Rules of origin under NAFTA

Rules of origin under NAFTA

Agami, Abdel M

INTRODUCTION

Recent years have witnessed a blossoming increase in trade agreements among many countries. The Treaty of Rome established the ECC in March, 1957, in response to competition facing European countries from the two economic powers, the US and Japan. Now EC stands as a threatening economic power itself. In turn many countries have combined their economic strengths in trade blocs so that they can face increases in world competition and improve their share in global markets. The Free Trade Agreement (FTA) between the US and Canada, signed on January 1, 1989, aimed to eliminate all Canadian and US tariffs between the two countries by 1998.

On February 5, 1991 the presidents of the US and Mexico and the prime minister of Canada announced their intention to begin negotiations on the North American Free Trade Agreement (NAFTA). After more than eighteen months of intensive negotiations, the agreement was completed on August 12, 1992. Its objectives are to: (1) eliminate barriers to trade and facilitate the cross-border movement of goods and services between the territories of the parties; (2) promote conditions of fair competition in the free trade area; (3) increase investment opportunities in the territories of the parties; (4) provide adequate and effective protection and enforcements of intellectual property rights in each party’s territory; (5) create effective procedures for the implementation and application of this agreement; and (6) establish a framework for further trilateral, regional and multilateral cooperation to expand and enhance the benefits of this agreement (NAFTA, 1992).

The essence of free trade agreements is to give products obtained or produced in participating countries preferential treatment in matters related to tariff and customs. However, in the global economy in which we are living today, it is becomming more difficult to determine the nationality of products. For example, a Nissan car where the parts are manufactured in the US, assembled in Mexico, finished in Canada and sold in the US might require some judgment as to the nationality of the car. Most free trade agreements establish rules for determining a product’s nationality, known as rules-of-origin.

For products that are partially produced in a country that is a member of a free trade agreement and partially in a country that is not, a judgment has to be made as to the percentage produced in the region and the percentage that is not. The judgment is usually based on the value added or cost incurred in the region (regional value content). The objective of this paper is to discuss the accounting issues involved in measuring the regional value content of products traded under free trade agreements.

NAFTA: THE DEBATE

Some claim that NAFTA will create a North American market with over 60 million consumers and combined gross domestic product of about 6 trillion dollars. (See Exhibit 1.)[exhibit 1 omitted] About 65% of US industrial and agricultural exports to Mexico will be eligible for duty-free treatment either immediately or within 5 years. With NAFTA, Mexican tariffs on vehicles and light trucks will be cut in half immediately. NAFTA will open Mexico’s $6 billion market for telecommunications equipment and services. Barriers to trade on $250 million of US exports of textiles and apparel to Mexico will be eliminated immediately, with another $700 million freed from restrictions within 6 years. All North American trade restrictions will be eliminated within 10 years. NAFTA will immediately eliminate Mexican import licenses, which covered 25% of US agricultural exports last year, and will phase out remaining Mexican tariffs within 10-15 years. Mexico’s closed financial services markets will be opened, and US banks and securities firms will be allowed to establish wholly owned subsidiaries. US insurance firms will gain major new opportunities in Mexican markets (Hills, 1992; Congress of U.S., 1992; Report of the Administration, 1992).

On the other hand, some believe that NAFTA will increase unemployment in the US and harm some US industries such as the steel, auto, athletic shoes, furniture, glass, cement, brooms, sugar, tobacco, citrus, and canning industries (Anders, 1992). Environmentalists predict there will be some damage to the environment such as poisoning of soil, water and air and other crimes against nature by companies that place manufacturing plants in Mexico near the US border. Other experts believe that NAFTA will also have some damaging effect on health and safety standards. Some argue that many US companies will move to Mexico to escape the more strict and rigid US laws related to health and safety standards (Donahue, 1991). In addition to impact on employment in the US and on the environment, some believe that NAFTA will negatively affect the industries that presently were established to take advantage of duty drawback, Maquiladora, and foreign trade zones (O’Dell, 1992).

