Request for Internal Advice; GSP; cookware; Nissho; related parties; sets

HQ H088815 September 28, 2011 CLA-2 OT:RR:CTF:VS H088815 KSG CATEGORY: Classification Field Director Regulatory Audit U.S. Customs and Border Protection 555 Battery Street San Francisco CA 94111 Re: Request for Internal Advice; GSP; cookware; Nissho; related parties; sets Dear Field Director: This is in reference to your memorandum dated December 18, 2009, requesting Internal Advice regarding the issue of whether certain steel and clad metal cookware imported by Company B is eligible for preferential treatment under the Generalized System of Preferences ("GSP") and whether the imported cookware may be appraised based on the sale between the foreign manufacturer and the related middleman. We have considered a submission from counsel dated August 6, 2010, which also deals with the issue of the eligibility and calculation of the 35% value-content for sets of imported cookware that include Chinese-made glass lids. At the request of counsel, a meeting was held on this matter at Headquarters. Additional submissions dated February 26, 2010, and February 18, 2011, are included in the file and were considered in this case. We have partially granted the Company's request for confidentiality in this case. FACTS: The case involves imported pots, pans and lids. Company B is the importer of record and is a wholly owned subsidiary of Company P. The pots are manufactured by Factory C and purchased by Company M or Company N. Further, the raw materials are purchased from related parties (and sometimes unrelated parties) such as xxx. CBP sampled 60 unliquidated GSP entries dated December 28, 2007, through September 25, 2008. The Office of Regulatory Audit concluded that 42 of the 60 entries did not meet the 35% value-content requirement for the GSP. Production of Pots and Pans The first step in the production of the pots and pans occurs in Country C or in China, where steel coil is cut into circular shapes or stainless steel blanks that are stamped to form the shell of the pan. To cut the blank, a mold is placed on an automatic blanking machine and the machine is programmed to cut the steel to the required diameter. Sample blanks are cut to shape, and checked and inspected for quality control. If the samples are satisfactory, mass production is commenced. The remainder of the processing of the pots and pans takes place in a facility in Country C. The circular blank is sent to the deep drawing machine where it is stamped by the mechanical action of a punch to create the shell of the pot. Quality control is then performed. After stamping of the shell, the edge is edge blanked, which means that the edges of the shell are made smooth. In some cases, friction bonding is used to bond the steel shell with an aluminum heat-conducting disc. The aluminum disc improves the conductivity and durability of the finished pots and pans. Not all the pots and pans are friction bonded. Friction bonding is done by spot welding the steel shell, aluminum disc and an additional stainless steel disc together. The piece is then fed into an auto forging machine which heats the plates in order to join them. At the screw press, the piece is marked with lettering (capacity code and date code). The pieces are then cooled and again undergo quality control. Next, the piece undergoes interior and exterior polishing, bottom base finishing and cleaning. Custom made machine molds, polishing fabric and polishing wax are used. The bottom base finishing is performed by a separate machine. Edge beading is also performed by a separate machine. Some products undergo annealing, which involves heating the metal to strengthen it and improve its cold working properties. A custom made machine performs bulging while the metal is heated up. Finally the piece undergoes both interior and exterior polishing and the handle is assembled onto the pot and pans, which are then packed. Counsel also submitted a chart that shows a breakdown of the value added at each stage of production by percentage. Blanking accounts for 6% of the total labor costs of production, stamping accounts for 7% percent of the total labor costs of production, and the remainder of the processing that occurs after stamping accounts for the majority (88%) of the labor costs of production. We were not provided with any information regarding what percentage the total labor costs of production of the imported pots and pans are, compared to the total costs for the materials used to produce the pots and pans. The August 6, 2010, submission relates to 10-piece cookware sets that include four glass lids that are produced in China with 6 pots and pans produced in Country C. First sale Issue The Group's website states that it is xxx and that it manufactures xxx. As described above, this case involves a related importer, middleman, manufacturer, and parent corporation. Some of the suppliers of raw materials are also