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Companies discover new loopholes to avoid Trump's tariffs

Business Insider logo Business Insider 6/24/2019 Rachel Premack

Even as the President Donald Trump's trade war with China ramps up, some manufacturers and retailers are not moving their factories out of China.

Instead, some are taking advantage of a little-known tax law called the "first sale rule" that allows companies to significantly undercut how much they pay in tariffs. Other e-commerce players are directly shipping to US homes from Mexican warehouses, where they can evade tariffs on goods that cost less than $800.

That's prompted some companies to set up warehouses in Hong Kong and in Tijuana, Mexico. Insiders say retailers and manufacturers have crowded into the border town, directly south of San Diego, in recent months to set up warehouses that will allow them to mitigate how much they're paying in tariffs.

"You buy things from China, you import them into Mexico," Manuel Diaz, the managing director of SEKO Logistics México, a Chicago-based global logistics firm, told Business Insider. "Sometimes, you ship your goods to Tijuana, they're very safe and you maintain your storage there. So, it's becoming a very popular market."

This 31-year-old tariff rule helps retailers pay less money in tariffs - but few know about it and some find it "taboo"

The first sale doctrine was quietly established in a 1988 court case. Lawyers from international trade law firm Sandler, Travis & Rosenberg argued that, if goods were purchased in one country for one price before going to their final destination and being sold for a higher price, tariffs levied on the good should reflect the first, cheaper amount.

The case was groundbreaking, but the law isn't widely known. Others believe the first sale rule is  taboo despite its total legality. Just 2.4% of all US imports use the first sale doctrine, according to the most recent US International Trade Commission report.

"It's interesting, when we talk to companies about it they're like, 'What? I've never heard about this. How come I've never heard about it?'," Nicole Bivens Collinson, who heads Sandler, Travis & Rosenberg's international trade and government relations practice, told Business Insider.

"It's because a lot of the products that have been imported in the United States are what we call a nuisance tariff - 2%, 3%, 4% or they're duty free," said Collinson, who is also the managing principal of Sandler, Travis & Rosenberg's Washington, D.C., office. "Now, suddenly they have a 25% tariff on them and people are freaking out." 

Related video: How Trump's tariffs, trade wars affect the US (provided by USA Today)

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The first sale doctrine works like this: let's say you have a blouse to produce in China. Rather than directly importing that blouse from your manufacturer in China, you can arrange for an importer who is located elsewhere, like in Mexico or Hong Kong, to buy the blouse for less money, say $7.

Then, you buy that blouse for $10 from your middle man and import it into the US.

If that blouse has, say, a 25% tariff on it, you'd normally pay a $2.50 tariff for it. But thanks to the first sale doctrine, the tariff charge is only $1.75. That's because you're paying the tariff on the first, lower-priced sale of the item - between yourself and your middle man, for example.

For the economics to work out, your company needs to have huge amounts of product and already be using a variety of importers to coordinate your supply chain, the South China Morning Post reported. Otherwise, companies are hiring - and paying for - an importer in a country where they didn't already have one. 

For that reason, it's mostly large apparel companies that have seen the greatest savings from implementing the first sale doctrine. One prominent luxury brand is required to pay 15% in tariffs company-wide, but they scored a 10% reduction in duties using first sale. That led to $1.5 million in savings, according to a report from supply-chain management company GT Nexus. Another Fortune 500 clothing company saved $40 million in duties spent.

The first sale doctrine strategy is also complicated to pull off without an accounting, law, logistics, or another sort of firm to broker these transactions and ensure trust on all sides.

"This requires cooperation and trust between the buyers and the manufacturers because you don't want to get in a situation where now the buyers know, 'Hey, that's really only $7 and I'm paying $10,'" Collinson said. "So, there has to be a level of trust ... You try to create these walls that protect each other, protecting both the manufacturer, protecting the buyer."

The US International Trade Commission says that it's mostly apparel companies that have been using first sale. 

