Establishing a Customs Compliance Program
January 1, 2003
By: Robert E. Burke
I. EXECUTIVE SUMMARY
Management responsible for finance, purchasing, importing and logistics as well as the controller, and legal departments must take careful note of United States Customs initiatives under the recent Customs Modernization Act. Understanding the new rules and adapting your systems for compliance will mean cost savings. A failure to respond to the new environment will result in costly penalties and possible embarrassment to the company.
Many companies have been eager to use changes in the law permitting duty and cost reductions through programs such as the Generalized System of Preferences, NAFTA and electronic entry. Some companies have been slow to realize that Congress has also mandated that importing companies begin specific legal compliance initiatives. Customs and Congress recognized that while companies commonly devote substantial resources to tax planning and compliance, they often devote little or no efforts to Customs compliance. Recent changes to the law under the Customs Modernization Act establish a dramatically new approach designed to ensure that all importers exercise reasonable care through informed compliance.
- "Reasonable Care" requires that the importer:
- Use complete and accurate information in the entry and duty assessment process, and
- Ensure the correctness of all legal decisions relating to the entry of merchandise, tariff classification, valuation and the rate of duty, including the use of any duty reduction preferences.
- Customs is enforcing the law armed with an expanded Regulatory Audit program and new mandatory, penalty based, record retention requirements.
- Congress has charged Customs with enforcing the accuracy of NAFTA certificates of origin prepared by U. S. exporters and producers.
- The law specifies new drawback requirements with stiff penalties for violations which can be reduced through statutory Customs-approved compliance programs.
The message is clear, all importers, particularly companies using duty-reduction programs, must dedicate resources to systems that ensure legal compliance. In view of the new and highly specific rules, unless a company adopts a conscious system of customs compliance, it is vulnerable to costly penalties, civil claims, delays in transit, the possible loss of Internal Revenue tax deductions and the possible retroactive assessment of duties on goods imported over the previous five years. At the same time, a well-developed compliance program will identify potential cost savings and confirm that your company pays no more than the lawful minimum duties.
A sound compliance program will include:
- Recognition by management of the importance of the law and assignment of ownership;
- Adoption of formal procedures to eliminate violations;
- Establishment of a formal record keeping system;
- Training; and
- A system of internal reviews to detect and report infractions.
The extent to which management resolve and resources should be put into a program should be directly proportionate to the dollar volume of your imports or the value of goods certified as eligible for NAFTA duty preferences.
By establishing a Customs legal compliance and management system companies frequently realize cost savings. Through a legal compliance program, you will assure the use of important electronic communication opportunities with Customs and identify incorrect and costly tariff misclassifications, over-valuations, new opportunities for lawful tariff avoidance, and efficiencies in the administration of the Customs function.
This paper will address factors that Senior Executives, Corporate Controllers, Customs Managers, Logistics Managers, Purchasing Managers, General Counsel and others directly or indirectly involved in the importing process should consider prior to adopting a Customs Compliance Program.
II. WHAT THE "REASONABLE CARE" STANDARD MEANS
A. The New Standard of Compliance
Prior to the Customs Modernization Act, an importer could comply with the law regulating entry, classification, duty rate and valuation simply by ensuring that it reported all material facts to Customs at the time of entry. Then, it was solely up to the United States Customs Service to determine the proper duty assessment. With the advent of paperless electronic entry, the new law created a significant "shared responsibility" on importers to ensure that each importer's entry, classification, rate of duty and valuation decisions are based on documented evidence and procedure. An importer should be ready to demonstrate to Customs that it consciously and deliberately confirmed prior to entry that:
- Classification under the Harmonized Tariff Schedule of the United States was correct as a matter of law and fact;
- Customs valuation used for entry was correct as a matter of law and fact;
- The use of any tariff preferences was correct as a matter of law and fact;
- The entry of the merchandise into the United States satisfied all appropriate laws and regulations relating to the product including the country of origin marking laws and regulations.
- The importer can prove each of these elements through evidence maintained for five years from entry.
In making this substantial change in the law, Congress stated:
With respect to the concept of "shared responsibility," it is the intent of the Committee that the importer have the responsibility to correctly value and classify the merchandise and Customs have the responsibility to ensure entry was made correctly and determine the amount of duties due.