related parties. Company B states that it performs the following functions: acts as the purchaser and importer of record, places orders for merchandise with its offshore related suppliers Company M and Company N, purchases finished merchandise from related companies Company M and other affiliates, and settles payment to Company M and Company N. Company M engages in the design, sales and marketing of xxx cookware and other related products. It contends that it receives and processes orders placed by Company B for merchandise destined for the U.S., places orders for merchandise with Factory C, purchases merchandise from related companies, sells merchandise to Company B, settles payment to Factory C for merchandise sold to Company B and receives payment from Company B for merchandise. It states that it also is responsible for settling product defect claims relating to products sold in the U.S. Factory C is based in Country C where it manufactures and operates xxx. Factory C receives orders for merchandise from Company M, purchases raw materials. sells merchandise to Company M, and receives payment from Company M for merchandise. Factory C manufactures and sells exclusively to related companies for further distribution to domestic and overseas markets. The Office of Regulatory Audit in San Francisco, California, completed a Focused Assessment ("FA") Referral Audit Report dated August 31, 2009 ("the Audit Report"), of Company B. Company B requested duty refunds by claiming the "first sale" between the middleman and factory as the basis of appraisement. The Audit Report concluded that Company B was not entitled to claim "first sale" for entries valued at $xxx, because these entries involved first sale transactions between a related manufacturer and middleman that did not satisfy the arms length requirement. The remaining $xxx involved first sales transactions where the manufacturer was not a related party. Further, the Audit Report examined a statistical sample of unliquidated entries for the period of December 28, 2007 to September 25, 2008, and determined that of 60 entries examined, 42 entries did not satisfy the 35% value-content requirement for GSP. Of the 60 entries, only two entries were filed in December 2007. The remaining entries were filed in 2008. The Audit Report concluded that the 35% value-content requirement was not met for 42 entries because foreign-origin materials did not undergo a double substantial transformation and therefore, could not be counted toward the 35% value and because CBP determined that first sale should not be used as the basis of appraisement, which affected the value used for the denominator in the formula for the 35% value-content calculation. The Audit Report found that 3 of the 60 entries involved a first sale between Company M and an unrelated manufacturer, xxx. These entries were found to satisfy the first sale requirement. According to the Audit Report, the unrelated manufacturer manufactured tea kettles, which Factory C does not produce. Of the 60 entries, 58 entries were from calendar year 2008. The Audit Report reviewed a transfer pricing study conducted by PriceWaterhouseCoopers ("PWC") dated September 23, 2008, that dealt with the use of first sale methodology, for the period ending December 31, 2007 ("PWC Study"), and concluded that the PWC Study, which examined seven (7) Country C xxx cookware companies, was not sufficient to establish that the prices were settled in a manner consistent with the normal pricing practices of the industry in question. Further, the Audit Report concluded the PWC Study was insufficient to ensure recovery of all costs plus a profit that is equivalent to the firm's overall profit, in sales of merchandise of the same class or kind. The CBP FA also reviewed company documents including: the Master Manufacturing Agreement; the Master Distribution Agreement; several e-mails; consolidated financial statements for Company B for 2005, 2006, and 2007; updated unaudited financial documents for Factory C and Company M for 2008 and 2009; and a table marked Exhibit C titled "Updated Benchmarking Analysis." We note that Company B did not submit any financial documents for Company P, which is the parent corporation of the xxx. Company B submitted two documents which are identified as the basis of the intercompany transactions: a Master Manufacturing Agreement between Factory C and Company M, dated February 14, 2003; and a Master Distribution Agreement between Company M and Company B dated May 16 2003. The Master Manufacturing Agreement provides for a minimum order obligation from Company M to Factory C and that Factory C agrees to manufacture goods ordered by Company M via purchase orders. Company M agrees to own or procure the technology at its own cost. The terms of sale are FOB Country C port - title and risk of loss to the product shall pass to Company M upon delivery. The Master Agreement states that "the per unit price