There were a few worried faces on the 23rd floor of a skyscraper in the business hub of Hong Kong’s Taikoo Place last Wednesday afternoon.
One of the most worried faces belonged to a supply chain manager for a Canadian technology company which manufactures the bulk of its products in China for export to North America.
A few years ago, in an effort to combat rising labour costs in the southern mainland province of Guangdong, his company shifted some of its production to Laos, only to find that the quality and support was nowhere near the level in South China.
“We wanted to move back to China,” he said. “Yes it is more expensive, but the support is much better.
“But then they started talking about tariffs.”
The company is now stuck with sub-par production facilities in Laos. However, since the trade war began last July, anything produced in its plants in China is subject to a 10 per cent tariff when exported to the US. In March, if there is no trade agreement, this is due to increase to 25 per cent.
The worried businessman – who spoke to the South China Morning Post on condition of anonymity – says his company is being whacked twice by Donald Trump’s tariffs.
“We can take 10 per cent, we divide the cost between our suppliers and pass some on to our customers. But if it goes up to 25 per cent, I don’t know what we will do. I may lose my job,” he said.
He was one of about 20 people in the room, listening to presentations from PwC and Deloitte, about how companies in Hong Kong can avoid paying tariffs in China, but mainly in the US.
The secret lies in an arcane, decades-old customs rule that was codified into US law during the Ronald Reagan administration.
“I don’t usually come to these things,” said a director of a logistics company, who also wished not to be identified, but who said questions from clients had driven him to attend the event.
Cargo volumes at the port of Hong Kong are down by 5 per cent in 2018, and while it is difficult to quantify how much of that is directly related to the trade war – only 16 per cent of the total freight volume is directly related to the US – experts are expecting to see a further fall off once the effect of front-loading of export orders wears off.
“Hong Kong, from a shipping perspective, is 70 per cent transshipment. It is volume coming into Hong Kong and going out to China, volume coming into Hong Kong from China, going to other parts of the world,” said Peter Levesque, group managing director of Modern Terminals, the second largest container terminal operator in Hong Kong.
“So whatever happens between the US and China, it definitely impacts on Hong Kong,” he said.
The mood in Hong Kong is as palpable as it is understandable.
Hong Kong financial secretary Paul Chan, speaking at the city’s 12th Asian Financial Forum this week, said he entered the new year full of “anxiety” over the decline of the rules-based trading system.
Wilson Chong, senior economist at the Hong Kong General Chamber of Commerce, confirmed the mood of general anxiety.
“Some chamber members have received fewer orders from their US clients due to the trade war,” Chong said.
“Some are worried that the situation might last longer and this uncertainty is hindering them from making important investment decisions.”
While many companies are considering moving their manufacturing out of China, that’s not always possible.
It can take years to relocate. And – as the experience of the Canadian technology company in Laos demonstrates – the quality, expertise and reliability in Southeast Asian countries can often fall well short of that in China.
Furthermore, few of these hubs have the infrastructure and capacity to absorb a mass exodus of manufacturing from China. The population of Vietnam, for example, is smaller than that of Guangdong province, while Cambodia in its entirety would fit neatly inside Hebei province, China’s 12th largest.
It is unsurprising, then, that companies are looking for technical workarounds to dodge tariffs.
The presentations from the accountancy firms were complex and high on jargon. But those who sat in the room at Taikoo were engaged, asking questions and scribbling notes.
Desperate times call for desperate measures and one such measure being considered is an arcane, mysterious, 30-year-old piece of trade legislation known as the “first sale rule”.
The first sale rules applies to goods bought and sold multiple times en route to their final buyer in the US, and works like this:
If you have a factory in China making smartphones, you sell that product first to your trading company in Hong Kong (or anywhere else). Your Hong Kong trading company sells it on to the US, but Trump’s tariffs are only payable on the first sale price – that is, what the trading company paid the factory.
There’s a catch: each of these transactions needs to be legitimate. Each party must make money and you have to prove this through reams of documentation, such as purchase orders that require transparency from your suppliers in China.
A major challenge is convincing Chinese suppliers to share details of their finances.
It can be “a pain” to implement, said Farouk Merzougui, chief financial officer of Native Union, a designer of luxury tech accessories, which is using the first sale rule to skirt tariffs.
