BIS Imposes Record Penalty on Applied Materials, Rejects Customs’ Substantial Transformation Test, but Offers No Clear Standard for Foreign-Origin Determinations

At issue was Applied Materials’ reexport to proscribed Chinese customers of semiconductor manufacturing equipment, assembled in South Korea and reportedly made largely with parts that came from the United States.

This enforcement action — representing the maximum statutory penalty of twice the value of the underlying transactions — signals BIS’ aggressive posture toward a trifecta of current export control priorities: semiconductor manufacturing, Entity List entities, and China. At the same time, it raises significant questions about how companies should treat items assembled abroad incorporating US-origin components. 

Overview of Alleged Violations

The proposed charging letter alleges that between 2020 and 2022, Applied Materials reexported or attempted to reexport chipmaking equipment from South Korea to Semiconductor Manufacturing International Corporation (SMIC) or certain SMIC subsidiaries in China. BIS had issued an “is-informed letter” in September 2020 to tell Applied Materials that a license was required to sell the equipment to these entities. Further, all of the customers were designated on the Entity List a few months later. A license is required to export, reexport, or transfer (in-country) any items subject to the Export Administration Regulations (EAR) when any such listed entities are a party to the transaction. 

The items at issue were ion implanting machines assembled in South Korea using components that were either US-origin or shipped from the United States. According to BIS, upon receiving the “is-informed” letter and even following the addition of SMIC and several of its subsidiaries to the Entity List, Applied Materials reacted by accelerating plans to move part of its manufacturing process to South Korea. The supply chain operated as follows: Upon receipt of an order from SMIC, the company began production of the ion implanters in the United States, then shipped the partially built machines — along with other US- and foreign-origin parts — from the United States to South Korea for assembly and testing, and then sent onto SMIC in China. According to BIS, every component in the machines was either US-origin or shipped from the United States, except two pieces shipped directly from Singapore to China for final installation at the customers’ facilities (plus a handful of parts that may have been sent to Korea from abroad on some occasions). 

Applied Materials did not obtain BIS licenses for these so-called “dual-build” items. The company believed that the ion implanters were foreign origin because they were “substantially transformed” through assembly and testing in South Korea. Further, Applied Materials reasoned that the machines were not subject to the EAR because they did not contain more than de minimis controlled US-origin content. (We assume that the company also determined the machines were not captured by the relevant Foreign Direct Product rules.) 

BIS disagreed, stating in its order, “The correct application of the EAR would have concluded that the ion implanting equipment was of U.S. origin because … [T]he fact that the ion implanting equipment may have been further assembled and/or tested in South Korea is of no moment; these items were all subject to the EAR at the time they were reexported from South Korea to SMIC in China.”

No Clear Guidelines on De Minimis and Origin Analysis

This settlement carries significant implications — but few answers — for how companies should assess whether items assembled outside the United States qualify as “foreign-origin” for purposes of the EAR’s de minimis rules.

• Rejection of Substantial Transformation Standard: BIS flatly rejected the application of the “substantial transformation” test¹, which is used under US customs laws for determining whether an item assembled abroad becomes foreign origin. Under traditional Customs rules, an article’s country of origin is determined by the country in which the article was substantially transformed. Courts have defined substantial transformation to mean that the article emerges from a manufacturing process with a new name, character, or use distinct from the original materials. Factors that may be considered in a substantial transformation analysis include the complexity of the processing undertaken and amount of labor hours involved, the latter of which Applied Materials heavily relied upon in its arguments that its ion implanting equipment were of foreign origin. However, BIS made clear in its order and settlement agreement that assembly operations in a foreign country do not convert US-origin items into foreign-origin products merely because some manufacturing processes occurred abroad. 

• Focus on Content, Not Process: Indeed, BIS was not interested in what types of processes Applied Materials used to create the final item in a foreign country. Instead, BIS hinted that whether an item is foreign origin (which would make de minimis treatment applicable) depends on having a certain level of foreign-origin content that is not shipped from the United States, although BIS did not specify what that threshold of foreign content would be. Critically, even the foreign-origin parts used in the assembly of Applied Material’s equipment were — with the exception of the two parts that came from Singapore — shipped from the United States. 

• The Threshold Remains Unclear: While BIS has indicated what standard not to apply, it did not articulate any useful test for determining when an item assembled abroad with US content may be considered foreign origin. 