of each type of the Products shall be such amount as is reasonably prescribed by the company (Company M) in the relevant purchase order or such other amount as the Company (Company M) and the supplier (Factory C) may from time to time agree." The Master Distribution Agreement provides that Company B is the distributor and must pay for the goods within 21 days of invoice. Company M owns the imported goods until the total amount owed is paid in full. Risk passes to Company B from the first to occur of the passing of property to the distributor or the physical delivery of the products to the distributor. The company (Company M) must charge the distributor (Company B) the prices which have been negotiated and agreed upon by the parties prior to the placement of orders for the products. Company B also submitted the PWC Study which was conducted to determine the arm's length nature of the related party transactions between Factory C and other related companies in the Group. As stated in the PWC study, the Transaction Net Margin Method ("TNMM") was chosen as the most appropriate method for testing the operating results of Factory C. The TNMM compares the operating profit earned by one of the parties engaged in the controlled transactions to the operating profits earned by uncontrolled parties engaged in similar business activities. The PWC Study searched for companies in Country C engaged in the manufacture of cookware products during 2002-2006 and identified seven (7) companies. The Return on Total Cost ("RTC") was selected as an appropriate profit level indicator. The PWC Study concluded that the TNMM analysis showed that the operating results of Factory C fell within the range of the adjusted operating results of the seven selected independent Country C companies. The five year weighted-average ROC of Factory C is 4.99% while the five-year weighted average ROC adjusted to the tested party of comparable independent companies ranged from 2.71% to 7.08%, with a median of 3.92%. Therefore, the report concluded that "Factory C's operating results fell within the range of the operating results adjusted to Factory C's basis of independent companies performing similar functions, similar risks, and employing similar assets." The PWC Study stated that aluminum was used and accounted for more than half of all cookware sold in that time frame and the main alternative was stainless steel. The PWC Study stated that during 2007, there was a significant increase in the price of stainless steel and aluminum and that Factory C was affected by raw material price increases. Further, the PWC Study stated that there was a vast fluctuation in foreign currency as Country C's strengthened significantly against the U.S. dollar. The sales of Factory C in 2007 were xxx and the operating profit margin was -3.05%. The PWC Study stated that it is not binding on the Country C tax authorities or any other tax authorities. There is no assurance that the tax authorities agreed with the PWC Study. PWC stated that all of the factual information and financial data on which the report is based was provided by Factory C and PWC did not independently audit or verify the accuracy of any of the information provided by Factory C. The PWC Study also noted that "it is crucial to point out that in the context of the 60 item sample drawn by Customs, an evaluation may also need to be made of fiscal year 2008 (ending December 31, 2008) since the vast majority of the sample items selected fall within fiscal year 2008." In selecting comparables for its analysis, PWC reviewed publicly-available databases and focused on companies operating in Country C under the following Standard Industrial Classification ("SIC") keywords or codes: cookware, containers, fabricated metal products, kitchenware, metal drums, tableware, utensils, water tanks, home and office products, packing, 28993 (manufacturer of cutlery), 28999 (manufacturer of metal products), 27310 (casing of iron and steel), 28920 (treatment and coating of metals), and 28120 (manufacture of tanks, reservoirs and containers of metal). The search identified 411 companies. Of those companies, 282 companies were discarded since they manufactured products in industries in significantly different environments or products of significantly different stages of production. Twenty seven companies were discarded as engaged in businesses other than manufacturing. Eleven companies with sales of less than xxx were eliminated. Three companies were discarded because information was not available or they had ceased business operations. This screening resulted in a list of 87 companies, for which PWC requested financial statements from the government. After detailed screening, seven companies remained as comparable companies. None of the seven companies used in the PWC Study were direct competitors of Factory C in the domestic market or the global market. The PWC Study stated that xxx are the main