B. Violations and Potential Penalties
As can be seen by the above legislative history, Congress and the Customs Service expect that each importer will have an auditable trail of decision making with respect to the entry of merchandise. Customs is incorporating this new process into its Regulatory Audit programs. Importers should expect an audit that will initially inquire into an importer's system for compliance.1 Customs has announced that future Regulatory Audits will involve two stages: First, a review of the systems in place to confirm compliance and then, if the first stage reveals an ineffective compliance system, a detailed audit. Often, detailed audits extend 18 to 24 months or longer, involve substantial administrative time from the company and frequently lead to the discovery of duty payment deficiencies and possible penalties.
Under the new law, an importer's failure to have any compliance system in place when Customs detects a violation could result in assessments for negligence or gross negligence as high as four times the revenue amount. For fraud, which includes intentional omissions, the penalties could be as high as equal to the value of the imported merchandise. Penalties for an importer's failure to retain required entry records could result in assessments as high as $10,000 dollars per entry. The opportunity to achieve cost reductions by increasing administrative efficiencies and avoiding Customs penalties is important and should involve the top management of companies regularly engaged in importing.
C. Special Attention to Duty Preference Programs
While every company engaged in importing should establish a compliance program, some importers assume a higher profile in terms of legal compliance by taking advantage of duty preference programs. These lawful programs, which reduce the duty rate or render merchandise duty free, are based on the fulfillment of a specific set of legal conditions or circumstances.
Typical examples include:
- Entries under the North American Free Trade Agreement (NAFTA);
- Assembled American goods (HTSUS 9802.00.80);
- Goods exported for alteration or repair (HTSUS 9802.00.50);
- Generalized System of Preferences, Caribbean Basin Initiative, U.S.-Israel Free Trade Agreement;
- Auto Parts Trade Act (APTA);
- American goods returned (HTSUS 9802.00.60 or 9802.00.80);
- Maquiladora-type assembly;
- Foreign Trade Zones;
- Drawback and similar duty reduction provisions.
Often, a business that uses these opportunities becomes a higher profile target for a Customs regulatory audit because the opportunity for error is great, especially where a business lacks a compliance system.
D. Related Party Transactions
An increasingly significant area of Customs attention is the valuation for Customs purposes of products imported from related suppliers. The valuation statute, and the Customs regulations and rulings have defined the requirements in this complex area. As a related party importer, you have the affirmative obligation to maintain a legal and factual rationale supporting the entered values. See, Customs Guidelines for Valuation in Related Party Transactions published in the Federal Register of January 21, 1993. Your analysis of related party pricing under the Customs valuation laws should be coordinated with your Tax Department. The discovery by Customs or the Internal Revenue Service of errors in your related party Customs valuation could have serious Internal Revenue implications under 26 U.S.C. ' 1059A. An incorrect Customs valuation used by a related importer could result in the retroactive assessment of Internal Revenue taxes resulting from the loss of inventory or basis deductions.
III. ELEMENTS OF A CUSTOMS COMPLIANCE PROGRAM
Based upon the Customs Modernization Act, its legislative history, public statements by Customs officials, trade compliance programs the Bureau of Export Administration has recommended under the analogous regulations of the Export Administration Act and experience in numerous Customs enforcement proceedings, there are six essential elements in an effective Customs compliance program. You should not adopt these factors superficially but rather dynamically within the company.2 A prudent business will employ the assistance of an experienced professional to assist in establishing and implementing the following elements:
1. Statement of Customs Policy and Delegation of Responsibility and Authority
2. Formalized Procedures
3. Record keeping
5. Internal Reviews
1. Statement of Management Policy and Formal Delegation of Authority and Responsibility
This first element has two parts: adopting a formal company policy regarding legal compliance, with the additional goal of cost savings, and, secondly, a formal delegation of authority to management.
