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HQ 229589

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October 24, 2002

FOR-2-01 RR:CR:DR
229589RDC

Tammie Goldstein Krauskopf, Esq.
Katten Muchin Zavis Rosenman
525 West Monroe Street
Suit 1600
Chicago, IL 60661-3693

Dear Ms. Krauskopf:

This is in response to your request dated July 2, 2002, on behalf of your client, R. P. Scherer Corporation (“RPS”), for a binding ruling per 19 CFR, Part 177, regarding manufacturing in a foreign trade zone (“FTZ”).

FACTS:

RPS manufactures pharmaceutical, nutritional, cosmetic and recreational softgels in its foreign trade subzone. During its encapsulation process, RPS encapsulates “fill ingredients” in a gelatin capsule. You state,

RPS sources gelatin from both foreign and domestic vendors. Gelatin is converted into gelatin mass (raw gelatin, plasticizer, water and possibly dye) per specific formula per softgel product. The gelatin mass is assigned to a production batch to manufacture the softgels. The softgel contains pharmaceutical drugs, nutrition vitamins, nutrition supplements, or cosmetic ingredients. The fill ingredients are either purchased by RPS from vendors or supplied, on consignment, to RPS by its customers. For the most part, fill materials are received in the zone as domestic status.”

You further state,
gelatin waste is generated from the softgel manufacturing process. Some gelatin generated during production is not suitable for use by RPS and some of this gelatin is valueless and some is sold to glue manufacturers. In the manufacture of pharmaceutical, nutritional, and cosmetic softgels, gelatin mass is lost as a result of a rotary die process. . . .

This loss is referred to as “netting.” Further, finished softgels which fail to meet specifications are considered waste.

Some gelatin is consumed or lost, before, during or after the production process. RPS refers to three categories of “gelatin losses” generated by the softgel manufacturing process. The first category
involves gelatin that is simply consumed or lost before, during or after the production process. There is no waste to recover. The second category is gelatin waste that is produced in the process and has no value. We will refer to this gelatin waste as irrecoverable gelatin waste. The [third] category is gelatin waste, which is produced in the process and can be sold to glue manufacturers. We will refer to it as recoverable waste.

RPS contracts outside parties to destroy all waste resulting from pharmaceutical softgel production as required by the Food and Drug Administration.”

ISSUES:

1. Are losses of gelatin during manufacture due to evaporation, spillage, leakage, etc., reported?

2. Is irrecoverable waste included in the dutiable value of the non-privileged encapsulated product that enters the US?

3. How is the recoverable gelatin waste which results from the manufacture of non-privileged foreign status merchandise into softgels in a FTZ valued?

LAW AND ANALYSIS:

1. Are losses of gelatin during manufacture due to evaporation, spillage, leakage, etc., reported?

Regarding the characterization of waste, there appears to be some confusion. Waste in various Customs’ contexts has been the subject of the following court decisions. In Patton v. United States, 159 U.S. 500, 503, 16 S. Ct. 89 (1895), the Court stated that

[t]he prominent characteristic running through all these definitions [of waste] is that of refuse, or material that is not susceptible of being used for the ordinary purposes of manufacture. It does not presuppose that the article is absolutely worthless, but that it is unmerchantable, and used for purposes for which merchantable material of the same class is unsuitable.

See also, Latimer v. United States, 223 U.S. 501, 504, 32 S. Ct. 242 (1912), in which the Court stated that "[t]he word [waste] as thus used generally refers to remnants and by-products of small value that have not the quality or utility either of the finished product or of the raw material." These Supreme Court cases were cited and relied upon in Mawer-Gulden-Annis (Inc.) v. United States, (17 CCPA 270, T.D. 43689 (1929)), in which broken green olives, imported in casks in brine and used to make garnishing or sandwich material, were held not to be waste on the basis that the broken green olives "possess[ed] the same food qualities and some of the uses of whole pitted green olives" (17 CCPA at 272). See also, Willits & Co. v. United States, 11 Ct. Cust. App. 499, 501-502, T.D. 39657 (1923), in which certain beef cracklings were held to be waste as material not susceptible of being used in the ordinary operations of a packing house, material not sought or purposely produced as a by-product in the industry, material not processed after it became a waste, and not possessing the characteristics of its original estate.