competitors in the Country C market. The seven companies used in the PWC Study were xxx. According to the PWC Study, these companies produced stainless steel kitchenware products as well as stainless steel tanks and drums. Exhibit C, labeled as an "updated benchmarking analysis" is a one-page table. The table lists seven companies, and three columns: a column for 2008, 2007, and 2006. The seven companies listed are: xxx. We note that only one company listed in Exhibit C was used in the PWC Study. There are figures for "full cost markup" ("FCM") and "operating profit margin" ("OPM") for each company for each of the three years. The 3-year average FCM lists a low of -11.08%, a high of 7.4% and a median of -2.71%. The 3- year average OPM lists a low of -11.63%, a high of 6.8% and a median of -2.81%. Factory C lists a FCM of -0.38% and an OPM of -0.43%. CBP requested more information regarding the seven companies listed in the table that had not been included in the PWC Study. In a March 30, 2009, submission, Company B provided information that it described as summary profiles and financial statements for the seven companies used in the table marked Exhibit C. The financial statement descriptions, which consist of several terse bullets, covers the period 2002-2006. The company profile for xxx (which cites to four sources) states that the company is a manufacturer of enamel cookware and enamel and stainless steel teakettles. The company profile for the unrelated manufacturer xxx (which cites to three sources) states that it is a manufacturer, exporter and importer of stainless steel kitchenware and cutlery. The company profile for xxx (which cites to one source) states that it manufactures kitchenware. The company profile for xxx (which cites to two sources) states that it is a manufacturer, importer and exporter of kitchenware products/cutlery. The company profile for xxx (which cites to one source) states that it is a manufacturer of enamel cookware. The company profile for xxx (which cites to three sources) states that it produces stainless kitchenware products, which includes pots, pans, hotel and restaurant kitchenware, utensils, and houseware. The financial statements do not indicate that they were audited and provide profit and loss statements and balance sheets for the period 2002-2006. Company B also submitted two e-mails which it states are evidence of transfer price negotiations between the parties. The first e-mail states "would you pls. advise the selling price for the following items. Thanks." A list of goods from a particular product family were then listed. The second e-mail states as follows: 7/26/07 Pls note that the unit price is the selling price for customer. Pls add the xxx price into this file. Besides, Would you pls provide your price list to us? We can revise the price on the vendor part data Firstly that the new price will be uploaded automatically for any new order via EDI 7/27/07 After reviewing with Joe, I have added xxx suggested selling price, % increase and sales increase in bold blue. The price increases from xxx% to xxx% and result in xxx USO sales increase. Please review. If OK, I shall amend xxx part sales data ourself and sales orders shipped after 2007/08/02. thanks 8/7/07 Pls note that the P/O's has been revised by customer gradually BUT I found our margin for few items to be sold for xxx is negative, in xxx% or only xxx% (pls see the sh Pls see the worksheet2 (2) in yellow color and review for us. Thanks A list with codes and prices and percent increases is attached to the e­mail. Company B also submitted a four page document prepared by PWC titled "Economic Analysis of Pricing Practices of Factory C in 2006 and 2007" dated February 15, 2011, which analyzed the sluggish adjustment of product prices by Factory C and tied to losses incurred in 2006 and 2007. It provides economic theory, both macroeconomic and microeconomic, which could explain the rationale for acceptance of short-term losses by a company. ISSUES: Whether pots and pans manufactured in Country C from Chinese-origin circular blanks undergo a double substantial transformation. Whether 10-piece sets of cookware that include Chinese-origin glass lids are eligible for preferential tariff treatment under the GSP. Whether the imported pots and pans produced by Factory C, which is related to Company M, the middleman, may be appraised based on the transaction between the foreign manufacturer and related middleman. LAW AND ANALYSIS: Substantial Transformation Title V of the Trade Act of 1974, as amended (19 U.S.C.A. 2461-65), authorizes the President to establish a Generalized System of Preferences ("GSP") to provide duty-free treatment for eligible articles from beneficiary developing countries ("BDCs"). Articles produced in a BDC may qualify for duty­free treatment under the GSP if the good are imported directly into the customs territory of the U.S. from the BDC and the sum or value of materi