A. Company Policy
With respect to the establishment of a management compliance and cost reduction policy, it is clear that the most effective policy is based on objectives established by the chief executive officer or another top corporate officer. The policy must be tailored to the individual objectives of the company and should dovetail with existing management policies and your company culture. Your policy can be broadly stated or specifically drafted. In either case, it should present the message that corporate management is conscious of the company's compliance responsibilities in this area and expects compliance from its management and employees. At the same time, there is an opportunity to emphasize the electronic efficiencies that may be gained and confirm that duties are not be paid in an amount greater than lawfully necessary. Clearly, the essential underlying ingredient of such a compliance program is that it have the full support of top management. Without an effective policy, any delegation of authority and responsibility will be unclear and ineffective. Without a proper policy, some levels of management may be less willing to devote the necessary resources to satisfy the mandates of the Mod Act.
- Formal Delegation of Responsibility and Authority and Appointment of Responsible Officials
To implement the policy, an importer should establish a formal customs administration and compliance system in writing and provide it to everyone involved in the compliance process. Ideally, a compliance system will include the delegation of authority and responsibility for compliance to specific management functions within the company, starting at the top and working along the chain of management to the Import Manager. This will require the company to focus on the placement of ownership of the process, be it in finance, control, law, tax, logistics, purchasing, regulatory compliance or some other function.
Another important element of delegation is to ensure that management functions that are seemingly peripheral to the activities of the Import Manager are made aware of their responsibility in the compliance process. These will include the activities mentioned above, as well as manufacturing, engineering, traffic and similar functions. This is essential because information gathering relating to entry, classification, valuation, record retention and all the other aspects of reasonable care cannot, in most cases, be physically performed by the Import Manager alone. Certain information relating to classification (e.g., product description, composition and use) and valuation (e.g., separate payments and assists) might have to be reported to the Import Managers and be maintained by them. Information relating to cost, country of origin, and NAFTA analysis, for example, may need to be obtained and maintained by the corporate controller's office. The director of purchasing may have access to information regarding valuation (e.g., purchase orders or price renegotiation) which the Import Manager needs for entry purposes.
No two formal Compliance Systems will be identical as they must reflect each individual company's management structure and be tailored to the activities and objectives of the company. Such a formal written compliance system can range from a comprehensive Customs or NAFTA manual to a series of memoranda or letters. However your company accomplishes it, your adoption of a policy and a formal compliance system will facilitate cost reduction and will also serve as convincing proof to Customs that the company is serious about compliance.
2. The Adoption of Formalized Procedures
The establishment of legally correct procedures logically begins with identifying all Customs and related laws and regulations that your company is required to satisfy. Doing this, you must consider your own import activities, organization and products. The next step is to survey the activities of the company to determine existing procedures and the degree to which you are in compliance. This exercise is legal in nature because it applies specific facts to the Customs laws and regulations. This review is not an accounting audit since ordinarily the financial books and records of the company can be presumed to have integrity, as maintained by the company's controller and outside public auditor.
Once you have ascertained the applicable legal requirements and your current degree of compliance, the company is in a position to document and establish formal procedures to ensure required compliance. These documented procedures will form the essence of a functioning system and will include information gathering methodologies. The procedures must begin with the institution and flow of the commercial transaction and incorporate a proper determination of the legal requirements for entry, valuation, classification, duty rate, NAFTA and drawback for that specific importer. The compliance system will be administered by and through a cooperative management, as set out in the corporate policy.
In setting up and implementing these company procedures, the importer, drawback claimant or NAFTA certifier should be mindful of Customs' expectations. The legislative history to the Customs Modernization Act makes it clear that an importer should either develop in-house expertise in entry, classification, valuation and duty rate considerations or rely on outside professionals.
The development of in-house expertise should be the ultimate goal of every concerned importer. Participating in a proper legal review conducted by an experienced professional is a useful exercise for training in-house managers and employees how to maintain a comprehensive company compliance program. An experienced outside professional, such as specialized customs counsel or an experienced licensed customs broker, should be able to offer bench marking experience of substantial benefit to the company. Accountants may be called upon to assist with accounting issues for which the company may not have internal accounting staff available. Consultants are useful if the company does not have, for example, needed scientific expertise.
