Original sin

Original sin

Although the U.S.-Central American Free Trade Agreement has yet to be ratified by Congress, many U.S. exporters are already making plans to take advantage of the increased business opportunities that the agreement will provide in the form of preferential tariffs available to buyers in the CAFTA countries.

Unfortunately, however, many companies will go about that process sloppily - and expose themselves and their foreign buyers to loss of preferential-duty treatment as a result, said Margaret M. Gatti, an attorney at Gatti & Associates, a firm specializing in international trade. "Many companies apply the incorrect rule of origin," a key requirement of trade pacts that determines which exports are eligible for preferential tariff treatment, she said. "Companies don't understand that rules of origin are terms of art. They don't understand that each free-trade agreement defines 'origin' differently and has its own set of origin rules. Or they apply the origin rule prescribed by a free-trade agreement with no understanding of what is involved and no ability to substantiate the claim they make."

Although free-trade pacts may look and sound alike, they are anything but a standard commodity, in large part because they vary so widely in terms of rules of origin. Each trade pact is, after all, the product of a series of compromises between various interest groups in the U.S. and its foreign partner. Even if an exporter has experience implementing the rules of origin in a previous free-trade pact - say, NAFTA or the U.S.-Israel agreement - it needs to do plenty of hard work, adjusting to the requirements of the rules of origin in any new trade agreement. Moreover, when it comes to paperwork, free-trade agreements are anything but free. On the contrary, taking advantage of the intricate rules of origin requires exhaustive record-keeping.

How can companies maximize their results? Gatti advises companies to begin by looking at the text of the relevant trade pact to see how "origin" is defined. When it comes to rules of origin, the most generic definition involves a term of art known as "substantial transformation." Substantial transformation is a subjective determination, but generally requires the creation of a product, which has a name, character and function that differs from those of its constituent materials. For the U.S. trade agreements involving Israel and Jordan - and to some extent Morocco - substantial transformation comprises a significant portion of the operative rule of origin, making use of those trade agreements comparatively simple for U.S. exporters. According to the origin rules in the referenced trade agreements, a U.S.-made product qualifies for preferential-tariff treatment under the accord if it has undergone "substantial transformation," and more than 35 percent of its appraised value is derived from U.S. content and labor.

However, this rule does not apply to CAFTA and other recent pacts such as NAFTA, Singapore, Chile and Australia. Although the U.S. has used "substantial transformation" as the default origin rule for years, it is "subjective" and "squishy" in application, Gatti said. Too often, "Two Customs officials come to a different conclusion about whether substantial transformation has occurred in the same product."

In search of a more objective standard, a more complex rule of origin known as "Tariff Shift" has become the norm in recent U.S. free-trade agreements. These rules are product-specific. To qualify a product for a preferential tariff, an exporter must consult the annex at the back of each trade agreement and study the origin rule outlined for each specific product, in accordance with its Harmonized Tariff Schedule (HTS) number.

Even so, applying this approach is "very hard," Gatti said, because "you have to know the origin for each component" that goes into the final product you export. For those components that are not U.S.-made, you also need to know the components' HTS numbers and their values, so you can determine whether the imported components undergo the tariff shift prescribed by the origin rule and then, if necessary, calculate the value of all U.S.-made components involved in the final product.

Having completed that calculation, it could turn out that your final product may not qualify as an "originating good" under the rule of origin because the imported components do not undergo the requisite tariff shift or because the U.S.-made content does not reach the level prescribed in the origin rule for the final product. In such a case, your foreign buyer will be subjected to a "normal-trade-relation duty," rather than a "preferential duty," Gatti said. Consequently, your product might no longer be price-competitive to your buyer.

This process is painstaking, Gatti said, and involves an enormous amount of paperwork. "You must keep a lot of records, including manufacturers' affidavits proving the origin of the components used to produce your product." It's easy to handle this part of the process when your components are all U.S.-made, and you can get sworn statements to that effect, she noted. However, the especially tricky part comes when your supplier may be purchasing his subcomponents from other countries - and may not have ready access to information about their origins. In such a case, proving that your product has sufficient U.S. content may be quite a challenge.

