1. FTA Compliance Understanding the Rules of Origin (“ROO”) and Origin Certification Requirements

2. The Importance of ROO Determining the Country of Origin (“COO”) of imported goods is necessary to apply trade policy measures such as tariffs, quantitative restrictions, anti-dumping and countervailing duties and safeguard measures, as well as for requirements relating to origin marking, public procurement and for statistical purposes. Non-preferential ROO are used to determine the origin of goods imported from countries with MFN status. Preferential ROO, on the other hand, are used to determine the eligibility of imports from FTA partners (or LDCs in certain cases) to receive preferential treatment.

3. Defining ROO Where a product is produced in a single stage or is wholly obtained in a preferential trade partner country (“Partner Country”) then the COO of the product is relatively easy to establish. Proof that the product was produced in the Partner Country is normally sufficient. For all other cases, preferential ROO define the methods by which it can be ascertained that the particular product has undergone sufficient working or processing in a Partner Country, or incorporates sufficient originating inputs, and that it has not simply been transshipped from a non- qualifying country or subjected to only minimal processing.

4. Defining ROO In practice, the higher the level of work/processing or originating content that is required by the ROO, the more difficult it is to satisfy those rules and the more restrictive those rules are in constraining market access relative to what is required simply to prevent trade deflection. Three main methods are used to establish if sufficient work/processing has been undertaken or originating content incorporated: 1.a change of tariff classification; 2.a minimum amount of domestic value added or Regional Value Content (“RVC”); or 3.a specific manufacturing process. Many FTAs, including most of those implemented by the EU and the U.S., use all 3 methods.

5. Change in Tariff Classification/“Tariff Shift.” Origin is granted if the exported product falls into a different part of the tariff classification from any imported inputs that are used in its production. Stated otherwise, each non-originating material used in production must undergo the applicable change as a result of production occurring in the applicable country (or region). Application of this “tariff-shift” method has been facilitated by the widespread adoption of the Harmonized System (“HS”), under which most of the world’s more than 190 countries are now classifying goods according to the same harmonized categories. The level of classification of the HS at which change is required remains an issue. Typically, however, it is specified that the change should take place at the heading level (that is, at the four- digit level of the HS).

6. Change in Tariff Classification/“Tariff Shift.” Example using NAFTA’s Annex 401 tariff change ROO: Frozen pork meat (HTS 02.03) is imported into the U.S. from Hungary and combined with spices imported from the Caribbean (HTS 09.07-9.10) and cereals grown and produced in the U.S. to make pork sausage (HTS 16.01). The Annex 401 ROO for HTS 16.01 states: A change to heading 16.01 through 16.05 from any other chapter. Since the imported frozen meat is classified in Chapter 2 and the spices are classified in Chapter 9, these non ‑ originating materials meet the required tariff change. There is no need to consider whether the cereal meets the applicable tariff change since it is originating.

7. Change in Tariff Classification/“Tariff Shift.” The change of tariff classification may be used to define both a positive test of origin, by stating the tariff classification of imported inputs that can be used in the production of the exported good (for example, those under a different heading), or a negative test, by stating cases in which change of tariff classification will not confer origin. For example, the NAFTA ROO for tomato ketchup states that a change to ketchup (HTS 2103.20) from imported inputs of any chapter except subheading 2002.90 (tomato paste) will confer origin.

8. Change in Tariff Classification/“Tariff Shift.” Although, in practice, it generally incorporates many individual rules, the rule on change of tariff classification, once defined, is clear, unambiguous, and easy for companies to learn, and it is relatively straightforward to implement. In terms of documentation, it requires that companies keep records showing the tariff classification of the final product and of all the imported inputs. This may not be a demanding requirement if the exporter directly imports the inputs, but it may be more difficult if inputs are purchased from intermediaries in the domestic market.

9. Value Added/RVC When the value added to a product in a particular country exceeds a specified percentage, the goods are defined as originating in that country. This criterion can be defined in two ways: 1.the minimum percentage of the value of the product that must be added in the country of origin, or 2.the maximum percentage of imported inputs in total inputs or in the value of the product.