In the legislative history to the Mod Act, the House Ways and Means Committee stated:
In meeting the "reasonable care" standard, the Committee believes that an importer should consider utilization of one or more of the following aids to establish evidence of proper compliance: seeking guidance from the Customs Service through the pre-importation or formal ruling program; consulting with a Customs broker, a Customs consultant, or a public accountant or an attorney; using in-house employees such as counsel, a Customs administrator, or, if valuation is an issue, a corporate controller, who have experience and knowledge of customs laws, regulations and procedures; or when appropriate, obtaining analyses from accredited labs and gaugers for determining technical qualities of an imported product.
For example, in seeking advice for a classification issue, the Committee expects an importer to consult with an attorney or an in-house employee having technical expertise about the particular merchandise in question. In seeking advice for a valuation question, the Committee expects an importer to consult with an attorney or a public accountant, and as appropriate, personnel within the company knowledgeable regarding the importer's accounting system and how cost elements are booked.
3. Record Keeping
Customs has moved to a paperless environment. As a result, Congress has placed a greater burden on importers and NAFTA certifiers to retain information to support entry, classification, valuation and NAFTA certification.
Currently, penalties exist for the failure to retain records that are required to be maintained under 19 U.S.C. Sec. 1509(a)(1)(A), the so-called A(a)(1)(A) list@ published as Treasury Decision (Customs) 96-1 and Appendix . The law also requires that importers retain other records supporting the information they provide to Customs, such as the purchase contracts. The Customs Regulations are extreme. In the case of (a)(1)(A) violations, Customs could assess a penalty as great as $10,000 per entry for negligence or $100,000 for intentional violations. In cases involving an alleged substantive violation, where required records are not timely produced to Customs in an audit or investigation, Customs has stated that the failure could result in aggravating the amount of penalties finally assessed. Moreover, an importer could face the loss of duty preference benefits for the previous two years if it fails to satisfy the record keeping regulations.
Each importer should, therefore, install an information and record keeping system. Such a system must be based on the specific legal and factual requirements of each importer with regard to entry, valuation, classification, rate of duty, drawback and NAFTA. The importer will not only need to consider which documents it must maintain, but how and where to maintain them.
Ultimately, an importer may consider entering into a Statutory Record Retention Certification procedure managed by United States Customs. Once qualified, an importer will be guaranteed that no penalty will be assessed on the initial violation. Other benefits for this procedure exist, and each importer will need to decide whether its degree of general compliance will justify proceeding through the required application process. Similarly, drawback penalties may be avoided through a Statutory Drawback Certification process.
An essential component of an effective Customs compliance program is training the people who are directly and indirectly involved in the importing process. The Customs Regulations are very complex, as are valuation, tariff classification and duty preference entitlements. Unless a company has substantial independent knowledge in these areas, it should seek outside assistance in its training efforts.
Even then, not all responsibilities of an importer may be delegated to outside Customs attorneys or licensed Customs Brokers. The importer maintains primary responsibility under the law to ensure that relevant personnel receive adequate training. The adage "Ignorance of the law is no excuse" is particularly applicable to importers and NAFTA certifiers.
A company may elect to conduct training in a number of ways, including:
- Company Customs compliance manual, including the statement of corporate policy, internal procedures and reference materials.
- In-house educational seminars covering the above as well as general substantive Customs subjects applicable to the company.
- Outside sponsored Customs programs, such as are periodically sponsored by the American Association of Exporters and Importers.
The company should take substantial care to ensure that all persons relating to the importing function receive training and individuals in the import department, finance, controller, procurement, traffic, law and engineering departments might ordinarily be included. Again, the purposes of training are twofold: the first purpose is to educate personnel to become familiar with the legal requirements of importing. The second is to identify lawful cost savings in the process.
5. Internal Reviews
An essential component of an effective Customs compliance program is internal review. These reviews should be formalized and be conducted periodically, preferably by persons outside the day-to-day management of customs activities. These reviews do not confirm the integrity of the company's financial system; other activities in the company should address that function. Several ways to accomplish this are: (a) include Customs compliance as an adjunct to the normal internal audit function, (b) retain an experienced Customs broker or an experienced Customs counsel to conduct compliance reviews and consider utilizing accountants relative to accounting issues, and (c) conduct internal reviews through the Import Department. The obvious drawback in proceeding in the latter manner is that the import management will, in effect, be auditing itself, which is not the most desirable procedure in that errors and omissions that are endemic in the system may be overlooked by even the most scrupulous import manager. Customs has recently established a jointly administered importer self-analysis program that may be very suitable to certain importers. Recognize, however, that in any such joint self-analysis Customs will expect to review the results of all information gathering and analysis performed by the importer.