Based on the foregoing therefore, we believe that some of the gelatin that RPS describes as “process losses” is in fact waste, for example, “discarded gelatin” described on page 4 of its submission, is almost certainly waste. Further, “discarded gelatin” and any other waste is not a “shortage” as provided for 19 CFR § 146.53(c)(1). Moreover, irrecoverable waste is that which cannot be recovered; irrecoverable waste is not synonymous with valueless waste (see HRL 22896 (September 27, 2002)). Some valueless waste can be recovered. Finally, waste typically includes material captured during clean-up, i.e., material gathered by rags, mops and filters.

RPS states that it “believes that it is not required to pay duty on the first category of process losses that were a result of spillage, evaporation, or leakage . . . .” We explain below how duty is calculated with regard to manufacturing in a FTZ. However, you also ask “must gelatin, which is lost in the process through evaporation, spillage, leakage, etc., be reported? We are uncertain as to the meaning of “reported” but draw your attention to 19 CFR, Subpart B which contains the accounting requirements for foreign trade zones, including the requirement that a FTZ operator be capable of accounting for all merchandise in its FTZ.

The general requirements for inventory control and recordkeeping in a FTZ are provided in 19 CFR § 146.21. Under this provision, a FTZ operator is required to maintain inventory control and recordkeeping systems capable of: (1) accounting for all merchandise undergoing operations in a FTZ, including the admission into, storage in, and/or removal from a FTZ; (2) producing accurate and timely reports and documents as required by the applicable Customs Regulations; (3) identifying shortages and overages of merchandise in a FTZ in sufficient detail to determine the quantity, description, tariff classification, zone status, and value of the missing or excess merchandise; (4) providing all information necessary to make entry for merchandise transferred to the Customs territory; and (5) providing an audit trail to Customs forms from admission through transfer of merchandise from a FTZ either by zone lot or Customs authorized inventory method.

Under 19 CFR § 146.23(a)(1), which provides for the accountability for merchandise in a FTZ, a zone lot number or unique identifier is required to be used to identify and trace merchandise. Under paragraph (b) of this provision, inventory records are required to specify by zone lot or unique identifier the following information: (1) location of the merchandise; (2) zone status of the merchandise; (3) cost or value of the merchandise; (4) beginning balance, cumulative receipts and removals, adjustments, and current balance on hand by date and quantity; (5) destruction of the merchandise; and (6) scrap, waste, and by-products. Under paragraph (a)(2) of this section, fungible merchandise may be identified by an inventory method authorized by Customs which is consistently applied, such as FIFO, and using a unique identifier. Under paragraph (c) of this provision, the FTZ operator is required to take at least an annual physical inventory of all merchandise in the FTZ and to notify Customs of any discrepancies in accordance with 19 CFR § 146.53. Per 19 CFR § 146.53 “shortages and overages” must be reported to the port director in writing “upon identification.” (See also 19 CFR § 146.25, under which the operator is required to prepare an annual reconciliation report for Customs.)

RPS also states that it “believes that these losses [evaporation, spillage, leakage, etc.] fall within 19 CFR § 146.53(c). Per § 146.53(c) the FTZ operator is responsible under its FTZ Operator's bond for shortages (unless Customs is satisfied that one of the listed excuses pertains). Upon demand by Customs, the FTZ Operator is required to make entry for and pay duties and taxes applicable to merchandise which is missing or otherwise not accounted for. Without further information we are not persuaded that gelatin which has been spilled or has leaked out of a container can be described as missing or otherwise not accounted for. Losses per 19 CFR § 146.53(c) must be distinguished from waste as defined by the courts above. It appears that RPS confuses these two separate and distinct concepts.