10. Value Added/RVC Example using NAFTA (though this applies to many U.S. FTAs): Some Annex 401 specific ROO require that a good have a minimum RVC, meaning that a certain percentage of the value of the goods must be from North America. Article 402 gives two formulas for calculating the RVC. In general, the exporter or producer may choose between these two formulas: (1) the "transaction value" method and (2) the "net cost" method. The transaction value method calculates the value of the non- originating materials as a percentage of the total price paid for the good, with certain adjustments for packing and other items. Because the transaction value method permits the producer to count all of its costs and profit as territorial, the required percentage of RVC under this method is higher than under the net cost method.

11. Value Added/RVC The formula for calculating the RVC using the transaction value method is: RVC = TV – VNM x 100 TV Where RVC is the regional value content, expressed as a percentage; TV is the transaction value of the good adjusted to an FOB basis; and VNM is the value of non ‑ originating materials used by the producer in the production of the good.

12. Value Added/RVC There are a number of situations where the transaction value method cannot be used and the net cost method is the only alternative. For example, the net cost method must be used when (1) there is no transaction value, (2) in some related party transactions, (3) for certain motor vehicles and parts, (4) when a producer is accumulating RVC, as well as (5) to determine the RVC for designated intermediate materials. The producer may also revert to the net cost method if the result using the transaction value method is unfavorable.

13. Value Added/RVC The net cost method calculates the RVC as a percentage of the net cost to produce the good. Net cost represents all of the costs incurred by the producer minus expenses for sales promotion (including marketing and after ‑ sales service), royalties, shipping and packing costs and non ‑ allowable interest costs. The percentage content required for the net cost method is lower than the percentage content required under the transaction value method because of the exclusion of certain costs from the net cost calculation.

14. Value Added/RVC The formula for calculating the RVC using the net cost method is: RVC = NC – VNM x 100 NC Where RVC is the regional value content, expressed as a percentage; NC is the net cost of the good; and VNM is the value of non ‑ originating materials used by the producer in the production of the good.

15. Value Added/RVC As in the case of change of tariff classification, the value added rule has the advantage of being clear, simple, and unambiguous (at least as stated). In application, however, it can become complex and uncertain. First, there is the issue of the valuation of materials, which may be based on several prices, e.g., ex-works, FOB or CIF. Each method yields a different (here, ascending) value of non-originating materials. Second, the application of this method can be costly for firms that will require sophisticated accounting systems and the ability to resolve often complex accounting questions.

16. Value Added/RVC Finally, under the value added method, origin is sensitive to changes in the factors that determine production cost differentials across countries, such as exchange rates, wages, and commodity prices. For example, operations that confer origin in one location may not do so in another because of differences in wage costs, and an operation that confers origin today may not do so tomorrow if exchange rates change. As you can see, these intricacies can pose significant compliance and monitoring burdens on producers.

17. Specific Manufacturing Process This criterion delineates, for each product or product group, certain manufacturing or processing operations that define origin (positive test) and manufacturing or processing procedures that do not confer origin (negative test). These rules may require the use of certain originating inputs or prohibit the use of certain non-originating inputs.

18. Specific Manufacturing Process The main advantage of specific manufacturing process rules is that, once defined, they are clear and unambiguous so that, from the outset, producers are able to clearly ascertain whether their product is originating or not. There are, however, a number of drawbacks to this system, including obsolescence (as a consequence of changes in technology) and documentary requirements, such as an up- to-date inventory of production processes, which may be burdensome and difficult to comply with.

19. Complying with ROO Typically, detailed rules specify which method applies to which product or product group. In certain agreements, the ROO for a particular product will specify that two or more of the methods must be satisfied, e.g., a change of tariff heading and a certain proportion of domestic value-added. Clearly, satisfying multiple requirements to confer origin is more restrictive. In certain agreements, the rules will stipulate alternative methods for particular products, satisfaction of any of which will confer origin, e.g., a change of tariff heading or the specified amount of domestic value- added. Such an approach is more liberal and gives greater flexibility to producers in obtaining origin.

20. Complying with ROO No one method is more prevalent, and each has its advantages and disadvantages. It is clear, however, that different ROO can lead to different determinations of origin. Thus, producers who are eligible for preferential access to different markets under different schemes with different rules of origin may find that their product qualifies under some schemes but not others. There are several other typical features of the ROO of preferential trade schemes that can influence whether or not origin is conferred on a product and hence determine the impact of the scheme on trade flows. These are: 1.cumulation or accumulation; 2.tolerance or de minimis rules; and 3.absorption.

