September, 2017

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Here, There and Everywhere:
FTAs are All Around

Mark K. Neville, Jr.

One of the most controversial policy reversals launched by the Trump Administration must surely be the decision to withdraw from the negotiations for new Free Trade Agreements (FTAs) with the European Union (the Transatlantic Trade and Investment Partnership, TTIP) and with trading partners in the Pacific Basin (the Trans-Pacific Partnership, TPP).1 Instead, the new US Administration pledged to enter into bilateral trade agreements. All of this coincided with the pledge to revise or withdraw from NAFTA, and more recently there have been noises about revising the Korea/US FTA as well.

Based on those developments, if you are thinking that, taken together, FTAs have pride of place at the top of the league tables for international trade, you would be right. Jostling with the demand for enhanced enforcement of the antidumping and countervailing duty laws, the continued participation of the US in the network of FTAs that crisscross the globe has been an ever present topic for discussion in the past year.

FTAs’ Strategic Role

But the attention paid to FTAs extends well beyond discussion. For some time, and notwithstanding these recent reversals, exploiting the opportunities for duty-free entry created by eligibility under an FTA has been a central planning point and a key “driver” in sourcing decisions by experienced traders. That will continue regardless of what the US does on FTAs. One reason for that focus is that there are many instances where production has been outsourced to foreign contract manufacturers, some of them related parties and some of them third party companies. FTAs will still play a role because of the “global factory” and “global market” phenomena.

FTAs in Play

Let’s take an example. A US-based company decides to contract with a company based in Vietnam to make its products. The finished products will be exported from Vietnam and imported into Canada, the US, Japan and the EU. While the US imports may attract customs duty, because the US will have withdrawn from the TPP, the imports into Canada and Japan would potentially qualify for duty-free treatment under a TPP once it is negotiated and in place. This is because Vietnam, Canada and Japan are all participants in the TPP. As for the exports to the EU, the Vietnam/EU FTA will enter into force in 2018. The only result of the US withdrawal from the TPP, short of any bilateral FTA with Vietnam, is that the imports into the US will be dutiable. For all other product movements, assuming that they meet the rules of origin under the TPP and the Vietnam/EU FTA, the goods will be cleared on a duty-free basis. In other words, applying the FTA strategy will generate savings.

Let’s take another example. Assume that the US company decides to keep manufacture in the US, and is looking to sell to the same markets—US, Canada, Japan and the EU. Obviously, the products will be sold on a domestic basis in the US, so there are no duty implications in those sales. For the time being, assuming the origin rules are met, the goods can be sold and shipped to customers in Canada on a duty-free basis under NAFTA. Of course, if NAFTA were terminated, it might or might not replaced by a bilateral US/Canada FTA. In the case of a bilateral FTA coming into play, any sales would be accomplished on a duty-free basis, but if NAFTA goes away and is not replaced, then sale to Canada will attract customs duty. For sales to Japan and the EU, duty would be paid on the imported products, given the US having dropped out of the TPP and the TTIP. It could be that US production would lead to collection of duty in all markets except the US.

Depending on the relative projected sales volumes, then, for any well-advised trader, the calculus employed in studying an outsourcing to Vietnam will have to take the FTA posture into account.

FTA Benefit

For some of you, all of these references to FTAs and their potential benefits must have prompted the question, “How does an FTA work?”

The short answer is that they work by conferring duty free status on goods that qualify for the FTA benefit. The country of importation will grant that status because the partner country or countries will reciprocally grant duty free status to exports from that first country. Thus, there is duty free treatment for goods coming from one FTA partner and going to another FTA partner.

That is the 30,000 foot version.

Rules of Origin

Going below that, we find that all FTAs will follow the same basic themes but that there will generally be variations from one FTA to another. There is even variation within a given country’s FTA network.. Thus, the basic rule of eligibility is that only goods that are the products of the participating country will qualify for the benefit. As an example, a product that has been imported into the US and then is simply repackaged into another container will never qualify for FTA benefits. The benefit is reserved for goods that are local in origin. If the goods have been locally grown or mined, or if they are livestock that were born and raised in that country, they will always qualify. To use the NAFTA term, they are “wholly obtained or produced entirely” in the territory of a NAFTA partner. To take another simple case, if the finished products have been made with 100% locally-produced materials or parts, they will always qualify for the FTA benefit. To use the NAFTA terminology, they are “goods produced entirely in [the NAFTA territory] exclusively from originating materials.”

It is where the finished products have been made with some or all non-originating materials, i.e., where the inputs have been imported from outside the FTA partners’ territories, that the rules begin to assume a more complicated character. The overall theme is where the non-originating parts have been substantially transformed, so that, in effect, as a result of the production process the parts have become local and the resulting finished product will be seen to qualify.

To take an example, we should look for the NAFTA rule that applies to an airbrake for railroad rolling stock, which is classified in subheading 8607.21, Harmonized Tariff Schedule of the United States (HTSUS). We find that for goods falling within the grouping of subheadings 8607.21-8607.99, which subheading 8607.21 clearly does, the finished product will qualify if the importer can show that the finished product was made with any non-originating materials (i.e., parts) that are classified outside heading 8607. This test is set forth in General Note 12 to the HTSUS. The test anticipates that the imported non-originating materials must have undergone a “tariff shift” when gauging the HTS status of the imported part vs. that of the finished product. In this case, as an example we could look to the use of a steel leaf spring, classified in subheading 7320.10, HTSUS), imported from, say Germany. That material bears a tariff classification (subheading 7321.10) that is outside heading 8607. As a result, the finished airbrake will qualify for NAFTA if it is exported to Canada or Mexico or, conversely, if it is exported from those countries to the US.

