INCOTERMS Rules – How They Can Improve Your Company’s Compliance, Reduce Your Risk and Maximize Your Profit

Global business is fueled by private contracts and industry standards. One of the best examples of industry standards is the set of INCOTERMS® (International Commercial terms) rules, published by the International Chamber of Commerce (ICC) and updated in 2010. INCOTERMS® rules bring predictability to international commercial contracts by defining the responsibilities of the buyer and seller with respect to the packing, transportation and insurance of goods as they are transferred from the seller to the buyer. INCOTERMS® rules can be invaluable for shifting costs and liability associated with exporting, importing and shipping and for avoiding disputes down the road — but only if companies understand how to use them properly. While many businesses employ INCOTERMS® rules in their commercial contracts, these contracts are often negotiated by individuals who don’t really understand what the INCOTERMS® rule means and don’t know how to use them effectively. This article explains some of the benefits of using INCOTERMS® rules and how they can improve your international commercial contracts.

Conflicts with Contract Language

As an initial matter, companies must ensure that INCOTERMS® rules used in contracts do not conflict with other standard provisions.  Employing an INCOTERMS® rule may radically alter the meaning of a previously-negotiated, standard form contract that companies often pull out and dust off when negotiating with parties over what may seem the mundane subject of transportation of goods. Thus, as companies begin using INCOTERMS® rules, they should have their standard contracts reviewed by counsel to ensure that the use of an INCOTERMS® rule does not conflict with existing provisions and if it does, the conflicting language should be redacted.

Understanding and correctly using INCOTERMS® rules is also critical. There are eleven INCOTERMS® rules in the 2010 edition, divided into two classes: rules for any mode of transportation and rules for sea and inland waterway transport. The eleven terms allocate title, risk and responsibilities. The terms exist on a continuum with the buyer having the most obligations with the INCOTERMS® rule EXW (meaning named place of delivery) and the seller having the most obligations with the INCOTERMS® rule CIF (meaning cost, insurance and freight). One common misused INCOTERMS® rule is FOB. FOB means “Free on Board,” and is used for shipping goods only by sea and inland water transport. However, companies frequently also use FOB when shipping goods by air, rail or land. This misuse can lead to misunderstandings and costly disputes regarding responsibilities and risk allocation between the parties. Thus, INCOTERMS® rules cannot be used loosely or casually; they exist to provide certainty and precision, and contracting parties must understand their real meaning and use them appropriately.

Reducing Risk

INCOTERMS® rules can also be used to reduce a party’s risk in the transaction. The INCOTERMS® rule EXW offers sellers the minimal obligation for the goods. For example, if the producer contracts to sell to the buyer 1,000 widgets “EXW [Guangzhou factory] on January 1, 2013,” the producer’s obligation is to put the 1,000 widgets at the buyer’s disposal at the producer’s factory in Guangzhou on January 1. The price quoted for the goods applies only at the factory and all charges for shipping and insurance, including even the loading of the goods at the producer’s factory, are the responsibility of the buyer. Title to the goods, and consequently risk of loss and damage, pass to the buyer once the goods have been made available to the buyer (or its agent) at the Guangzhou factory.

Use of INCOTERMS® rules can have a significant impact on import/export responsibilities. A very important implication of the use of EXW in the transaction described above is that the buyer is both the exporter and the importer of the goods for customs purposes when the buyer transports the goods (or orders them transported) from the factory to a foreign country. If the goods had been sold DAP  New Orleans” (short for “delivered at place”) instead, the producer would have been the legal exporter from China, but the buyer would have been the legal importer into the United States. This is because DAP means that the seller pays for carriage to the named place of destination (New Orleans), except for costs related to import clearance, and retains title and assumes all risks up to the point at which the goods are ready for unloading by the buyer in New Orleans. Title to the goods transfers to the buyer in New Orleans because the buyer is the importer of record, has to file all import paperwork and is responsible to the government for the compliance of the goods with all legal obligations on importers, including electronic filings, country of origin marking requirements and payment of duties. If a buyer is unaware of the meaning of the INCOTERMS® rules, it can unwittingly assume responsibility for significant unexpected duties, like 300 percent duties on an import from China subject to a dumping penalty. The buyer can’t be reimbursed by the seller or importer for such duties. Surprising senior management with such a hefty liability is hardly conducive to job security. On the other hand, understanding who is going to be the importer of record and learning the duties, other costs and restrictions that apply to the product in the destination country can enable a party to negotiate a price that takes these factors into account.

