S. customs will treat that first sale as the qualifying sale for export on which a transaction value appraisement can proceed. In effect, the importer will lower the customs duty exposure by pulling out the vendor’s markup from what is effectively the tax base.

Conclusion

For those tax professionals who are already aware of the customs duty status as a tax, the foregoing may be a useful reminder. For those tax professionals who have not had that focus to this point, perhaps this may serve as a wake up call. Mitigation strategies abound and compliance hazards are thick on the ground. It’s best to be prepared to seize those opportunities and to avoid those pitfalls.

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