2. Is irrecoverable waste included in the dutiable value of the non-privileged encapsulated product that enters the US?

The Foreign Trade Zones Act of 1934, as amended (48 Stat. 998; 19 USC § 81a through 81u) regulates the creation and operation of FTZs. Per 19 USC § 81c(a), in part,

Foreign and domestic merchandise of every description, except such as is prohibited by law, may, without being subject to the customs laws of the United States, except as otherwise provided in this chapter, be brought into a zone and may be . . . , mixed with foreign or domestic merchandise, . . . be manufactured except as otherwise provided in this chapter, and be exported, destroyed, or sent into customs territory of the United States therefrom, . . . but when foreign merchandise is so sent from a zone into customs territory of the United States it shall be subject to the laws and regulations of the United States affecting imported merchandise . . . .

Thus, 19 USC § 81c(a) provides that foreign and domestic raw materials may be brought into a FTZ without such raw material being subject to US customs law. While in the FTZ the raw materials may be mixed with foreign or domestic merchandise and manufactured. When the foreign merchandise leaves the FTZ, in whatever form it leaves the zone, as finished product, valuable waste, valueless waste, or otherwise, and is sent into the US customs territory, it must be entered (see 19 CFR § 146, subpart F). When foreign merchandise leaves a FTZ, regardless of its form when transferred, it is then subject to US laws, including regulations affecting imported merchandise and assessment of import duty.

Conversely, if foreign merchandise does not leave the FTZ or leaves the FTZ but does not enter the customs territory of the US (e.g., is exported or destroyed within the zone) it is not subject to US law. However, regarding your statement, that “gelatin [waste] is not sold but sent to a landfill, RPS considers it to be destroyed.” First, please note, if the landfill is located outside the FTZ, this waste must be entered (see 19 CFR § 146, subpart F) and applicable duty, if any paid. With regard to destruction by depositing in a landfill, in HRL 220095 (February 9, 1989) we held, in part, that, “the nutshell waste from the shelling operation may be destroyed in the foreign trade zone, exported, or entered into the United States. However, depositing the nutshell waste in the trash would not constitute destruction for these purposes.”

Consequently, we note that merely depositing gelatin waste into a landfill does not necessarily constitute “destruction” for Customs’ purposes. See also 19 CFR § 146.52(e) which authorizes a district director to permit merchandise in a foreign trade zone to be destroyed outside of the zone if it cannot be properly destroyed within the zone, and also provides that any residue from the destruction of merchandise within a zone, which is determined to be without commercial value, may be removed to the customs territory for disposal. For further guidance on destruction in a FTZ please see HRL 224110 (March 17, 1993) which addresses destruction for purposes of 19 USC § 81c(a).

19 USC § 81c(a) further states,

Provided, That whenever the privilege shall be requested and there has been no manipulation or manufacture effecting a change in tariff classification, the appropriate customs officer shall take under supervision any lot or part of a lot of foreign merchandise in a zone, cause it to be appraised and taxes determined and duties liquidated thereon.

This first proviso of 19 USC § 81c(a) therefore, authorizes privileged foreign merchandise status. Section 146.41(a), Customs Regulations (19 CFR § 146.41(a)), provides that, for purposes of foreign trade zones,
foreign merchandise which has not been manipulated or manufactured so as to effect a change in tariff classification will be given status as privileged foreign merchandise on proper application to the district director.

Such merchandise is called privileged foreign (“PF”) merchandise (19 CFR § 146.41). But for waste, privileged foreign merchandise retains its original identity even if it later goes through a manufacturing process (19 CFR § 146.41(e)). PF merchandise is classified and valued as provided in 19 CFR § 146.65. According to its counsel, RPS does not use privileged foreign merchandise in this subzone.

19 USC § 81c(a) further provides,

If merchandise so taken under supervision [PF merchandise] has been manipulated or manufactured, such duties and taxes shall be payable on the quantity of such foreign merchandise used in the manipulation or manufacture of the entered article. Allowance shall be made for recoverable and irrecoverable waste; and if recoverable waste is sent into customs territory, it shall be dutiable and taxable in its condition and quantity and at its weight at the time of entry.

