Under the authority of the Arms Export Control Act, State requires exporters to obtain licenses for defense exports unless an exemption applies. State has long exempted the export of many unclassified defense items to Canada without prior department approval. While these items are exempt from licensing requirements, they are still subject to the provisions of the Arms Export Control Act. Exporters who use the exemption and violate any provisions of the Act are subject to fines, penalties, or imprisonment, if convicted. State requires exporters to register with its Office of Defense Trade Controls; determine whether the articles or services they are exporting are covered by the exemption; in most cases, obtain written documentation stating that exports are to be used for a permitted purpose; and inform the recipient that items are not to be re- exported without prior authorization from State. The Canadian exemption, first codified in 1954, grew out of the unique geographic relationship and strong economic trading partnership between the United States and Canada and their mutual interest in the defense of North America. The two countries share the world’s longest unfortified border. They are also each other’s largest trading partner. The countries are committed to maintaining a strong integrated North American defense industrial base to help fulfill their defense and security responsibilities to the North Atlantic Treaty Organization and the North American Aerospace Defense Agreement, as well as for common defense of national territories. Appendix I provides a chronology of selected defense and economic agreements between the United States and Canada since 1940. The Canadian exemption has evolved since inception in terms of scope. For example, earlier versions allowed the export and import of arms, ammunition, and implements of war, and the export of unclassified technical data without a license. Later versions changed the coverage to include defense services and increased the types of items requiring a license. In April 1999, State revised its regulations to clarify when the exemption could be used and limited the defense items that could be exported under the exemption. State took this action based on its analysis that exports were being re-exported from Canada to countries of concern without U.S. government approval and that controls over arms and ammunition transfers needed strengthening. Nineteen criminal investigations and seizure cases related to the Canadian exemption were identified, including 3 diversions to China, Iran, and Pakistan and 16 attempted diversions to these and other nations of concern or technical regulatory violations. For example, a major U.S. defense company exported U.S.-controlled communication equipment to its Canadian facility under the exemption and then re-exported the equipment to Pakistan without U.S. government approval. In another case, an Iranian intelligence group established a company in Canada and was accused of attempting to use the exemption to acquire U.S.-controlled components for the Hawk missile system. Appendix II summarizes these and other cases. In addition, State received 23 voluntary disclosures from exporters who inappropriately used the Canadian exemption. For example, in a few instances, exporters admitted providing technical manuals and software engineering support without obtaining State approval. State consulted with the Department of Defense about these cases and indicated that had these exporters submitted the appropriate license applications, they would have likely been denied. In another instance, an exporter submitted a voluntary disclosure after being contacted by law enforcement officials. In this case, the U.S. exporter was ineligible to export because the firm was debarred and under criminal investigation for diversions of military equipment to Iran and other locations. In response to export concerns identified by State, the U.S. and Canadian governments negotiated changes to their respective export control systems. The Canadian government changed its export control laws and regulations to cover all items currently controlled on the U.S. Munitions List, established a registration system in April 2001 for persons and entities in Canada eligible to receive U.S.-controlled items under the exemption, and required U.S. government approval for re-export of U.S. controlled items from Canada or transfer of these items within Canada. In turn, State again revised the Canadian exemption effective May 30, 2001. This revision in general broadened the exemption to cover temporary imports of unclassified defense items, some defense services, and some additional items, but continued to exclude other items such as Missile Technology Control Regime items. Since the conclusion of the negotiations, the U.S. and Canadian governments have met and continue to exchange information on enforcement and border security issues not fully addressed during the negotiations. We found instances where exporters have been implementing the Canadian exemption inconsistently. Some items, such as technical data and smokeless ammunition powder, are being exported under the exemption by some exporters and not by others. These inconsistencies may result in the same item being licensed by State in some instances and not licensed in others, which may put some exporters at a disadvantage and lessen government oversight of exports. For example, exporters followed different processes when they exported technical data. Before April 1999, some exported technical data under the exemption for offshore procurement activities, based on their