International Law Advisory - BIS Publishes Rule Amending De Minimis Regulations

October 3, 2008

On October 1, 2008, the US Department of Commerce Bureau of Industry and Security (“BIS”) published an interim final rule at 73 Fed. Reg. 56,964-70 revising the Export Administration Regulations (“EAR”) controls with regard to the application of the de minimis rule to foreign-produced products containing US-origin software and technology. This amendment reflects a significant change from the pre-existing rules used to determine when US re-export jurisdiction applies to items made abroad containing US-controlled content. The interim rule is effective immediately, but BIS is soliciting comments until December 1, 2008.

By way of background, foreign produced products are subject to the export and re-export controls under the EAR if they contain more than a certain percentage (by value) of US-origin controlled content. In other words, US-origin content is considered controlled for purposes of the de minimis rules when it requires a license to the intended ultimate country of destination for the foreign-made item. The rule primarily affects non-US manufacturers abroad that “incorporate” US-sourced materials, parts, components, technology, software, and other US-origin content.

Generally, an item remains subject to the EAR after export from the United States, and may require a license from BIS, if it contains more than 10 percent US-controlled content and is destined for an E:1 Group country (Cuba, North Korea, Iran, Sudan, and Syria). For all other country destinations, EAR re-export jurisdiction is triggered under the de minimis rules when an item contains more than 25 percent US-controlled content. (No “substantial transformation” exception exists for EAR export and re-export control jurisdiction.)

Previously, the de minimis rule did not allow the value of US-origin software or technology incorporated into a foreign-produced commodity (e.g., a computer) to be compared against the total value of the foreign-made item, even when the technology or software was embedded in the foreign-made item. Rather, calculations of US-origin software or technology content had to be conducted on an “apples-to-apples” basis — e.g., US-origin software content could only be compared (for de minimis purposes) to the foreign-origin software content in the foreign-produced item. Therefore, if the US software content was more than 25 percent of the total software in the foreign-made item, the item was subject to US jurisdiction, even if the total value of the software (as compared to the machine in which it was incorporated) was less than 25 percent.

The new regulation is intended to address the commercial realities of items today where systems and software are being developed and delivered to customers, particularly where software is an integral part of the hardware system and is customized to work with a specific product. The rule moves US export control jurisdiction away from the “apples-to-apples” comparison requirement for US-origin software in a foreign-made item, although it does not totally abandon that approach. Most notably, the regulation makes changes to the following areas:

Bundling: Section 734.4 is amended to exclude, in certain cases, foreign-made commodities “bundled” with de minimis amounts of US-origin software from the jurisdiction of the EAR. US-origin software will remain subject to the EAR when exported or re-exported separately from (i.e., not incorporated or bundled with) a foreign made commodity, and exports or re-exports of software for additional users and upgrades are considered separate transactions for export control purposes. Moreover, the “bundling” rule does not appear to apply to any US-origin technology that is included with the commodity or software. The “bundling” concept applies to “software that is configured for a specific commodity, but is not necessarily physically integrated into the commodity” (e.g., printer driver software that is not loaded into the printer itself but shipped on a CD along with the printer for uploading to the connected computer software). Only certain US-origin software falls within the scope of bundling for foreign made commodities — the rule applies exclusively to software controlled for Anti Terrorism (“AT”) reasons or which is classified as “EAR99.” Therefore, software that is controlled for other reasons (e.g., 5D002 encryption software), or software that might be associated with specific products and controlled for reasons other than anti-terrorism (e.g., software under ECCNs 4D003 or 6D003), will not be considered bundled with foreign-produced items and shall remain subject to the EAR.
Revised De Minimis Calculations: Supplement No. 2 to Part 734 of the EAR, which includes guidelines for calculating de minimis values as defined by § 734.4, has been amended in various respects. The amendment clarifies the previous rule on “controlled” content, noting that US-origin content need only be included in the de minimis calculation if it is controlled for re-export to the end destination, and stipulating that Part 744 controls should not be considered in making this assessment. Note that the special rules on encryption in § 734.4(b) are otherwise retained. The guidance also now clarifies that costs should be determined by the local market costs in the country of export, and that cost depreciation for components is not permitted.
Definition of “Incorporated”: Supplement No. 2 to Part 734 is amended to make clear that US-origin controlled content is considered “incorporated” for de minimis purposes if the item is: (1) “essential to the functioning of the foreign equipment”; (2) “customarily included in sales of the foreign equipment”; and (3) “reexported with the foreign produced item.” BIS has removed as imprecise the "rack mounted" and "cable connected" concepts previously utilized to determine the extent to which US-origin content is incorporated into foreign produced items.
One Time Report: Based on prior reporting history, BIS has removed the requirement for a one-time reporting requirement for foreign-made software that incorporated controlled US-origin software. However, BIS is maintaining the one-time report requirement for foreign-made technology that incorporates controlled US-origin technology.
General Prohibition 2: BIS has added language to General Prohibition 2 (see Part 736 of the EAR) to make clear that the de minimis rule applies to re-exports of technology and software, as well as re-exports of commodities.
Statement of Understanding-Medical Equipment: Supplement No. 3 to Part 744 is amended to establish the same definition of “incorporate” for purposes of the required Wassenaar Arrangement statement on medical equipment.
Recordkeeping: Section 734.4(g) of the EAR is amended to make clear that records must be retained in accordance with other provisions of the EAR concerning the method by which the percentage of de minimis US content is calculated.

Exporters and foreign re-exporters should study this rule carefully and identify issue areas that are not covered or adequately addressed. There are several important aspects of the amendments that do not offer specific guidance.

For instance, the amendment does not offer clear guidance concerning how to perform the de minimis calculation under the bundling rules. For pure hardware exports, the analysis is simple and reflects prior practice — the cost of US components, divided by the sales cost of the foreign-produced product. For software, the analysis is the cost of US components, divided by the total past and projected future sales of the product (also consistent with prior practice). It is unclear whether parties should use the hardware or the software framework for, hypothetically, a hardware/software combination where the software functionality represents the key value of the product (such as where high-performance, specially-designed software is running on generic hardware).

Likewise, the new definition of the term “incorporated” suggests that BIS will no longer examine whether a US-origin component is actually physically connected to the foreign product at the time of re-export; rather, the analysis will be focused on whether the component is essential to the functionality of the product, normally sold with the product, and shipped with the product. This invites the question whether generic US-origin components that are typically sold and shipped with a foreign-origin product could qualify for de minimis treatment — the regulation does not appear (at least explicitly) to require the US commodity component to be specially-designed or configured for the foreign end product, as long as it is “essential to the functioning” of the end product. Without further guidance from BIS, exporters and re-exporters must proceed cautiously with how they apply the definition to their items, and in all cases, be sure to document all de minimis calculations and determinations.

If you have any questions about this regulatory change and its implications, please contact David Lorello on + 44 207 367 8007 in London or Ed Krauland on 202.429.8083 and Jack Hayes on 202.429.6491 in Washington, DC.