21. Cumulation/Accumulation Cumulation is an instrument allowing producers to import materials from a specific country or regional group of countries without undermining the origin of the product. The most basic form is bilateral cumulation. In this case, originating inputs, i.e., materials that have been produced in accordance with the relevant ROO, imported from a Partner Country, qualify as domestic content when used in a country’s exports to that Partner Country.

22. Cumulation/Accumulation Second, there can be diagonal cumulation, on a regional basis, whereby parts and materials from anywhere in the specified region that qualify as originating can be used in the manufacture of a final product that can then be exported with preferences to a Partner Country market. Finally, there can be full cumulation, whereby any processing activities carried out in any Partner Country in a regional group can be counted as qualifying content regardless of whether the processing is sufficient to confer originating status to the materials themselves. Full cumulation provides for deeper integration by allowing for more fragmentation of production processes among the members of the regional group.

23. Cumulation/Accumulation While beneficial, cumulation/accumulation can create significant compliance and documentation burdens. For example, under NAFTA, the conditions for using accumulation are: producers/exporters who choose to use accumulation must use the net cost method to calculate any RVC; producers/exporters of goods must obtain information on net cost and the RVC of non ‑ originating materials used to make their goods from the producers (suppliers) of those materials; all non ‑ originating materials used in the production of the goods must undergo the tariff classification change set out in Annex 401 of the Agreement and the goods must satisfy any applicable RVC requirement entirely in the territory of one or more of the NAFTA countries; and the goods must satisfy all other applicable requirements of the ROO.

24. Tolerance or De Minimis Tolerance or de minimis rules allow a certain percentage of non- originating materials to be used without affecting the COO of the final product. Note that this rule applies to the change of tariff heading and the specific manufacturing rules but does not affect the value added rules. In some instances, however, where a failure of materials to undergo a required change in tariff classification triggers a requirement for a minimum RVC, the RVC calculation is waived if the value of all non-originating materils used in the production of the goods is not more than the specified de minimis amount. The tolerance or de minimis rule can act to make it easier for products with non-originating inputs to qualify for preferences.

25. Absorption The absorption principle provides that parts or materials that have acquired originating status by satisfying the relevant ROO for that product can be treated as being of domestic origin in any further processing and transformation. In other words, any non-originating materials are no longer taken into account when assessing the nature of further operations.

26. Impact of ROO Compliance with ROO can (and usually does) affect the sourcing and investment decisions of traders and producers. If the optimal input mix for a firm involves the use of imported inputs that are proscribed by the ROO of a FTA in which the country participates, then the ROO will reduce the value of the available preferences. The firm will have to shift to a higher cost source of inputs in the domestic economy which will reduce the benefits of exporting under a lower tariff. In the extreme, if the cost difference exceeds the size of the tariff preference then the firm will prefer to source internationally and to pay the MFN tariff.

27. Impact of ROO The ability to cumulate inputs from a partner under bilateral, diagonal or full cumulation will tend, in increasing order, to open the possibilities for identifying low cost sources of inputs that do not compromise the qualifying nature of the final product. If the lowest cost supplier is not, however, a member of the area of cumulation, then the benefits of the preferential scheme will always be less than indicated by the size of the preferential tariff.

28. Impact of ROO These problems will be exacerbated in sectors where economies of scale are important. A producer that supplies both preferential and non-preferential trade partners, or faces different ROO with different preferential partners, will have to produce with a different input mix for different markets if they are to receive preferential access. This may undermine the benefits from lower average costs that would arise if total production were to be based on a single set of material inputs and a single production process.

29. Impact of ROO ROO may significantly affect the investment decisions of multinational firms. Such firms often rely on imported inputs from broad international networks that are vital to support the firm specific advantages that they possess, such as a technological advantage in the production of certain inputs. More generally, if the nature and application of a given set of ROO introduces a degree of uncertainty concerning the extent to which preferential access will actually be provided, this may constrain investment. Restrictive ROO discriminate against small countries and LDCs where the possibilities for local sourcing are limited or nonexistent.