Failing to take these factors into account can have financial consequences. Suppose an Indian sugar company agrees to sell a U.S. confectioner refined table sugar “DDP Baltimore.” DDP means that the Indian seller is both the exporter from India and the importer into the United States, responsible for securing clearance of the goods through customs and paying the duties owed to the named place of delivery. In this case, it would be imperative for the Indian seller to check U.S. tariff laws applicable to refined sugar. The seller would find that refined sugar is subject to a tariff rate quota (a set amount that can be imported into the U.S. each year without incurring a punitive rate of duty), that the quota for refined sugar fills on the day it becomes available each sugar quota season, and that the above-quota tariff on refined sugar is 16.31¢ per pound. The seller’s costs of performance and therefore the price it should agree to would depend upon whether it could time its filing of the import paperwork to benefit from a share of the U.S. refined sugar quota. It could be financially devastating for the Indian company to charter a ship and send 100,000 metric tons of sugar to Baltimore, to find out that it owed almost $36 million in duties that it should have factored into the contract price.

Beyond mere monetary cost, assuming responsibility for import and export obligations through the use or misuse of an INCOTERMS® rules can have significant legal implications as well. If a U.S.-origin article subject to the International Traffic in Arms Regulations (ITAR) that has been transferred to a foreign party is reimported into the United States, a license or notification to the State Department is required for the reimportation. The party who, according to the INCOTERMS® rules is responsible for import clearance, has the import obligation. If that party is unfamiliar with the requirements of ITAR or has not previously applied for a license, the process of reimportation can be lengthy and time-consuming, not to mention legally complex. Take for example a Canadian police force that has surplus, U.S.-made night vision goggles (subject to ITAR) that it is selling to a New York hospital for its medevac helicopter pilots. The parties to the sale would need to make it very clear in the contract which company will be the importer of record so that party can file the necessary documents with the State Department. One option would be to specify in the contract of sale “CPT Albany,” short for “carriage paid to”, a term under which the buyer is the importer of record, along with a contractual provision requiring the buyer to comply with ITAR. Using CPT has the added advantage of placing the risk of loss on the buyer from the point at which the seller handed the goods over to the first carrier.

Train Your Sales Force to Use INCOTERMS® Rules to Your Advantage

As seen from the examples above, companies that understand INCOTERMS® rules and how to use them can have the advantage when negotiating international commercial contracts. Costly disputes can be prevented because the INCOTERMS® rules provide clear standards regarding who bears the transaction costs and risks of loss during each stage of the transfer of the goods.

How can you ensure that your company realizes the benefit of INCOTERMS® rules? Train your sales team. The ICC has made the task of learning the meanings of INCOTERMS® rules easy by providing a helpful glossary at its website: http://www.iccwbo.org/products-and-services/trade-facilitation/incoterms-2010/the-incoterms-rules/. The ICC also offers online training that can help your contract negotiators understand and better use the terms to shift risk and maximize profits. Legal counsel can also provide customized training for your company. A good negotiator who understands how to use INCOTERMS® rules to his company’s advantage can come away from the negotiations with a more lucrative contract and a clearer understanding of his company’s obligations.

Odds are the other party won’t even know what happened.

“Incoterms” is a trademark of the International Chamber of Commerce.

About the Author

Doreen M. Edelman

Doreen-Edelman-Baker-Donelson-Bearman-Caldwell-&-Berkowitz Doreen M. Edelman is a shareholder at Baker, Donelson, Bearman, Caldwell & Berkowitz P.C. in Washington, D.C., where she helps clients create business solutions for international trade compliance. She has more than 20 years of experience developing compliance programs and counseling clients on export licensing, export controls, FCPA and Office of Foreign Assets Control (OFAC) sanction laws. Ms. Edelman also helps companies prepare global business plans and work through foreign government market regulations.