January 1995

NAFTA'S RULES OF ORIGIN

Mexico City

A basic rule of NAFTA is that only goods that have a particular relationship to one or more of the NAFTA countries are eligible for NAFTA's preferential tariff rates. The rules that govern the specific relationship that a good must have to one or more of the NAFTA countries are called rules of origin.

Rules of origin have two purposes. The first addresses the free-rider problem inherent in any free trade area. Specifically, rules of origin are designed to prevent a manufacturer located in a non-member economy from taking advantage of the low tariff rates contained in a free trade agreement by (i) manufacturing a good in a non-member economy, (ii) exporting the good to a member economy, (iii) making a minor or no change to the good and (iv) re-exporting the good to a customer at the preferential duty rate. The second purpose is nefarious: rules of origin can be used to prevent a good with minor amounts of non-originating materials from qualifying for the preferential tariff rate of the free trade area.

Rules of origin have a potentially profound effect on investment and sourcing decisions. Members of a free trade area maintain a separate customs authority. They are at liberty to assess their applicable tariff on goods exported from non-member countries, but more importantly, from any member country that fails to meet the applicable rule of origin. Therefore, an importer of finished goods that fails to meet the rules of origin must either pay the applicable tariff rate each time the good is imported to a member state or establish distribution centers in each member state. Similarly, a manufacturer based in a free-trade area must also assess whether, by incorporating a good that does not meet NAFTA's rules of origin into a finished good, such finished good will subsequently fail to qualify for the preferential tariff. The costs associated with establishing additional distribution centers or manufacturing plants or paying non-NAFTA tariff rates can preclude an importer or manufacturer from competing in the North American market.

NAFTA contains five general rules of origin. Any good that meets any one of these rules qualifies as originating and, thereby, qualifies for NAFTA's preferential tariffs: (i) goods that were either harvested, mined or born and raised in the territory of one or more of the NAFTA countries; (ii) goods that were produced from goods originating entirely in the territory of one or more of the NAFTA countries; (iii) goods that contain non-originating materials but have, nonetheless, undergone a sufficient transformation, as specified in Annex 401; (iv) for some goods in some situations, even if the non-originating materials are not sufficiently transformed pursuant to Annex 401, the finished good may qualify as originating if it meets one of the regional value content tests; and (v) the non-originating materials incorporated into the finished good amount to less than seven percent of the total value of the finished good.

The first and simplest rule of origin test applies only to goods without any foreign components or content. Goods that are harvested, slaughtered, born and raised, mined, taken from the sea, the seabed or even outer space, wholly within one or more of the NAFTA countries, qualify for the preferential NAFTA tariff rates. Thus, for example, corn, even if grown from Honduran seeds, would qualify for NAFTA's lower duties so long as it is grown in Canada, the United States or Mexico.

The second way a good can qualify as originating is if the good is produced entirely in the territory of one of the NAFTA parties from originating goods. Thus, for example, if a manufacturer produces a phone, and all of the materials used to produce the phone, such as the plastic, wiring and audio components, are all made from originating goods, the phone would qualify as originating.

The third way a good can qualify as originating is that each and every foreign or non-originating component incorporated into the good has been sufficiently transformed in one or more of the NAFTA countries. The three major ways a good can meet the transformation test make this rule of origin extremely complicated. For the majority of goods, Annex 401 merely sets forth a tariff shift requirement, which means that the non-originating materials incorporated into the finished good must be listed outside specific tariff headings in the importing country's Harmonized Schedule. For other goods, non-originating components must meet either a tariff shift requirement or the finished good must pass one of the two regional value content tests, which are discussed below. For still other goods, non-originating components must meet a tariff shift requirement and the finished good must pass a regional value test.

The fourth way a good can meet the NAFTA rules of origin applies to a limited number of goods. Pursuant to Article 401(d), excluding certain textile and apparel goods, a good may qualify as originating even if it incorporates one or more non-originating materials that do not undergo a prescribed change in tariff classification pursuant to Annex 401. This rule of origin is limited to narrowly defined situations. For the majority of goods that qualify under this rule, this test allows a good to qualify as originating if (i) it failed a tariff shift requirement but the finished good is specifically named in the same tariff subheading as its parts in the relevant Harmonized Schedule and (ii) the finished good meets one of the regional value content tests.

Pursuant to Article 405, certain goods are eligible for NAFTA's preferential tariff rates even if they fail all the other rule of origin tests described above. This fifth and final rule of origin test, appropriately called de minimis, provides that, subject to certain limitations, most goods whose non-originating materials do not undergo the prescribed tariff shift or meet one of the regional value content tests nonetheless qualify as originating if (i) the non-originating materials do not amount to more than seven percent of the transaction value of the good, adjusted to an F.O.B. basis, or (ii) in cases where the transaction value of the good is unacceptable under Article 1 of the Customs Valuation Code, the value of non-originating material is not more than seven percent of the total cost of the good.

As described above, in order for some goods that incorporate non-originating materials to meet a NAFTA rule of origin, the given good must meet a regional value content test. Article 402 sets forth two methods that a manufacturer may use to calculate the regional value content of a particular good. The first is the so-called "net cost" method, which follows the costs of production incurred in a NAFTA member's economy. The second is the "transaction value" method, which analyzes regional value content by beginning with the price at which the good is sold for export and then subtracting the price paid for components imported from non-member countries. There are also a number of complex rules, such as "roll-up" and "roll-down," that are used to determine the regional value content of a specific good.

Generally, NAFTA states that if the "net cost" approach is used, a 50% threshold must be met (i.e., no more than 50% of the good's net cost can be attributable to non-originating materials) or if the "transaction value" method is used, a 60% threshold must be met (i.e., no more than 40% of the good's transaction value can be attributable to non-originating materials) for a good to qualify as originating and, thus, for the lower NAFTA duty rates. Despite these general thresholds, however, special rules apply to specific goods.

In sum, the NAFTA rules of origin are both comprehensive and complex. The starting point for determining whether a particular good qualifies as originating is to determine whether it contains any non-originating materials. If not, the analysis ends: the good is originating under either the first or second NAFTA rule of origin. If the particular good does contain non-originating materials, one must identify the good's tariff item number in the importing NAFTA country's Harmonized Schedule. Using the relevant tariff item number, one then identifies the specific rule of origin applicable to that good in Annex 401. Based on the applicable rule of origin, an assessment is made as to whether the non-originating materials were sufficiently transformed to meet the particular test or, if applicable, whether the finished good meets one of the regional value content tests. If so, the good is originating. If not, the good still might qualify under either the fourth test, which is applicable to certain types of goods and requires that the finished good meet one of the regional value requirements, or the fifth test, the de minimis test. If the finished good does not pass any of these tests, the finished good does not qualify for NAFTA's preferential tariff rates.