All in all, this seems to be a classic case of the maxim “bad facts make bad law.” In particular, BIS appeared to focus heavily upon the fact that Applied Materials “began production in the United States” upon receipt of a SMIC order, and that all parts necessary to complete production in South Korea were exported from the United States for the sole purpose of producing the equipment for SMIC. BIS does not provide companies with any guidance besides telling them to steer clear of Applied Materials’ exact same conduct: 

BIS deems that U.S.-origin items or items physically located in the United States on which production begins in the United States are not rendered “foreign-made” when the items are exported and then undergo further assembly and testing in a foreign country when, as here, those activities outside the United States involved little or no foreign-origin parts that were shipped to the foreign location from a non-U.S. location.

While we appreciate BIS’ detailed discussion of why the de minimis analysis was inappropriate in this case — which, as BIS observes, “is purely informative” considering that the conduct at issue is the reexport of US-origin items — we are left with more questions than answers. Besides the main question of when an item is “foreign enough,” we are also wondering: Would BIS have reached a different result if the foreign-origin parts that Applied Materials used were shipped from other countries? Does it matter which parts are foreign origin? And does the analysis change if the US-origin or foreign-origin parts shipped from the United States were not provided for the sole purpose of assembling a specific item? We hope that BIS will provide guidance on these important questions. 

Other Key Takeaways

Enforcement Posture and Penalty Considerations: The fact that BIS imposed the maximum statutory penalty — calculated at two times the value of the transactions — indicates that BIS did not give any mitigating credit and was intent on making a statement consistent with a commitment to aggressive enforcement of China-related export controls. BIS underlined this by also requiring two internal audits of Applied Materials’ export controls compliance program, with the audit reports to be submitted to BIS. BIS also imposed a suspended denial order on Applied Materials for a period of three years, but the suspension is contingent only on completing the audits and paying the penalties, not on ensuring no export control violations during the three years. Companies should expect that violations involving proscribed Chinese entities, particularly those on the Entity List like SMIC, and involving priority areas such as semiconductor manufacturing, will be treated with the utmost severity by BIS.

Potential Discrepancy Between Export Control and Customs Origin: The settlement raises an interesting question regarding potential discrepancies between country-of-origin determinations for export control and import purposes. Under BIS’ interpretation, an item built in South Korea using predominantly US-origin components “remained a U.S.-origin item” for export control purposes under the fact pattern before BIS. However, from a Customs point of view, the same item may well have been considered South Korean origin, if Applied Materials is correct that the assembly and testing of the ion implanters in Korea constituted a “substantial transformation.” The practical implications of this discrepancy may be limited because the two determinations apply in different regulatory contexts, but the potential for confusion seems high. 

US-China Relations: The action against Applied Materials arrives amid broader mixed signals from the US government regarding China policy. BIS, or at least the Office of Export Enforcement, seems keen on taking an aggressive posture toward China. On the other hand, there are hints of diverging views from other parts of the federal government, including the US Department of Defense’s unexplained withdrawal of its decision to list several major Chinese tech firms as “Chinese Military Companies,” the departure of senior officials at BIS’ Office of Information and Communications Technology and Services, and split reactions to the Administration’s decision to permit the export of certain NVIDIA chips to China. 

Recommendations

In light of BIS’ settlement with Applied Materials, companies with global manufacturing operations should consider the following steps:

• Beware of Compliance Solutions That Are Too Clever: Companies hoping to avoid being constrained by US export controls — especially those that manufacture products abroad using US-origin inputs — should honestly evaluate whether their manufacturing arrangements could be viewed as attempts to circumvent export control restrictions. Although BIS does not accuse Applied Materials of trying to evade export controls, the order goes into detail about how the company accelerated its offshoring plans after SMIC was placed on the Entity List allegedly for the purpose of continuing to make sales without having to obtain licenses. These facts may have made Applied Materials an especially enticing target for BIS. 

• Reassess De Minimis Calculations: Companies should not assume that assembly operations abroad convert US-origin products into foreign-origin items eligible for de minimis treatment. The critical factor appears to be whether the final product has meaningful foreign-origin content that was not itself shipped from the United States. 

• Monitor for Further Guidance: Because BIS has not articulated a clear standard for origin determination, companies should monitor for any additional guidance or enforcement actions that may provide greater clarity on the applicable test. 

1 BIS stated, “‘Substantial transformation’ does not appear anywhere in the EAR and is not the correct test for determining whether an item is subject to the EAR because it is an item of U.S. origin.”