Finding Tax Savings in Free-Trade Zones

Angela Adolph, Kean Miller LLP

Foreign-trade zones can offer substantial tax savings for businesses involved in various aspects of manufacturing and international trade. While there are costs involved in setting up and maintaining such a zone, the prospect of escalating trade wars is spurring companies to explore the FTZ designation as a potential cost-control measure.

First, some background. FTZs are the U.S. equivalent of what are known internationally as free trade zones. Authorized under the Foreign Trade Zones Act of 1934, they are usually in or near U.S. Customs and Border Protection ports of entry, and are generally considered outside CBP control. Many communities have integrated these zones into state or local economic development incentive programs.

Broadly speaking, FTZs are designed to stimulate economic growth and development. In an expanding global market, countries increasingly compete for capital, industry, and jobs, and FTZs promote American competitiveness by encouraging companies to maintain and expand their U.S. operations. The zones accomplish this by removing certain disincentives associated with operating in the U.S.

The best-known incentive is designed to level costs among domestic and foreign- manufactured goods. For a product manufactured in a foreign country and imported to the United States, the duty is based on the finished product rather than on its individual parts, materials, or components.

Domestic manufacturers must often pay duties on multiple parts, materials, or components that are imported to be incorporated into a finished product. When those duty payments are added together, the cost of the finished product is higher than for comparable finished goods. FTZs correct this imbalance by assessing duties on products manufactured in an FTZ as if they were manufactured abroad.

Companies operating in FTZs enjoy a number of other benefits:

• No duties or quotas on re-exports
• Deferred customs duties and federal excise taxes on imports
• Streamlined customs procedures
• Exemption from certain state and local taxes

These benefits become increasingly valuable to domestic companies during trade wars, particularly when the disputants impose steep tariffs on manufacturing parts, materials, and components.

State and Local FTZ Rules

FTZs are subject to the laws and regulations of the U.S., as well as those of the states and communities in which they are located, with one significant exception: The Foreign-Trade Zone Act specifically prohibits state and local ad valorem (“on the value”) taxation of imported, tangible personal property stored or processed in one of these zones, or of property produced in the United States and held in the zone for export.

Several states, including Arkansas, Kentucky, Louisiana, Maryland, Mississippi, Oklahoma, Texas, Virginia and West Virginia, impose ad valorem tax on business inventory. In a handful of other states, including Alaska, Georgia, Massachusetts, and Michigan, some jurisdictions tax some inventories. But even in these states, most legislatures have carved out “freeport” exemptions from ad valorem taxes on merchandise being shipped through the state.

The problem is, the longer it takes for the merchandise to be shipped out of state, the greater the temptation for an enterprising tax assessor to conclude that the merchandise is no longer actively in transit. In such cases, the exemption may no longer apply and the merchandise could become subject to an inventory ad valorem tax.

FTZs may offer a safe harbor from these taxes. Foreign and domestic merchandise may be moved into a zone for operations, including storage, exhibition, assembly, manufacturing, and processing. Such merchandise may remain in a zone indefinitely, whether or not it is subject to duties. And, while no retail trade of foreign merchandise may be conducted in an FTZ, foreign and domestic merchandise may be stored, examined, sampled, and exhibited in the zone.

Of course, there is a catch. When a proposed FTZ designation could result in a reduction to local tax collections, the zone’s governing authority must consider the potential impact on local finances. Specifically, an applicant must identify the local taxes for which collections would be affected, and provide documentation that the affected taxing jurisdictions do not oppose the FTZ designation. Importantly, in jurisdictions that already have “freeport” exemptions to ad valorem taxes, the adverse impact would be limited only to the amount of ad valorem taxes imposed on inventory that is determined by a tax assessor to have come to rest in the state, such that it is no longer subject to the “freeport” exemption.

There are costs associated with FTZs, including application fees and assessments as well as operating fees to maintain the designation. Therefore, individual companies must conduct their own cost/benefit analyses and determine whether these zones are right for them. A competent legal or tax advisor can help to project initial and ongoing costs.

Considering the other trade uncertainties currently buffeting manufacturers, eliminating ad valorem tax exposure alone may warrant using an FTZ.

Angela Adolph is a partner in the law firm of Kean Miller LLP, the Louisiana member of American Property Tax Counsel, the national affiliation of property tax attorneys. She can be reached at [email protected].