(Emphasis ours.) This portion of the FTZ Act must be read in conjunction with the preceding portion. The first words of this portion (underlined above) make it clear that this section applies to privileged foreign merchandise only. Thus, it provides that when privileged foreign merchandise has been subject to manufacture or manipulation duty is owed on the amount of PF merchandise used in the manufacture of the entered merchandise and allowance must be made for waste.

You state that your “letter deals with non-privileged foreign merchandise.” Since this proviso applies only to privileged foreign merchandise there is no allowance for waste applied to non-privileged foreign status merchandise. Therefore, Goodman Manufacturing v. United States, 69 F.3d 505 (Fed. Cir 1995) wherein the valuation of the waste from manufacturing furnaces from privileged foreign steel in a FTZ was determined, does no apply to the non-privileged foreign status merchandise used in the RPS subzone. In HRL 543048 Customs ruled that “the total cost of steel coil used in the manufacture of body stampings in a FTZ is included in the dutiable value of such body stampings” with a deduction for the value of the scrap or waste generated during production. You contend that the decision in Goodman (supra) reversed that methodology. However, in Goodman, the interpretation of the proviso discussed above required the allowance for recoverable and irrecoverable waste. There is no such requirement for non-privileged status merchandise. The deduction is necessary for privileged merchandise because it is liquidated when the request for privilege is granted – before manufacture or processing begins. Thus, Congress recognized the commercial reality that waste is produced during manufacture and required the allowance from the value for waste. Nonprivileged merchandise is appraised in its condition as it is entered from the zone and Customs, consistent with the language of 19 USC § 81c(a) applies the valuation principles affecting imported merchandise at the time it is entered.

Under § 146.65(a)(2) of the Customs Regulations (19 CFR § 146.65(a)(2)), nonprivileged foreign status merchandise (see 19 CFR § 146.42(a)) is subject to tariff classification in accordance with its character, condition and quantity as constructively transferred to Customs territory at the time the entry or entry summary is filed with Customs. Under this provision, the importer chooses to have the merchandise treated, for tariff purposes, in its condition as removed from the zone rather than in its condition upon its admittance into the zone.

Thus, when RPS manufactures softgels in the FTZ using non-privileged foreign status materials, duty is due on that merchandise which leaves the FTZ and enters the Customs territory of the United States. Moreover, duty is calculated based on the merchandise’s character and condition when it exits the FTZ and enters US Customs territory. No allowance for waste is permitted for non-privileged foreign status merchandise.

3. How is the recoverable gelatin waste which results from the manufacture of non-privileged foreign status merchandise into softgels in a FTZ valued?

Per 19 USC § 81c(a), “if recoverable waste is sent into customs territory, it shall be dutiable and taxable in its condition and quantity and at its weight at the time of entry.” Thus, waste which results from manufacture in a FTZ, if such waste leaves the FTZ and enters the customs territory of the US is valued as NPF merchandise per 19 CFR § 146.65(b)(2):

The dutiable value of merchandise provided for in this section shall be the price actually paid or payable for the merchandise in the transaction that caused the merchandise to be admitted into the zone, plus the statutory additions contained in section 402(b)(1) of the Tariff Act of 1930, as amended by the Trade Agreements Act of 1979 (19 USC. 1401a(b)(1)), less, if included, international shipment and insurance costs and US inland freight costs.

Therefore any waste which leaves the FTZ and enters US Customs territory, regardless of value, or whether it is sold or disposed of after leaving the zone, is dutiable “ in its condition and quantity and at its weight at the time of entry.”

HOLDING:

1. A FTZ operator must be capable of accounting for all merchandise in its FTZ as required by 19 CFR § 146.21.

2. There is no allowance for waste, irrecoverable or recoverable applied to non-privileged foreign status merchandise.

3. Recoverable gelatin waste which results from the manufacture of non-privileged foreign status merchandise into softgels in a FTZ is valued per 19 CFR § 146.65(b)(2).

Sincerely,

Myles Harmon, Acting Director

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