However, the majority seem to believe that all these problems will be eliminated in the long run as the standard of living in Mexico rises, and as a result of tightening laws and rules for environment protection and health and safety standards in Mexico, a process already started by the Mexican government. Most economists believe that, in the long run, NAFTA will spur economic growth in all three countries (USITC, 1992).

RULES-OF-ORIGIN

Most free trade agreements such as the US-Canada Free Trade Agreement (CFTA) and the North American Free Trade Agreement (NAFTA) give preferential treatment in tariffs and customs to products and services grown or produced regionally within the countries that are members of the agreement. However, the rules for determining the country of origin (rules-of-origin) where the product or service has been grown or produced are, in most cases, complicated. In the global economy we live in, a product could be partially manufactured within countries that are members of a trade agreement and partially within countries that are not. The purpose of rules-of-origin is to prevent products originating outside the region of the free trade agreement from utilizing the region to escape tariff and duties, i.e., the Trojan horse problem (Weekly, 1992).

According to the North American Trade Agreement, a good is considered an originating good i.e., satisfying the rules-of-origin and qualifying for preferential treatment in tariff and customs if (1) the good is wholly obtained or produced entirely in the territory of one or more of the countries that are members of the agreement (US, Canada or Mexico), (2) materials used in the production of the good undergo a change in tariff classification as a result of production occuring entirely in the territory of one or more of the member countries, (3) the regional value content of the good is not less than a certain specified percentage, or (4) the good meets the De Minimis Rule of NAFTA.

Examples for goods wholly obtained or produced entirely in the territory of one or more of the countries that are members of the free trade agreement are: (1) mineral goods extracted in the territory of one or more of the member countries; (2) vegetable goods harvested in the territory of one or more of the member countries; (3) live animals born and raised in the territory of one or more of the member countries; (4) goods obtained from hunting, trapping or fishing in the territory of one or more of the member countries; and (5) goods produce in the territory of one or more of the member countries.

The second criterion (a change in tariff classification) requires a change in the appearance and physical condition of materials as a result of production in one or more member country that is acceptable under the Harmonized System that was adopted by the United States on January 1, 1989. The Harmonized System is an internationally recognized system of goods classification used to determine duty and tariff rates (Dick, 1991). An example of a physical transformation that qualifies as a change in tariff classification under the Harmonized System is the manufacturing of a desk from imported board. This criterion emphasizes physical appearance rather than economic substance, and has caused some disputes among parties involved. For example, in the textile and apparel industry there seems to be a disagreement among retailers and manufacturers as to what constitutes a substantial transformation. Retailers and wholesalers claim that a single process, such as cutting and sewing should qualify as a substantial transformation, while manufacturers maintain that the fabric must be woven in a country that is a member of the trade agreement to qualify for preferrential tariffs and customs. Because there were many disputes in interpreting when substantial transformation takes place in earlier trade agreements, NAFTA developed very detailed and tougher rules for transformation. NAFTA requires that textiles, apparel, and other textile products be made in North America from the yarn-spinning stage forward to qualify for preferrential treatment. The NAFTA rule is even tougher for cotton, man-made fiber yarns, knit fabrics, certain other textile products, and sweaters of man-made fibers; for these, the NAFTA rule requires that they be made from the fiber forward in the member countries. Only products for which raw materials are not available in North America, a single transformation is acceptable (Morrison & Foerster, 1992).

A product manufactured within one or more member country may qualify for preferential tariffs and customs even though it contains materials, pans, or components obtained or produced outside the region provided it meets certain regional value content. Generally, according to Article 401 of NAFTA, the regional value content should not be less than 60 percent of the “transaction value” or 50 percent of the “net-cost.” Transaction value means the price actually paid or payable for a good. Net-cost is total cost of the product less royalties, sales promotion expense and cost of packing and shipping, etc.

NAFTA contains a De Minimis rule. According to this rule, a product is considered to be an originating product (obtained or produced in the US, Canada, or Mexico) if the value of all non-originating materials used in its production is not more than seven percent of the transaction value of the product or the value of all such non-originating material is not more than seven percent of the total cost of the good.

