By Michael Martina, Chris Kirkham

Jan 7 (Reuters) - Washington's addition of CATL 300750.SZ to a list of firms it says work with China's military could put Tesla TSLA.O founder Elon Musk in a tight spot, challenging how he balances his role in the Trump administration with his ties to China.

CATL, the world's largest battery maker, is a major supplier of lithium iron phosphate (LFP) batteries to Tesla for its Shanghai factory, the U.S. automaker's largest. Tesla has been exporting these cars equipped with CATL batteries to other markets such as Europe and Canada.

Lawmakers have decried some of CATL's battery storage projects across the United States, arguing they represent potential security threats. The U.S. market accounted for 4% and 35% of CATL's electric vehicle $(EV)$ and electric storage systems $(ESS)$ batteries, respectively, in 2023, according to Citi estimates.

The U.S. Department of Defense on Monday designated CATL and other Chinese companies including tech giant Tencent Holdings 0700.HK as linked to China's military. While the designation does not involve any restrictions on CATL's business, it can be a blow to the reputations of affected companies and serves as a stark warning to U.S. entities about the risks of doing business with them. It could also add pressure on the U.S. Treasury Department to sanction the companies.

Tesla and CATL are working on an agreement to license CATL technology for battery production in Nevada. A person familiar with the matter said that the deal is expected to launch in 2025.

CATL is also set to supply battery cells and packs to Tesla's Shanghai plant for Megapack, its energy storage product, people familiar with the matter said. The two are also in talks over how CATL can increase its supplies as the Megapack business grows.

Tesla and Musk did not respond to requests for comment.

No near-term impact is expected for Tesla, but Seth Goldstein, a Morningstar analyst, said "being potentially excluded from military contracts may give everyone considering a partnership with CATL a pause."

Last February, under pressure from lawmakers, U.S. utility company Duke Energy DUK.N said it would decommission energy-storage batteries produced by CATL at one of the nation's largest Marine Corps bases and will phase out CATL products at its civilian projects.

Goldstein added he expects Tesla to continue its partnerships with CATL because of the importance of the company's relationships with the Chinese government. Upending those ties "could potentially be worse than any political ramifications in the U.S.," he said.

Since the 2021 law that created the Pentagon's Chinese Military Companies list requirement, Congress has passed measures that could prevent federal contracting with designated companies.

The sweeping 2024 defense authorization act, for example, had provisions that would ban the Defense Department from contracting with companies on the CMC list or procuring goods and services that include products from such companies beginning in 2026 and 2027, respectively.

The company's inclusion on the U.S. CMC list also deals a blow to the company at the time when it has been pursuing international expansion and is looking for more deals in the United States. CATL on Tuesday called the designation a mistake, saying it "is not engaged in any military-related activities."

"CATL's role in the battery sector mirrors Huawei's in telecom. It's a strategic bid for dominance with far-reaching national security implications," said Craig Singleton, a senior fellow at the Foundation for Defense of Democracies.

CATL's deal with Tesla is modeled after an existing CATL partnership with Ford Motor F.N, which plans to start producing low-cost lithium-iron batteries by 2026 using technology licensed from CATL at a plant in Michigan.

Goldstein said he would not be surprised if Musk's favorable relationship with incoming President Donald Trump might allow Tesla some kind of waiver from potential future restrictions. Musk, the world's richest person, has been tapped by Trump to co-lead a newly created Department of Government Efficiency, an entity Trump indicated will operate outside the confines of government.

In November, Robin Zeng, chair of CATL, told Reuters that the company would consider building a U.S. plant if Trump opens the door to Chinese investment in the electric vehicle supply chain.

(Reporting by Michael Martina in Washington and Chris Kirkham in Los Angeles; additional reporting by Rachael Levy in Washington, Donny Kwok in Hong Kong, Samuel Shen in Shanghai and Lewis Jackson in Beijing; Editing by Chris Sanders, David Gaffen and Matthew Lewis)