And as Trump's trade war intensifies, the rest of the economy is picking up on how much they can save with the first sale doctrine. Sandler, Travis & Rosenberg says the use of the first sale "has increased dramatically over the past several months as companies seek to lessen the impact of the additional Section 301 tariffs on imports from China."

Diaz said Tijuana is "getting popular" among those using the first sale doctrine.

Retailers can also get around tariffs if they ship in piecemeal

Another mitigation tactic to get around tariffs doesn't require a legal degree to understand - most travelers take advantage of it every time they come back to the US.

Travelers bringing goods to the US don't have to pay duties, as long as what they're bringing in has a value of less than $800.

And under section 321 of the Code of Federal Regulations, companies based in the US can send individual packages valued under $800 from countries like Mexico or Canada - with no duties at all. It just must be a direct shipment to one person's house, and no more than one shipment a day to their home.

"There's additional costs associated with that obviously because you're not able to truck over a 25-foot container for all these," Collinson said. "You've got to box them up and then you have to pay for UPS or whomever to ship the individual boxes."

E-commerce players, in particular, are starting to ramp up usage of that law, said Collinson and Diaz.

"It's become popular to move your shipments from China to Tijuana and then truck them to the US duty- and tax-free," Diaz of SEKO said. 

"People are filling orders from Mexico, from Canada, from China to be duty-free as long as they keep the value under $800," Rick Helfenbein, the president and CEO of the American Apparel & Footwear Association, told Business Insider. "I'm not sure that's a mitigation strategy as much as it is a loophole in customs law." 

But it's not a particularly cost-effective way to ship goods unless you're an e-commerce company shipping lots of low-value packages every day. Major manufacturers aren't using this tactic.

"I have heard discussions that you could use these warehouses just south of the border to break up the packages and ship them over," Ken Roberts, president and founder of import-export firm WorldCity, told Business Insider. "But it's a relatively inefficient way to do business ... I would be surprised if you can do it efficiently."

Tijuana is the perfect setting for both methods

Mexico has long been a hub for US companies, thanks to cheap labor costs, its proximity to populous California and Texas, and robust manufacturing infrastructure.

It's also growing as a US importer more generally, according to US Census Bureau data. Imports from Mexico have jumped 15.2% since Trump took office, compared to an increase of 0.7% from Canada and a decrease of 2.1% from China.

Even before Trump's trade war, logistics in Mexico were more cost-effective than in China or Hong Kong, according to an IVEMSA report. The cost of shipping a container from China to the US was roughly $7,000 in 2014, compared to $2,800 from Mexico. Industrial leases in China cost three times that of Mexico's.

"Tijuana has become - I'm going to say this in a good way - it's become like the backyard, the very positive and good backyard, of American business," Diaz said.

a close up of a map © US Census Bureau; Andy Kiersz/Business Insider

Now Tijuana is taking off in particular as American retailers and manufacturers look to mitigate tariff payoffs. Whether the company specializes in steel or sweatshirts, goods must be warehoused when they're being moved from China to Mexico before their final destination in US homes and stores.

"It's just amazing to see that it's a logistics city," Ohad Axelrod, CEO of Fr8Hub, a Laredo, Texas-based digital freight startup specializing in US-Mexico trade, told Business Insider, referring to Tijuana and Laredo. "It's just thousands of trucks and hundreds of warehouses. Every time I go there, there is something new building. The demand is increasing."

Warehouse workers in Tijuana cost $2 to $4 an hour instead of $18 to $24 in neighboring California, Diaz said. Real estate is much cheaper, too; storing a pallet costs $6 to $8 in Tijuana rather than $15 to $22 north of the border.

Trump's trade war is creating jobs after all - but they appear to be in Tijuana warehouses. Diaz emphasized that Americans still win in the end.

"The most important thing is that that doesn't mean that you're taking jobs to Mexico, because the real revenue is still distribution, it's still the patents and the trading brands and the royalties of the brands," Diaz said. "So, you take your cheapest cost, which is the warehousing and logistics, you do it in Mexico and you save a lot of money. It makes a lot of sense."

Are you a logistics professional who works with cross-border trade in Mexico? Share your insights with me at rpremack@businessinsider.com.

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