REGIONAL VALUE CONTENT

The first criterion (goods are wholly obtained or produced entirely in the territory of one or more of the countries that are members of the agreement) creates no measurement issues or raises many disputes among parties involved. The same could be said about the second criterion for rules-of-origin (change in tariff classification). However, very few products satisfy these two criteria. Most products are manufactured partially in countries that are members of the free trade agreement and partially in countries that are not. For these products a scheme of measurement must be developed to determine the percentage of the “regional value content” of the products, i.e., the value added within the countries that are members of the free trade agreement. A definition of “regional value content” is needed for the application of criteria three and four of the rules-of-origin.

NAFTA provides two methods of measuring the regional value content; one is based on the transaction value (price), and the second is based on net-cost. They are:

RVC = (TV – VNM)/TV >= 60% or

RVC = (NC – VNM)/NC >= 50%

where :

RVC is the regional value content

TV is the value of the good

VNM is the value of non-originating materials

NC is the net-cost of the good.

Generally, producers can choose one of the two methods (transaction value or net-cost) in computing the specified percentage needed to qualify for preferrential tariffs and customs. However, the net-cost method must be used where the transaction value is not acceptable under the General Agreement on Tariff and Trade (GATT) Custom Valuation Code and for certain products such as cars. NAFTA requires that 62.5 percent of the net-cost of cars, engines, and transmissions and 60 percent of the net-cost of heavy trucks and buses be incurred in the region. This is larger than the 50 percent required for other products and the requirement under the US-Canada Free Trade Agreement. The increase in the percentage was in response to pressure exerted by the autoworkers labor union and the lobbying orchestrated by the US auto producers during the negotiation of the treaty.

VALUES AND COST: MEASUREMENT ISSUES

In the author’s opinion the requirement of regional value content for preferential tariffs and customs is much better than the requirement of change in tariff classification. Regional value content emphasizes economic substance, value added and incurrence of cost within the region, while change in tariff classification emphasizes form, physical transformation and appearance of the products. However, the regional value requirement raises many problems and disputes among parties involved. In the global economy we live in, a product could be partially manufactured within countries that are members of a trade agreement and partially within countries that are not. The components of a product could be produced outside the region and then assembled in the region to escape tariff and duties (the Trojan horse problem). Exhibit 2 provides an illustration for this case.[exhibit 2 omitted]

Some argue that measuring regional value content on the basis of price of the finished product rather than its net-cost is much better and more objective since it avoids all judgments that must be made by accountants in determining the cost of the product, especially the arbitrary allocation of overhead and other common costs. This argument is valid only if the prices of final products, pans, components and intermediate products are the result of arm-length transactions among unrelated parties. However, if the parties are related, manipulation of this rule can easily be achieved through either artifically lowering the price of the non-originating materials, parts, components, subassemblies, and intermediate products or by artifically increasing the price of the final product. To avoid this problem, most trade agreements reject the use of prices for measuring regional value content among related parties and require the use of the net-cost method when the transaction is between related parties. For this purpose NAFTA defines related parties broadly to include officers or directors of one another’s business, partners, employer and employees, any person directly or indirectly owning control or holding 25 percent or more of the outstanding voting stock of the business, one of the two parties involved directly or indirectly controls the other, both of the two parties are directly or indirectly controlled by a third person, and the two parties are members of the same family. If the transaction is between related parties, price is not acceptable under the GATT Custom Valuation Code, or if the product involved is an automobile, NAFTA requires that the net-cost method be used in measuring the regional value content.

In all the cases mentioned above, the net-cost method is the only acceptable method of measuring the regional value content. The net-cost method opens opportunities as well as raises some challenges for accountants to provide a framework for measuring cost that will stand the challenges that are likely to be raised in disputes among parties involved. NAFTA expresses explicitly the acceptance of Generally Accepted Accounting Principles (GAAP) applicable in the territory of the party in which the good is produced for purpose of measuring cost. This is likely to encourage the harmonization of GAAP among countries that are members of the agreement (Canada, Mexico, and US), just as the CFTA has helped the efforts to harmonize GAAP between Canada and the U.S.