interpretation of the regulations. However, State officials said that exporters were required to obtain approval before they could export the data to Canada. In April 1999, State revised the regulations to clarify that the export of technical data for offshore procurement activity requires a license. After this regulatory revision, a number of companies or their subsidiaries voluntarily disclosed to State that they had inappropriately exported technical data or defense services for offshore procurement and other activities using the exemption. Since that time, some exporters said they were unclear about when they could export technical data and defense services under the May 2001 revised exemption because the language in the regulations was subject to interpretation. For example, we were told that design data under the new exemption was broadly defined, and in some instances has been interpreted as either subject to the exemption or requiring a license. Appendix III highlights the complexities of the regulatory language and major changes made to the Canadian exemption in recent years. Some exporters have been interpreting the May 2001 reporting requirements differently. This, in turn, can decrease the government’s visibility over sensitive exports. For example, exporters using the Canadian exemption are now required by the International Traffic in Arms Regulations to provide State “a semi-annual report of all their on-going activities authorized under this section.” Two exporters interpreted the phrase “under this section” to mean that the requirement solely pertained to defense services because it fell under the paragraph of the regulations entitled “Defense services exemption.” These exporters, therefore, reported activities exclusively involving defense services. Another interpreted the language to refer to all activities occurring under the Canadian exemption, including those related to defense articles and technical data, as well as defense services. When we discussed this matter with State officials, they said that the second interpretation was correct and that the report should encompass all activities and not just defense services. Some exporters also said they were unclear about certification requirements. The regulations require exporters to obtain written certification from Canadian companies that “the technical data and defense service being exported” will be used only for a specified activity.Some exporters said they obtain this certification when exporting defense articles in addition to technical data and defense services, following preface language in the Federal Register notice that changed the regulation in May 2001. One company we spoke with said that it only obtains this certification for defense services. Another company noted that when it tried to get a Canadian company to fill out the certification for a defense article being exported to Canada, the Canadian government told the company that only the regulations are legally binding, and certifications should be provided only for defense services and technical data. State officials said that this interpretation was correct, and the certification only needed to be obtained for defense services and technical data. It is important that exporters correctly interpret these requirements, since the certifications enable exporters to document their compliance with regulations. The effectiveness of the process depends on the exporters making the right decisions when interpreting regulations. However, State has an important role to play in responding to inquiries about exports. In some instances, we found that State provided inconsistent answers in situations where exporters or U.S. Customs officials responsible for enforcing export regulations raised questions to State about particular situations. For example: One exporter who had been shipping smokeless ammunition powder using the exemption was stopped by U.S. Customs for inspection on several occasions. Each time, U.S. Customs asked State if the exemption could be used. The first two times, State said yes, but on a subsequent occasion, it determined the powder was a Missile Technology Control Regime item and required an export license. This exporter has since obtained numerous licenses for this item. Another exporter shipping the same type of powder to Canada was also stopped by U.S. Customs for inspection. One time, State told U.S. Customs that the powder required a license and another time said the item was not a Missile Technology Control Regime item and was, therefore, exempt. One exporter had planned to temporarily import aerial target aircraft for North Atlantic Treaty Organization (NATO) ongoing training exercises that were being conducted in the United States and informed U.S. Customs in advance that it was going to do this under the exemption. Under the changes made to the exemption in May 2001, such items are allowed to be imported temporarily. However, in this case, State denied the use of the exemption. State officials acknowledged this mistake to U.S. Customs, and told us that it occurred inadvertently, immediately after the exemption change. Nevertheless, at the time, the exporter cancelled its plans, which in turn, led to the cancellation of the remaining NATO training exercises. An exemption places the burden of proper implementation on exporters. Nevertheless, exporters said they needed guidance from State to assist them through the process of deciding what to export and what not to export under the exemption, as well as what activities to report. State officials said that exporters are to rely on the regulations as their guide.