Beyond this tariff shift rule, which emphasizes the need to correctly ascertain the HTS status of the finished product as well as all non-originating materials used to make the finished product, in the case of NAFTA and other FTAs, there is sometimes an opportunity to satisfy the origin rule though a value added test. In the case of NAFTA, that test is sometimes an alternative and in some instances a requirement in addition to meeting the tariff shift. The NAFTA test is for a Regional Value Content (RVC) measured either as 50% of net cost or 60% of the transaction value of the finished product. The airbrake example sets forth this RVC as an alternative route to establish NAFTA eligibility.

Variation in Rules

Beyond NAFTA it is vitally important to recognize that the origin rules for each of the twenty FTAs in which the US participates must be examined closely because each FTA has separate rules which will often vary from one to the next. In the case of the railroad airbrakes, for example, the origin rule under the US/Singapore FTA also makes use of the tariff shift rule—a change to subheadings 8607.21-8607.99 from any other heading, i.e., from outside heading 8607. That is identical with the NAFTA rule. The RVC alternative, however, is not available for the trader seeking to take advantage of the US/Singapore FTA.

Going beyond this last point we must be mindful that the other FTAs, those in which the US is not a participant, will have their own separate rules of origin. To stay with the airbrake example, we have seen the NAFTA rule governing eligibility for exports of products from Mexico, the US or Canada to the other NAFTA participants. Let’s suppose that a manufacturer in Mexico wanted to take advantage of the EU/Mexico FTA. What rule applies, i.e., how can the importer show that the finished goods will qualify for the benefit? The origin rules are set up differently from NAFTA, usually on the basis of 4-digit headings rather than 6-digit subheadings or 8 or 10-digit tariff item numbers. In the case of heading 8607, which would cover our airbrakes, we find the rule of origin is a showing that no more than 40% of the ex works price of the product is represented by non-originating materials. Thus, the cost of the German leaf springs would count toward the qualifying 60% threshold, as would any Mexican parts, but the cost of any US parts would not be counted toward meeting that test level. We also note that there is no “tariff shift” rule (“sufficient transformation” to use the EU term) in play for this product.

Additional Requirements

Quite apart from the origin rules each FTA will also include certain common elements. These will include documentation presented to the customs authorities.2 In the case of NAFTA, this is the Certificate of Origin (COO), which is represented in the US by CF 434, as well as the proper annotation on the Customs Entry Summary, the CF 7501. In the case of the EU/MX FTA there is the “EUR1” document as well as the need to declare origin on the invoice.

There is also a “direct shipment” (“direct transport” is the term used by the EU) requirement, meaning that the goods cannot stop in another intermediate country except if they remain under customs control in that country and, in some instances, transiting an intermediate country is not permitted except to preserve the goods. Certainly no processing or manipulation of any kind in that intermediate country is permitted.

Finally, it is worth noting that there is a relaxation of the rules that will excuse a failure to make the requisite tariff shift. In the case of NAFTA, that de minimis rule allows materials in non-originating status representing up to 7% of the transaction value or, alternatively, 7% of total cost to remain in such status.3 In the case of the EU/Mexico FTA, the “tolerance” levels are normally set such that materials valued at either 10% or 15% of the ex works price need not meet the “sufficient transformation” test.

Apart from these general rules, there other, more specific rules for such sectors as automotive goods.

Conclusion

With all of the focus on FTAs it is important to circle back to the each of the various FTAs in place and to be mindful of the opportunities they create. Certainly one of the lessons from this discussion is that the rules of origin are quite specific and will vary from one FTA to another. We saw that in the case of the airbrakes, with different rules applying to NAFTA, the US /Singapore FTA and the EU/Mexico FTA. A trader looking to take full advantage of multiple FTAs for goods produced in a given country, e.g., using Mexico or Colombia as a manufacturing platform, is well advised to see if it might be possible to “square the circle” with its sourcing so as to finesse those varied rules of origin for each of the FTAs in which Mexico or Colombia participates to the greatest extent possible and to thereby garner eligibility for the largest number of FTAs.

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1. For a discussion of these and other trade policy initiatives, see Neville, “US Trade Policy Relaunch—Possible New Directions,” 28 JOIT Feb. 2017 at 30. For a longer discussion of FTAs, see Neville (ed.), International Trade Laws of the United States: Statutes and Strategies, chapter 7 at ¶7.09.

2. To be sure, in the case of the FTAs in which the US partcipaiates, the importer would typically claim the benefit at the time of entry. However, in the case of seven such FTAs, including NAFTA and the US/Korea FTA, there is an extended opportnity to file a post-importation claim within one year of the date of importation. 19 USC § 1520 (d). For a fuller treatment, see Neville, “Claims for Duty-Free Treatment Under Free Trade Agreements,” 26 JOIT Dec. 2015 at 23.

3. In the case of textiles, the 7% level is based upon weight rather than value.

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