Tax & Accounting Blog

Intermediate Materials – Can They Help Me Qualify for FTAs?

Blog, Global Trade, ONESOURCE February 10, 2017

In complicated manufacturing environments many producers create sub-assemblies or intermediate products before combining them in final products for export.  This is often reflected in complicated multi-level bill of materials (BOM) during manufacturing.  If these intermediate materials are qualified and considered originating in the production country, the possibility of meeting originating content requirements to meet rules of origin and utilize the FTA is vastly improved.

However, caution should be taken and rules well-understood to avoid false origin claims or investigations from Customs agencies based on over-aggressive origin claims. This article is intended to clear-up the intermediate materials concept by outlining the regional differences in application and interpretation, and suggests best practices for companies looking to use this concept.

Overview of intermediate materials

Intermediate material is a material that is self-produced and used in the production of a good. The purpose of the intermediate material designation places manufacturers on common ground with producers who purchase materials from independent suppliers.

The absorption or roll-up principle is an industry-wide rule which permits origin qualification of intermediate materials when they are used for subsequent manufacturing operations. All non-originating inputs contained in the intermediate materials are disregarded when assessing the origin of the final good. This makes origin rules less restrictive because they allow the use of more non-originating inputs than would be possible in a situation where no intermediate materials were qualified. Vertically-integrated manufacturers therefore have greater opportunities to utilize FTAs with the intermediate materials concept.  A simple example below illustrates this:

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In the above example, assume that local/regional content (RVC) rule of origin sets a 40% threshold to qualify for the FTA.  Using a flat BOM, the product cannot meet the threshold because it only has 30% local content.  However, parts B-a and B-b are combined as an intermediate material part B used in the final assembly, the entire value of part B can be used and the material qualifies with 45% local content.

This is quite simple math and immediately seems attractive from a producer standpoint.  However, there are general and FTA specific rules that must be followed to utilize the intermediate materials concept.

Global view of intermediate goods acceptability in FTAs

Countries and agreements differ in their approach to the intermediate materials concept.  Many agreements are silent on the concept based on our experience and research.

Below are examples for some of the more widely known uses of this principle.

NAFTA

The principle stipulates that non-originating parts of intermediate materials which have acquired originating status cannot be taken into account for the origin determination of products in subsequent manufacturing processes.  Multi-level qualification of intermediate materials that qualify under substantial transformation or change in tariff chapter/ heading (CTH/CTSH) is allowed.

A further limitation is the absorption or roll-up principle in the NAFTA model and is not a general regime-wide principle for all goods sectors since its application for motor vehicles is excluded. Due to the exceptions and limitations, the absorption or roll-up principle in the NAFTA model has less impact than in the European context where the principle is applied across all products.

EU FTAs

The absorption principle in the European origin legislation is used regime-wide without any exception or limitation in the EU FTA. Exporters are able to apply roll-up principle in all FTAs and all products are subject to absorption rule. In EU FTAs, “intermediate material or absorption or roll-up principle” are explicitly referenced in the agreements.

For example, we can find the roll-up principle in article 6 (Sufficiently Worked or Processed Products) of trade agreement ratified between the EU and Colombia and Peru.  The absorption rule is also called out in article 5 (a) (Sufficiently Worked or Processed Products) of the FTA ratified between Korea and the EU. In the agreement ratified between the EU and Central America Association, the roll-up principle is found in the article 5 (Sufficiently Worked or Processed Products).

Korea

As of now, 15 FTAs are ratified in Korea. Most of Korea’s FTAs regulations identify the principle for intermediate material, except for the Korea-ASEAN FTA and Korea-India FTA. The Korea-Chile FTA (article 4.4), Korea-Singapore FTA (article 4.7), and Korea-Columbia FTA (article 3.5) expressly specify “intermediate material”. Other FTAs with Australia, Canada, China, New Zealand, Vietnam, and the EU do not provide explicit guidance in the text; however Customs guidance is that the concept may be used under Korea FTA legislation ’Enforcement Regulation on the Act on Special Cases of the Customs Act for the Implementation of Free Trade Agreements’ applying to the intermediate materials concept.

The regulation stipulates that the KR-SG rules of origin are followed for intermediate material concept. As a note of caution; exporters should apply the intermediate material rule very carefully under Korea-ASEAN FTA because there is no legal basis on it under the FTA.

According to the Korea FTA-related law called ’Act on Special Cases of the Customs Act for the Implementation of Free Trade Agreements’ article 3 (in relation to other Acts) if the Act or the Customs Act conflicts with any free trade agreement, such agreement takes precedence in the application.

So, the KR-ASEAN agreement would take precedence in an application over Korea FTA-related legislation. Specifically meaning, it’s likely to levy customs duty and other taxes if they apply under the rule of the FTA.

ASEAN

There is no absorption or roll-up principle related to intermediate material in the ASEAN origin model. In the existing FTAs, producers are advised to contact Customs authorities of the exporting and importing nations before using the intermediate materials concept in origin calculation.

Conclusion – Best practices to maximize utilization and minimize risks

The simplest approach to FTA qualification is to use a single level BOM or flat BOM.  This is acceptable under all agreements and will not be questioned.  However, qualification based on a flat BOM is not always possible and this is where the intermediate materials concept should be considered.

If intermediate materials are necessary to qualify, companies should first check the FTA text.  If intermediate materials are explicitly specified, the producer can proceed with confidence by following the guidelines of the agreement; if not, consultations should be made with advisors and customs authorities before proceeding.  Explicit restrictions or exclusions should, of course, be followed.

Requirements should be followed closely.  For example, agreements may require explicit identification of self-produced materials when submitting applications for final goods.  They may also require proof that multi-level roll ups are not being used.

Some agreements are silent on the ability of producers to use multi-level roll ups of intermediate materials.  In general, most agreements prohibit multi-level roll ups using local-content or RVC rules, but may allow multi-level roll ups for substantial transformation or CTH/ CTSH-type rules.  As much as possible, the flatter the BOM, the easier it will be to explain and defend in case of origin audit.

Finally, intermediate materials introduce new complexity into FTA processes.  Many producers may keep records to support the audit claims of final materials for which they are claiming FTA benefits, but they often overlook the requirement to properly qualify and keep records for intermediate materials as well.  Leveraging technology to manage intermediate material effectively ensures that FTA origin verification or investigation can be expedited quickly. Records should be kept for a minimum of 5 years or following any explicit retention period specified in an agreement.

The intermediate materials concept can be a powerful tool to qualify more products for FTA benefits.   A conservative approach that follows legislation carefully and is supported by robust processes and systems can create competitive advantage for exporters.

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References

http://www.customs.go.kr/kcshome/main/content/ContentView.do?contentId=CONTENT_ID_000002802&layoutMenuNo=30713#none

https://www.nafta-sec-alena.org/Home/Legal-Texts/North-American-Free-Trade-Agreement?mvid=1&secid=feb541cc-bfc2-4240-829f-b5a7ec26a08a#A404

http://ec.europa.eu/trade/policy/countries-and-regions/agreements/index_en.htm#_other-countries

http://asean.org/asean/external-relations/

https://ustr.gov/trade-agreements/free-trade-agreements/trans-pacific-partnership/tpp-full-text