To see how this might work, Gatti cites the U.S. trade pact with Chile, and a product known as a "vacuum motor blower." Suppose a U.S. manufacturer of vacuum motor blowers wants to export them to Chile, and enable its Chilean buyer to take advantage of the preferential-tariff treatment available for that product under the Chile-U.S. Free Trade Agreement. In such a case, the exporter must acquire an origin certificate from each company that supplies components for those blowers, certifying the country of origin for each component.

"As an exporter, I rely on that signed statement in making a claim for preferential treatment from Chilean Customs," Gatti explained. "Chile is losing customs revenue as a result of those preferential tariffs, and their Customs may demand proof that a product qualifies for preferential-tariff treatment, to justify the loss" of those duties.

Chilean Customs may ask the Chilean company that imports the U.S.-made blowers to prove that the blowers qualify for preferential treatment. In this case, the rules of origin require that, when comparing the HTS numbers of the imported components to the final product, there be a "change from sub-heading 8414.59 from any other sub-heading, including a sub-heading within the same group." In less technical language, all the components for the final product must be from another subheading of the HTS; they cannot be from 8414.59.

Here is how this might work in the case of vacuum blower motors, which have an HTS number of 8414.59.9080. Suppose the two imported components of the motor are "universal electric motors" - with an HTS number of 8501.20, and "vacuum motor parts," with an HTS number of 8509.90. "When I combine these two subheads, I meet the rule of origin" of the U.S.-Chile agreement, Gatti explained, "because I used components that had other subheads."

Although the U.S.-Chile trade pact is young, experience with NAFTA shows that U.S. exporters had better be ready, years after they sell in a foreign market, to produce the documentation that proves their product meets a trade agreement's rules of origin. The Canada Border Services Agency, Canada's customs service, has been very active recently, asking for proof - a year so after transactions are made. "They see a lot of duty-free claims on U.S. exports, and they go to Canadian buyers and ask for proof of origin."

In one recent case, Canadian customs inquired about 20 products - each of which include at least 25 components and some as many as 200 components. To prove that the products qualified for NAFTA rules of origin, Gatti's firm had to create a spreadsheet with the HTS numbers of each component to determine if the origin rule for the final product had been met. "Had this company done some advance planning, they could, at the time of purchase, have asked their suppliers for origin statements," Gatti said. "Because this company didn't have origin statements, we had to assume everything was imported, and determine the harmonized numbers for each component."

In this case, the U.S. exporter was able to meet NAFTA rules of origin - and qualify for preferential tariff - but "it took a lot of time to prove that," she said.

Gatti advises exporters to "plan ahead and get origin certifications from your U.S. suppliers." The cost is not always worth the effort. "If the average duty is 5 percent, and the paperwork adds, say, 10 percent or more to your costs, then it may make sense to tell your foreign buyer: 'I will cut my price to you, so that my product remains price-competitive for you - even without a preferential duty.' " If, however, the Chilean tariff on the exporter's product is, for example, 11 percent, "it may be worthwhile keeping the records" and absorbing the 10 percent paperwork expense.

Beyond managing the paper, extra exposure is also involved. An exporter's foreign buyer can be called on to substantiate the statement of origin for his customs authorities, and must be able to prove that the exporter's products meet the pact's rules-of-origin requirements. "The Chilean Customs official has the right to reverse the preferential-tariff treatment rendered" earlier and charge duty on them, retroactively - and possibly even penalties - to the Chilean importer, who is legally responsible for those duties.

If the importer is left holding the bag, the exporter must decide whether to make good on his loss of preferential-tariff treatment - and maintain his business relationship - or let the relationship end right there. Gatti said, "That may be appropriate if you and your buyer have already had a falling out. If your buyer stuck you for a past payment, you may not want to bother repairing the relationship."