30. ROO Compliance ROO compliance entails not only complying with the rules on sufficient processing but also the costs of proving compliance with those ROO. The costs of proving origin involve satisfying a number of administrative procedures so as to provide the documentation that is required and the costs of maintaining systems that accurately account for imported inputs from different sources to prove consistency with the rules. The ability to prove origin may well require the use of sophisticated and expensive accounting procedures.

31. ROO Compliance Importers' Obligations Importers claiming preferential tariff treatment under a FTA must generally make a declaration, based on a valid certification of origin, on the import documentation. In some instances, e.g., NAFTA, where no claim for preferential tariff treatment is made at the time of importation, importers may request preferential tariff treatment within a prescribed period after the date on which the good was imported, provided a Certificate of Origin for the goods is obtained. Importers must generally provide the certification of origin to the importing country's customs administration upon request, and must generally submit a corrected declaration and pay the corresponding duties whenever there is reason to believe that the certification contained inaccurate information. The customs administration of the importing country may deny preferential tariff treatment to the goods if the importer fails to comply with any of the customs procedures set out in the FTA. Importers are usually required to maintain records pertaining to the importation for a period prescribed by the FTA, e.g., five years under NAFTA.

32. ROO Compliance Exporters' and Producers' Obligations Exporters or producers that prepare certification of origin documents may be required to provide copies to their own customs administration upon request. Exporters or producers that provide a certification of origin must generally maintain records pertaining to the exportation for a prescribed period, e.g., five years under NAFTA. Such records include: Purchase, cost, value of, and payment for the exported good; The purchase, cost, value of, and payment of all materials, including indirect materials, used in the production for the exported good; and The production of the good in the form in which it was exported. Exporters or producers that complete a certification of origin are generally required to notify parties to whom the certification was given of any change that could affect its accuracy or validity.

33. ROO Compliance FTAs may authorize the importing country's customs administration to conduct verifications of the exporter or producer to determine whether goods qualify as originating as certified by the Certificate of Origin. Verifications are generally conducted by written questionnaires, verification visits, or by telephone, facsimile or other means. FTAs will often empower participating jurisdictions to maintain measures imposing criminal, civil or administrative penalties for violations of their laws and customs procedures. For example, under NAFTA, an exporter or producer who falsely represents on a NAFTA Certificate of Origin that a good qualifies as originating may be penalized. An importer may also be penalized for making a false claim for preferential NAFTA treatment on the customs import documentation. Importers, exporters and producers who prepare a Certificate of Origin may also be penalized for failing to retain their records as required by the NAFTA (generally five years). In many cases, exporters and producers may avoid such penalties if they promptly and voluntarily advise all concerned parties of the incorrect information contained in the Certificate of Origin. Importers may avoid penalties if they promptly and voluntarily submit a corrected customs declaration and pay any duties that are owed upon learning of the incorrect information contained in the Certificate of Origin.

34. ROO Compliance Under some FTAs, and in certain instances, the importing country's customs administration may choose to deny FTA benefits for failure to comply with its customs regulations. Examples of conduct which may result in the denial of preferential treatment include: Failure to provide a certificate of origin for commercial importations; Failure by the person who signed a Certificate of Origin to consent in writing to a verification visit during the 30 days after notice of an intent to conduct such a visit is sent. A country may also deny benefits once its customs administration verifies that a good does not qualify as originating. Where two or more verifications indicate a pattern of conduct by an exporter or a producer of false or unsupported representations that a good qualifies as originating, the customs administration of the importing country may withhold preferential tariff treatment from identical goods exported or produced by that person, until compliance with the ROO is established.

35. ROO Compliance There is limited information on the costs of ROO compliance but available studies suggest that the costs of providing the appropriate documentation to prove origin can be around 3 per cent of the value of the export shipment for companies in developed countries. These costs may be even higher, and possibly prohibitive, in countries where customs mechanisms are poorly developed. Even if producers can satisfy the ROO, in terms of meeting the technical requirements, the costs of proving origin relative to the duty reduction that is available may lead to the producer opting to forego preferential access.

36. Contact Information: Matthew A. Bock, Esq Partner (781) 272-7966 mbock@mstradelaw.com