Kin-Keung Lai, City University of Hong Kong, and Christopher Tang, UCLA Anderson School
Every year, U.S. companies import more than one trillion dollars’ worth of products ranging from raw materials (e.g., seeds) to finished goods (e.g., knitted apparel). However, in many instances, these products went through a series of sales along the supply chain. For example, it is common for a U.S. company (e.g., Target) sources its denim jeans through a middleman (e.g., Hanbo of Hong Kong) rather directly from a contract manufacturer located in Asia. In general, the customs duties for importing goods from Asia amount to anywhere from 5% to 20% of the declared value (i.e., the price paid by the U.S. importer to the middleman plus certain statutorily enumerated additions). However, under the “First Sale” rule adopted in a 1996 Treasury Division, an importer is allowed to pay duty based on the “First Sale” price that is paid by the middleman to the contract manufacturer. Clearly, the “First Sale” price is lower because it excludes middleman markups and other additional expenses. For example, suppose an importer sources a pair of denim jeans from a middleman, who in turn sources the jeans from a factory (see Figure below).
Under the First Sale rule, the importer can declare the value based on $8.2 instead of $10 when importing a pair of jeans. By reducing the declared value by $1.8, the importer can reduce its customs duties by $0.3 for importing each pair of jeans when the tariff rate is 16.6%. (This is because $1.8 x 0.166 = $0.3.) This savings is so substantial and it should be a “no-brainer” that every importer should adopt the First Price rule………. But few companies adopt the First Price rule. According to a report issued by the US International Trade Commission, only 2.4% of total U.S. imports (and 8.5% of all importing entities) used the First Sale rule during the year of 2009. Why would these companies leave so much money on the table?
Based on our discussion with Mr. Peter Cheng, Chairman of Hanbo Enterprise Holding, we learned that the First Sale price is often opaque because the middlemen want to give the impression that their markups are very small by showing their customers (i.e., the importers) that the invoice price is slightly above the First Price declared by the contract manufacturers. However, the First Price presented by the contract manufacturer often includes some “hidden rebates” that the contract manufacturer has to pay the middleman without the importer’s knowledge. As the contract manufacturer inflates the declared First Price so that the First Price is roughly the same as the invoice price, there is little incentive for the importer to take extra steps to adopt the First Price rule because the importer did not know the true First Price that can enable them to reduce customs duties.
Upon discussion with a key customer about the impact of hidden rebate on the reduction of customs duties under the First Price rule, Hanbo started a First Sale Program strategy under which Hanbo informs its customers the “true” First Sale price and declares that no rebates from its contract manufacturers will be requested. This way, Hanbo’s customers can gain the full benefit of the First Sale rule. However, without hidden rebates, Hanbo shows its true markup to its customers, which can appear to be higher than those middlemen who mask their markups using hidden rebates.
Will Hanbo’s “open kimono” strategy win long term customers? Only time will tell. Meanwhile, few angels fear to tread!
 U.S. Customs Service, Treasury Decisions: Determining Transaction Value in Multi-Tiered Transactions (T.D. 96-87), December 13, 1996.