Tuesday, December 20, 2016

Substantial Transformation Redux

Note: I am writing this post while on vacation at an undisclosed location. The Internet here is lousy. I am paying a fair amount of money for "high speed access." Despite that, I feel like I am working on a vintage 3600 baud dial-up modem. Consequently, you will have to make do with two links. I might go back and fill in more when I have a decent connection.
We just talked about a Customs and Border Protection ruling in which I complained about CBP straying from the traditional substantial transformation test of looking for a change in name, character, or use to determine country of origin. Now we run up against Energizer Battery, Inc. v.United States, in which the Court of International Trade addressed essentially the same question. The CIT started out strong and raised my expectations that we would see a very detailed analysis of the test. We did get a thorough and logical opinion. But, I still have some concerns. So, let’s walk through this.

Under the Buy America portion of the Trade Agreements Act of 1979, 19 USC §§ 2511-2518, the U.S. government can procure material from countries covered by the Act. Those are countries that have signed on to the WTO Government Procurement Agreement and U.S.-free trade agreement partners. China is not an eligible country.

The case involves a flashlight assembled in Vermont. Virtually all of the approximately 50 components, including the light-emitting LED’s, the lens assembly, and wires that are pre-cut to size, come from China. After importation, the assembly process involves workers at two stations and takes approximately 7 minutes and 10 seconds. The value of imported materials is $12.96 and the finished cost of the flashlight is $23.55.

The only way to make these flashlights eligible for government procurement is to determined that they are products of the United States by virtue of the assembly operation in Vermont. That requires a substantial transformation. The test for a substantial transformation under the Trade Agreements Act is that the product is “a new and different article of commerce with a name, character, or use distinct from that of the article or articles from which it was transformed.” While there have been few cases applying this test in the context of the procurement agreement, this is the well-established test used for non-NAFTA country of origin marking, some drawback, and for other purposes.

Energizer sought a final ruling from Customs on whether the assembly of the flashlights in the U.S. resulted in a substantial transformation. Customs found that after assembly in the U.S., the LED’s continue to perform their intended function of emitting light and that the assembly process was not complex or time-consuming. Customs also noted the traditional name, character, or use test. Based on its analysis, Customs found no substantial transformation.

The first issue the plaintiff raised is that Customs’ focus on the LED’s and “essential character” is not part of the test for substantial transformation. That is manifestly true. The statute does not reference essential character. The Court, however, noted that it must decide the origin of the flashlight on its own, based on the evidence presented to it. The original analysis CBP performed is, therefore, of limited importance.

Given my most recent post on this question, I was very happy to see the Court of International Trade focus its attention on the name, character, or use test. The Court went so far as to say the “’essential character’ is not an established factor in the substantial transformation analysis, although some courts have looked to the ‘essence’ of a finished article in order to evaluation whether there has been a change in character as a result of post-importation processing.” Essential character is a useful concept for tariff classification. Separately, “essential identity” comes up in the context of U.S. goods returned. Neither is traditionally part of the substantial transformation test. So far, I am happy.

The Court then reviewed the history of the substantial transformation test from its roots in the 1908 Supreme Court decision Anheuser Busch Brewing Ass’n v. United States. Since that time, the test has become “flexible” and the outcome depends on the facts of each case.

The Court noted that a change in name is generally the least compelling evidence of a substantial transformation. That said, let’s keep in mind that the imported components were not called “flashlights.” They were LED’s, wires, screws, switches, and other components all with their own name.

Regarding name, the Court followed the lead of a prior CIT decision in a case called National Hand Tool v. United States. That case involved hand tools that were partially finished prior to importation and machined, etc. after importation. In all cases, the name of the article as imported remained the same as that article in the completed tool. From this, the CIT held that the question is whether the imported components retain their names after assembly into the flashlight. The switch, for example, remains the switch even when it is fully incorporated into the flashlight.

Moving on to character, the Court looked for a substantial alternation in the characteristics of the components. That requires more than a cosmetic change. Rather, the end-use of the imported product must not be the same as (or “interchangeable with”) the end-use of the product after post-importation processing. Here, the Court found that the shape and material composition of the components was unchanged, meaning there was (according to the Court) no change in character.

The Court also noted that that prior cases have found a substantial transformation less likely where the imported item has an intended end-use and the post-importation processing is consistent with that end-use. This is where I start to get concerned. Here, the parts were all imported for the purpose of manufacturing flashlights. The lens assembly, in particular, had no other apparent use. This does not bode well for Energizer.

Regarding use, Plaintiff argued that none of the imported components are useful as flashlights. The Court rejected that approach and held that the correct inquiry is whether the imported parts have a predetermined end-use at the time of importation. Here, the lens head is partially assembled at the time of importation, with four of the five LED’s attached and pre-cut wires soldered to the circuit board. This, and other components, have pre-determined end-uses as parts of the flashlight. Based on this, the Court found no change in use.

To my way of thinking, the unassembled components of a flashlight do not constitute a flashlight and cannot be used as such. As imported, they mostly have functions that are distinct from the function of a flashlight. A switch makes and breaks an electrical circuit. Wires conduct electricity.

The problem for Energizer is that LED’s emit light and the lens assembly directs light. Those are pretty close to the functions of a flashlight, although they are not sufficient to form a flashlight. Keep that in mind as we go forward.

Next, the Court looked at several subsidiary tests for substantial transformation. The most important of these tests is the nature of the assembly process. When assembly is simple, the question is whether it is “minor manufacturing and combining” as opposed to extensive operations resulting in the loss of identity of the imported component, which becomes an integral part of a new article. Summarizing, the Court stated, “However, when assembly operations were manual and required some ‘skill and dexterity to put components together with a screw driver’ but the names of each article and the form and character of each component remained unchanged, and the use of the imported articles was predetermined at the time of importation, the court did not find that substantial transformation had occurred.” The Court found that the production process constituted simply attaching one component to another. It is not a complex process.

Having found no change in name, character, or use and that the assembly process was not complex, the Court of International Trade held that the flashlight components from China were not substantially transformed by assembly in Vermont. Thus, the Court affirmed the final determination from Customs and Border Protection.

I’m not entirely comfortable with this for a few reasons. First, I need to say that this is a well-reasoned opinion and it is clearly following the lead of National Hand Tools. I think that is admirable for purposes of providing predictability and business certainty.

The problem is that as an advocate, largely for importers, I don’t like the result. It is very hard to apply in practice. It seems to me that this decision makes a substantial transformation in the context of assembly very difficult to establish. Most assembly can be reversed by disassembly. That means a switch will always be a switch and an LED will always be an LED even after assembly. This ignores the name changes from switch and LED to flashlight. Furthermore, the use of components will almost never be the use of the finished article, even when the components are imported specifically for incorporation into that finished product. Under the Court’s analysis, an engine assembled into a car remains an engine and does not change its character because it was intended for use as a car engine. Nor does it change its intended end use. But, an engine is not a car. I cannot drive an engine.

By focusing on the components before and after assembly, I fear the Court has set the bar too high. It seems that substantial transformation will occur when the imported part is subject to further fabrication prior to final assembly. The murkier question is when assembly is sufficiently complex to produce a substantial transformation. That will depend on the facts of the case. Unfortunately, it appears to me that under this analysis the complexity of the assembly process—which is not name, character, or use—is firmly part of the name, character, or use test. That seems to go beyond what was required under the 1979 Trade Agreements Act and similar CBP applications of the test.

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