NAFTA has also raised some challenges for accountants. Among the challenges that accountants will face under the NAFTA agreement is the question of which elements of costs to include or exclude in determining net cost, and how to allocate common or indirect costs among various products. NAFTA provides some definitions and guidance for measuring the net cost. NAFTA, for example, defines total cost as all product cost, period cost and other costs incurred in the territory of one or more of the parties; the net cost as total cost minus sales promotion, marketing and after-sales services costs, royalties, shipping and packing costs, and nonallowable interest costs that are included in the total cost.

NAFTA provides three different methods for measuring net cost: (1) the producer of the good may calculate the total cost incurred with respect to all goods produced by that producer, subtract any sales promotion, marketing and after-sales service costs, royalties, shipping and packing costs, and nonallowable interest costs that are included in the total cost of all such goods, and then reasonably allocate the resulting net cost of those goods to the good; (2) the producer of the good may calculate the total cost incurred with respect to all goods produced by the producer, reasonably allocate the total cost to the good, and then subtract any sales promotion, marketing and after-sales service costs, royalties, shipping and packing costs and non-allowable interest costs that are included in the portion of the total cost allocated to the good; or (3) the producer of the good may reasonably allocate cost incurred with respect to the good so that the aggregate of these costs does not include any sales promotion, marketing and aftersales service costs, and non-allowable interest costs.

While these three alternative methods of measuring net-cost provide the producer with some flexibility, they are also likely to provide a vehicle for manipulating the percentage of net-cost needed to satisfy the regional value content requirement and cause disputes among parties involved. Exhibit 3 provides an illustration of this point.[exhibit 3 omitted] Another issue that is likely to provide producers with a tool for manipulation in satisfying the required percentage and may create disputes among parties involved is whether and how overhead should be allocated among products and included in cost. For example, should a Mexican producer include in the computation of net cost depreciation on machinery used in production, even though this machinery was purchased from Japan? Should the Mexican manufacturer include costs incurred in sending Mexican employees to be trained in Korea or training them in Mexico using Japanese or Korean consultants and instructors? While the CFTA between Canada and the US was explicit about allowing only direct cost of processing to be included in measuring cost, NAFTA appears to be permitting all product and period cost to be included. This seems to be a significant change that might cause some headaches in the implementation of NAFTA.

REFERENCES

Anders, George, “Heading South.” The Wall Street Journal Reports: World Business (September 24, 1992).

Congress of the United States, Office of Technology Assessment. US-Mexico Trade: Pulling Together or Pulling Apart, ITE-545. Washington, DC: US Government Printing Office (October, 1992).

Dick,, Toni, “Custom Procedures: Essentials For Exporting Under the CFTA.” Business America

Donahue, T.R., “The Case Against a North American Free Trade Agreement.” The Columbia Journal of World Business (Summer, 1991), 92-96.

Hills, Carla A., “The North American Free Trade Agreement: A Promise Fulfilled.” US Department of State Dispatch (September 14, 1992) Vol. 3, No. 37, 697-699.

Morrison & Foerster. What The North American Free Trade Agreement Means to Business. San Francisco: Morrison & Foerster (Summer, 1992).

North American Free Trade Agreement, Volume 1. Washington, DC: US Government Printing Office, 1992.

Report of the Administration on the North American Free Trade Agreement and Actions Taken in Fulfillment of the May 1, 1991 Committment. Washington, DC: US Government Printing Office (September 18, 1992).

O’Dell, Jane, “Of Customs and Customers. ” World, Vol. 26, No. 1, KPMG Peat Marwick, 1992.

US International Trade Commission. Economy-Wide Modeling of the Economic Implications of a FTA with Mexico and a NAFTA with Canada and Mexico. USITC publications 2516 and 2508 (May, 192). Washington, DC: USITC.

Weekly, James K., “The Trojan Horse Issue In A North American Free Trade Area.” Proceedings of the 1992 Conference of Association for Global Business (November, 1992), 357.

Abdel M. Agami Old Dominion University

Copyright College of Business Administration. University of Detroit Mercy Fall 1994

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