It should be recognized that written reports of internal reviews prepared by a customs broker or unlicensed consultant are not privileged and can ordinarily be obtained by the Customs Service. In fact, Customs Regulatory Auditors routinely request a copy of such reports.3 These company reports are available to Customs unless protected by the attorney-client privilege. If outside counsel is used, the privilege applies to protect the confidentiality of attorney-client information contained in the review reports sought by Customs. When in-house counsel is used to establish and maintain the privilege, great care must be taken to ensure that the review, in fact, originates with and is continuously administered by that in-house attorney. The review must be done in anticipation of litigation. Confidentiality must be maintained within a control group established by counsel. All appropriately privileged documents should be clearly identified and marked. Further, in-house counsel should not also be responsible for business counseling or reviewing related business decisions in the area of Customs or importing. The failure to take these steps could adversely affect the privilege.
Note that the attorney client privilege cannot be established for a broker-consulting firm through a licensed attorney who is employed by the consultant. Also, a company assumes a risk of having the privilege denied by a court where a consultant is hired through a nominally designated outside attorney solely for the purpose of seeking to establish a privilege.
A procedure should be in place encouraging employees to come forward and disclose to the Import Manager and then to legal counsel the existence of any events reflecting non-compliance. If the notice is to legal counsel, the privilege should apply. Legal counsel can then advise the importer as to the best way of handling the situation, including the possibility of a prior disclosure and duty tender to Customs. In significant matters, it may require legal advice as to whether such a notification should be a formal prior disclosure. A prior disclosure and tender should not be automatically done but should be made on the basis of a well-thought-out plan to ensure that the company is protected to the extent permitted by law.
A notification procedure should also address all communications with Customs, including the handling of Customs Forms 28 and 29, notices of regulatory audits and surprise visits by Special Customs Special Agents.
Taking all the above factors into account, the starting point in an effective importer's compliance program is the involvement of top management at the policy level. Once that is established, along with clear ownership of the Customs compliance process, the company is well on its way to satisfying the requirements of the Mod Act. There is no strict formula to follow when it comes to establishing a compliance program; however, the six points maintained above are essential. Beyond that, each company will establish its own compliance program depending upon the nature of its business, its document system, management structure, personnel and the resources the company is willing to devote to the process of compliance. The initial step in this process should involve experienced in-house or outside expertise to ensure the process (or improvements to an existing process), attain management compliance objectives in an efficient and productive manner.
1 For example, one recent initial Customs Regulatory Audit questionnaire posed the following questions:
- Who is responsible for the classification of the merchandise and how is classification determined?
- What is the basis of Customs appraisement used to determine the value of the imported merchandise?
- Explain the factors considered in determining entered values declared to U.S. Customs.
- Please detail the procedures or corporate policies for establishing transfer prices with related suppliers. Do transfer prices cover all costs plus profit? Are there temporary pricing considerations not reflected in the policy?
- With an emphasis on internal controls as they relate to Customs transactions how are import and export activities organized? Discussion should include the flow of documents from issuance of purchase orders to payment. Please describe the accounting system used (including hardware and software). To expedite the audit process, Customs access to electronic systems covering importations should be considered.
- What policies and procedures do you have to assure compliance with Customs laws and regulations?
- What type and frequency of reviews do you perform to assess the adequacy of your internal controls?
2 Each element should be legally sound in terms of the substantive areas required to be addressed in the Mod Act. Once again, these include entry, classification, valuation, duty rate, drawback and NAFTA
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3 Confidentiality is very important in the internal review process. For example, in statutory prior disclosure circumstances the law provides for disclosure of the violation but does not require the disclosure of the level of intent, which, in many cases, should be kept confidential. Confidentiality is also required where a company needs time to gather facts relative to other company activities that may also reflect a violation. Also, the company may need additional time to rectify a known condition. Finally, the law requires an attorney to permanently maintain confidentiality unless waived by the client.
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