China remains the world’s second largest economy, and may indeed surpass the US before the COVID-19 pandemic. An increasing proportion of China’s industrial output and other Asian output is consumed locally or regionally within the Asia Pacific. As a result, US brand owners, manufacturers, and retailers are not likely to abandon the China market. This strategic separation looks increasingly like regionalisation rather than globalisation.
Nevertheless, recent developments may accelerate these longstanding trends and impart some urgency into the discussions. Many companies in industries from consumer electronics, wearing apparel, pharmaceuticals, and of course medical supplies, have had serious discussions about the practical implications of friend-shoring manufacturing and divestiture. Amongst the first considerations in any serious divestiture analysis is the disposition or reposition of manufacturing machinery and tooling in on-shoring or friend-shoring alliance.
In modern manufacturing, production capacity and know-how are often tied directly to the machinery itself. Whether it is proprietary production processes for certain telecommunications or consumer electronics items, or specially designed moulds for auto parts or kid toys, the value embedded in this equipment is significant. Planning in advance how to handle its movement or disposal is therefore essential. Although this is not an exhaustive due diligence checklist, in this short piece we highlight some of the key considerations to be taken into account.
The valuation of used machinery and tooling
Machines that are used in the production of finished goods that are ultimately exported may be either, purchased by the buyer/importer and provided to its contract manufacturer free of charge, or, they may be purchased and maintained by the contract manufacturer itself in which case the value is assumed to be recaptured in the finished goods prices on exported merchandise.
At the outset we note that machinery or tooling must be valued appropriately in support of its move from the current country location to the new production location. The valuation of the machinery would ordinarily be:
- The acquisition cost (if purchased from an unrelated supplier); or
- Cost of production of the machinery and tooling (including R & D, royalties and license fees) if the assist was produced by the buyer or party related to the buyer; plus
- Cost of transportation to the place of the manufacture
In addition to the initial valuation of the machinery or tooling, we must also take into consideration the use and/or wear and tear on the machines. As a general rule, customs authorities accept depreciation recognised in accordance with generally accepted accounting principles. This may also include those machines depreciated to zero.
The value of any embedded intellectual property
As with any physical merchandise that crosses borders, the value of intellectual property embedded in machinery or tooling must be included within the total value reported to customs. For example, moulds used for the production of plastic injection moulded toys may be made out of aluminium or some other alloy, which is obviously a part of the value of the tooling at the time of its relocation. In addition, the shape of the mould may have significant intellectual property value. For example, the mould may be designed and used to produce a well-known plastic doll.
If the intellectual property is licensed and subject to royalties, or is owned by a third party, this value may well need to be captured in the total value of the machinery or tooling that is being relocated. Conversely, if the intellectual property was developed in the country to which the machines and tooling are being relocated, there may be a possibility to exclude that value. In either case, a detailed analysis of all elements of value must be conducted in support of the relocation.
Export controls on the machines, tooling, or embedded technology
In certain industries, the machines and tooling used in the production process may incorporate technology that is considered dual-use and therefore potentially subject to strategic trade controls. In addition, the technology incorporated within the machines may have been developed in the United States even if the machine itself was produced in a third country. If US-origin technology is indeed included in the machinery and tooling, the relocation of the machines from one country to another may nevertheless be subject to the US Export Administration Regulations. For these reasons, a careful analysis of the export control status of the machine, which would include the origin of the underlying technology, may be required in order to properly relocate the machine from one country to another. Failure to do may result in significant liabilities.
Unique contractual provisions
Some countries, most notably China, have unique regulations relating to the taxation and dutiability of certain capital equipment required for manufacturing merchandise for export. In addition, there may be certain regulatory limitations surrounding contracting with overseas counterparties or dealing in foreign currencies. These unique regulatory provisions may result in beneficial ownership being retained in the overseas buyer/importer whilst the machines and tools themselves are in the physical possession of the contract manufacturer and even recorded on the accounting books of the contract manufacturer in order to comply with these unique regulatory provisions.
An analysis of the contracts of sale, licenses for the use, and any other commercial arrangements between the parties is necessary in order to properly dispose of, sell, and relocate the machinery and tooling without giving rise to tax and customs penalties or other compliance concerns.
Other regulatory requirements
In addition to the above, there may be other regulatory provisions that impact the relocation of the machines. For example, the contract manufacturer may have registered the machines and tooling in order to take advantage of certain duty-free arrangements under processing trade structures. Therefore, the machines may need to be affirmatively inspected and formally deregistered by the customs authorities in order to avoid a potential duty claw back or penalty.
Furthermore, there may be product regulatory and safety requirements on certain machines in the country of destination. These requirements may need to be met, requiring inspection, certification, or other formality before relocation can be properly effectuated.
Finally, the current location of the machines may require an outbound inspection on used machinery. These inspections could interrupt the relocation if the condition of the machines, the supporting commercial agreements, and other arrangements are not consistent with the regulatory scheme applicable to the export of old and used machinery.
Conclusion
The above considerations are not meant to be an exhaustive due diligence list. Rather, this is intended to provide some key considerations in the planning and execution of any production relocation in on-shoring and friend-shoring. As a best practice, we encourage our clients to prepare a due diligence checklist to support their internal finance, manufacturing and supply chain teams that may be involved in such planning projects.
Should you require any assistance or wish to discuss this further, please do not hesitate to contact me at William@marshall-legal.com.