The practice of determining an item's country of origin ("COO") and utilizing the principal of "substantial transformation" to help make this determination is likely a familiar concept for many U.S. importers in the context of compliance with U.S. Customs regulations. However, the principal of substantial transformation is also recognized by the U.S. Office of Foreign Assets Control ("OFAC") as being applicable in the somewhat unique context of U.S. sanctions. In particular, OFAC's recent import prohibitions on certain Russian-origin products demonstrates how the substantial transformation principal is becoming more relevant for U.S. importers responsible for addressing sanctions risks in their supply chains. This article will examine OFAC's recognition of the substantial transformation principle in the context of U.S. sanctions to provide importers with an overview of how this principal may impact their sanctions compliance programs and supply chain due diligence.
What is Substantial Transformation?
Substantial transformation is a legal principle used in determining the COO of a foreign-produced item that does not come from a single country. In general, an item will be considered substantially transformed if it has undergone a "fundamental change in form, appearance, nature, or character." Evidence that a product has been substantially transformed includes a rise in value of the transformed item, a different classification of the item under the Harmonized Tarriff Schedule ("HTS"), and the overall loss of the item's previous identity through manufacturing and production processes.1
An item that was made or grown in one country then substantially transformed into a new product in a second country will be considered as having originated from that second country. Typically, this principle has the most relevance in the context of determining the proper COO for preferential tariff treatment. It can also have a significant impact in cases where the COO determination can mean the difference between standard tariff rates or extremely high tariffs under a particular trade program or policy.
The COO of an imported item is a determination reported to U.S. Customs and Border Protection ("CBP") by the importer, but CBP ultimately is responsible for ensuring the reported COO is correct and enforcing related laws and provisions. OFAC, though it may apply the principle of substantial transformation in its sanctions programs, is not the agency responsible for overseeing the application of this principle and determining the COO of imported merchandise. As explained in more detail in the sections below, it is important for importers to keep in mind that the purpose of applying the substantial transformation principle in the Customs context ultimately relates to determining the COO of merchandise for import and tariff purposes. The application of the substantial transformation principle in the context of OFAC sanctions gives rise to separate compliance considerations that are distinct from an importer's Customs obligations.
The Substantial Transformation Principle in Recent Actions
In general, OFAC employs the substantial transformation principle to determine whether goods that include materials sourced from certain countries are subject to U.S. sanctions. This assessment can be crucial as it may influence whether a product is legally permissible for importation, exportation, or other transactions involving a U.S. nexus (i.e., U.S. products, U.S. persons, or U.S. dollars). There is not an extensive history behind the application of the substantial transformation principle in the context of U.S. sanctions as implementing import prohibitions based on the COO of items has not been a usual tactic of OFAC's in the past. However, in recent years OFAC import prohibitions have become more frequent, especially with regard to Russia-related sanctions programs, putting more of a spotlight on the application of the substantial transformation principle in the sanctions context.
For example, on April 12, 2024, OFAC issued a new determination under Executive Order 14068, as amended by Executive Order 14114, prohibiting the importation of "Russian Federation origin" copper, nickel, and aluminum into the U.S. ("Metals Import Determination"). This determination is one of the most recent developments in a line of import prohibitions implemented by OFAC with respect to Russian-origin goods. Importantly, OFAC has clarified in issued guidance that the term Russian Federation origin excludes "any Russian Federation origin good that has been incorporated or substantially transformed into a foreign-made product."2 This means that products made from, or that incorporate, the Russian-origin metals will not be prohibited from importation if these products have been transformed in such a way that the original character or identity of the metals has changed.
Other recent actions under Executive Order 14068, as amended by Executive Order 14114, include the February 8, 2024, Diamonds Determination prohibiting the import of diamonds that were mined, extracted, produced, or manufactured in Russia, and the December 22, 2023, Seafood Determination prohibiting the import of seafood products (salmon, cod, pollock, and crab) that have been produced or harvested in waters under Russian jurisdiction. Unlike the Metals Import Determination, the Diamonds and Seafood Determinations include statements that these respective products are prohibited from import despite whether such products "have been substantially transformed into another product outside of the Russian Federation."
For Customs purposes the COO of processed diamond and seafood products originally procured in Russia may be a different third country if these products have been substantially transformed outside of Russia. However, these substantially transformed products could still be caught under OFAC's import prohibitions if they meet the product descriptions in the Diamonds and Seafood Determinations, despite having another country listed as the COO. Thus, importers of these products must be careful to assess their supply chains for hidden sanctions compliance risks.
Compliance Considerations
As import prohibitions become more common under OFAC sanctions programs, importers face heightened compliance risks. In a broader sense, most importers already have some form of supply chain due diligence measures in place to identify legal, ethical, and practical risks in their international supply chains. However, OFAC's recent target of Russian imports puts a spotlight on U.S. importers and necessitates the inclusion of sanctions-related risk evaluations as part of an importer's regular supply chain due diligence.
Determining the country of origin for imported products is always an important step in conducting supply chain due diligence as U.S. parties must assess whether their goods are coming from locations that present compliance risks related to U.S. trade controls and economic sanctions. These locations may include embargoed countries or regions, locations where there are increased risks of forced labor, and regions known to be hotspots for diversion of U.S. trade controls and economic sanctions. In addition, suppliers themselves should be screened against U.S. sanctions lists to ensure that they are not restricted parties. These steps should be completed with respect to first-tier suppliers as well as other downstream suppliers to fully assess compliance risks and may even include requests that suppliers certify that they are conducting business in compliance with U.S. trade controls and economic sanctions.
OFAC's application of the substantial transformation principle in the sanctions context also means that importers may need to add more specific compliance procedures to evaluate sanctions compliance risks that go beyond reviewing the COO of imported merchandise and screening supplier parties. Inquiring into where a supplier has sourced raw materials or other base products may be necessary to determine if an item substantially transformed outside of Russia is still caught within the bounds of OFAC import prohibitions. Importantly, importers must be careful to assess the specific language used in applicable import prohibitions and relevant published guidance to identify instances where OFAC provides insight on how the agency interprets the substantial transformation principle with respect to specific products and whether import prohibitions remain in effect despite a product having a COO that technically, for Customs purposes, is not Russia. While the substantial transformation principle used in the sanctions context is typically similar to a substantial transformation analysis that would be conducted for purposes of determining the COO of merchandise for Customs compliance, OFAC's policies and focuses are ultimately different than those of CBP and the application of the substantial transformation principle in the sanctions context will have different implications compared to application of the principle in the Customs context.
Understanding and applying the principle of substantial transformation is essential for U.S. importers, now particularly in the context of sanctions compliance. The increasing frequency of OFAC's import prohibitions, especially related to Russian-origin goods, highlights the need for diligent supply chain monitoring. Importers must thoroughly assess the origins of materials and products in their supply chains to ensure compliance with U.S. sanctions, consider the implications of COO determinations beyond what is typical for Customs-related requirements. Incorporating sanctions-related risk evaluations into regular supply chain due diligence is now more critical than ever. Ultimately, careful attention to the specific guidance provided by OFAC can help importers navigate these complex compliance challenges effectively.
Footnotes
1. See, Determining Origin: Substantial Transformation, International Trade Administration, https://www.trade.gov/rules-origin-substantial-transformation (last visited Sept. 19, 2024).
2. See FAQ #1019, Office of Foreign Assets Control, https://ofac.treasury.gov/faqs/1019 (last updated Apr. 12, 2024).
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