Tax & Accounting Blog

Free Trade Agreements: No “Free Lunch” for Compliance Staff

Blog, Global Trade, ONESOURCE May 5, 2015

With all of current talk about negotiations over the Trans Pacific Partnership (TPP), and Mr. Obama’s seeking of trade agreement Fast Track authority from the US Congress, it is a good time to remind everyone that free trade agreements (FTA’s) do not mean an “open border” with regard to the compliance requirements for merchandise trade among the parties. Not only can compliance with the regulations be burdensome and non-compliance result in costly penalties, but the fear of non-compliance can lead to savings opportunities not taken. Both importers and exporters can make use of automated tools to capture opportunities and reduce risk, but in a slightly different way.

Let’s use the North American Free Trade Agreement (NAFTA) as an example, but the principles can be applied to any FTA.

First let’s deal with manufacturers who could be exporting to Mexico or Canada and having to provide FTA eligibility certification to customers in those countries, or providing certification to domestic customers who want to use the certification of components in their own NAFTA qualification of a finished good to be exported later.

For a good to be qualified under NAFTA, it must meet the relevant “rule of origin” for that product. The rule of origin that applies is dictated by the Harmonized Tariff Schedule (HTS) classification of the product. Unlike the non-FTA method for conferring origin on a product (“substantial transformation”) which is more subjective, the FTA rules of origin rely on the two major principles of “tariff shift” and “regional value content.” There is additional complexity for industries that have been historically protected (automotive, wearing apparel, etc.), but for simplicity sake let’s stick with a simple tariff shift and straightforward regional value content (RVC) example.

The concepts are not that difficult. The complexity centers on data availability, tracking, and timeliness of information. For example, here is the NAFTA rule of origin for steel articulated link chain (HTS 7315.11 and 7315.12):

(A) A change to subheadings 7315.11 through 7315.12 from any other heading; or

(B) A change to subheadings 7315.11 through 7315.12 from subheading 7315.19, whether or not there is also a change from any other heading, provided there is a regional value content of not less than:

(1) 60 percent where the transaction value method is used, or

(2) 50 percent where the net cost method is used.

Since 7315 is the heading for steel chain, rule (A) is basically saying that if the materials used in production are not already classified as steel chain, they will “tariff shift” and would not have to be NAFTA originating (of course if the materials originated in the US, Canada, or Mexico they would not be required to tariff shift).

Rule (B) however, throws a curve with the stipulation that if a material is already classified as 7315.19, an articulated link chain “part”, then additionally there must be a value content percentage met, the details of which we will not get into here. Speaking at a high level, the total cost of producing the good in a NAFTA country minus the value of non-originating materials must be either 50 or 60 percent of the total cost.

To qualify the chain for NAFTA, one would need a bill of materials with each component classified with an HTS, assigned a country of “origination”, and possibly component and production costs if RVC was applicable. That is probably not too big a deal for our link chain example, but what if the item being manufactured was something more complex like a refrigerator, automobile, or television set? How would a manufacturer capture the origin, HTS classification, and costs for all components and validate against the relevant rule of origin? How would the manufacturer conduct the certification process accurately and efficiently on an order by order basis to reduce the risk associated with part substitutions during the manufacturing process, multiple suppliers for the same part number, and multiple origins for the same part?

The story is somewhat different for an importer who is claiming the benefits of an FTA. In theory, the importer relies on the certification provided by the supplier, in Canada or Mexico in our NAFTA example. The burden on the importer is to make sure a valid FTA certification is in their possession when they make the claim for FTA benefits. That sounds simple enough, but there are some other considerations:

  • The importer will be liable for unpaid duties if it is discovered by Customs through a verification procedure that the FTA claim was erroneous.
  • If the supplier is a related party to the importer, or the importer has significant control over the supplier’s procurement and manufacturing processes (vendor managed inventory and manufacturing requirements), it is unlikely the importer would be able to escape liability hiding behind the supplier’s certification if it was determined the qualification was in error.
  • Tracking and maintaining valid supplier certifications and accurately communicating FTA eligibility to Customs Brokers on a shipment by shipment basis can be problematic without automation.

The complexity for both importers and exports in dealing with FTA’s is already significant and bound to increase over time. If the TPP becomes a reality it will create one of the most far reaching FTA’s ever (12 participating countries). It is estimated that it will generate additional world exports worth $305B annually, including an additional $123.5B in US exports.

While the compliance requirements for importers and exporters may vary, both can benefit from the use of automation models that integrate FTA functionality with their Enterprise Resource Planning (ERP) systems, and/or leverage the capability of Global Trade Management (GTM) systems similarly integrated. These automation models will help ensure compliance with applicable FTA regulations while taking advantage of the cost reductions and market access benefits for which the FTA’s are created.

To learn more about FTA, visit our ONESOURCE for FTA page