It took five months to implement, but he’s now saving two-thirds of the duty slapped on his US exports.
When the trade war hit last summer, he was in the middle of inventory planning for the Christmas season. Merzougui’s firm looked at moving production to Cambodia or Vietnam, but had reservations about the manufacturing standards.
Native Union doesn’t own its facilities in South China but trusts its suppliers to deliver a quality product, according to Merzougui.
“We were looking for a bridge between a short term and long term supply chain solution, to Christmas basically. It’s not easy, it’s a very unknown rule. But based on our current organisation, it was likely to be the best short term fix,” he said.
“At [a tariff of] 10 per cent this is navigable, at 25 per cent, it’s survival,” Merzougui told the Post.
“It doesn’t protect you totally from the tariffs, it dilutes the burden. It’s not easy, a lot of preparation and documentation. But this trade war has become a competitive advantage.
“We’re a small organisation so we could move fast. Competitors were waiting to see, so we got a competitive advantage.”
The rule has been challenged numerous times but remains in place in the US, which is now the only major market in which first sale can be used, after the EU outlawed it in 2016.
For companies which have never dealt with trade tariffs before, the first sale rule offers a convenient solution.
“First sale is our baby,” said Sally Peng, Hong Kong-based Asia-Pacific practice group leader at Sandler, Travis & Rosenberg, a firm that specialises in trade and customs issues.
It was her firm that brought the litigation case that established the first sale rule in 1988.
In that case, tailored suits were being made to measure in Hong Kong, then shipped to Detroit, via a network of distributors and freight-forwarders, meaning that by the time they reached the final customer in Michigan, they had been sold numerous times.
Those involved in the import trade thought duty should only be paid on the price of the first sale. The United States Court of Appeals agreed.
Three decades on, Peng said, the esoteric loophole now accounts for more than 50 per cent of her practice’s business.
Until recently, first sale was used mainly by the apparel, footwear and electronics industries, which have been subject to relatively high import duties in the US. But, since the trade war began, other firms are catching on.
“In the past, there needed to be two things happening at the same time for first sale to be used. One is that you need a really high volume of exports, as much as possible.
“The second is you want the duty to be high. For some garments, such as yoga clothes, the duty is over 30 per cent, so it was widely used,” Peng said.
Now businesses that have previously enjoyed low tariff access to the US market are getting in touch, even those which don’t have a high volume of exports.
Peng says she is hearing from manufacturers of everything from tables, through car parts, to phone covers and air conditioning units which are produced in Chinese factories and exported to the US.
“The companies that may not have that high a volume [of exports] will consider doing first sale, because they need every little bit of help that they can get,” Peng said.
The common denominator is that each product is on the list of goods subject to US tariffs under Section 301 of the 1974 Trade Act, the legislation underpinning the US trade war.
The Post spoke to more than a dozen exporters, academics, lawyers, customs experts and consultants about the first sale rule. Some were fully familiar with it, others loosely, while about half had never even heard of it.
Deloitte and PwC said they were fielding more enquiries from Hong Kong companies looking for workarounds before the trade war “truce” expires on March 1.
“Half a year ago we started getting enquiries. That’s when people started to feel that the trade war is going to continue, even though in the beginning a lot of people were hoping that it would end pretty quickly,” Derek Lee, a partner specialising in trade at PwC, said.
Trade lawyers in the US said the rule was legitimate and usable, but warned that the US Customs and Border Protection agency (CBP) would be watching like a hawk for discrepancies.
“Establishing that the necessary conditions will be met for use of ‘first sale’ value is complex and requires careful evaluation,” said Craig Lewis, a trade partner at law firm Hogan Lovells’ Washington practice.
“CBP continues to recognise the validity of this valuation methodology in its practices and rulings, including a ruling recently issued in 2018,” Lewis said.
“Therefore, absent new legislation amending the valuation statute, first sale valuation should continue to be acceptable to use first sale value where the required factual conditions are met.”
Back in Taikoo, the reaction was a mixture of excitement and suspicion.
“Even if true, I wouldn’t recommend it to any of our customers as it doesn’t follow the spirit of the law,” said the logistics provider.
The supply chain manager who fears for his job was more enthused. “That was the first time I heard that we could transfer the cost of the tariff,” he said on the phone days later.
“This is something I am very excited about.”