Using trade deals for non-members

Because they are producing products out of Vietnam and Malaysia, I asked about whether the firm has been following the Trans-Pacific Partnership (TPP) negotiations.  Both countries are members of the TPP and many of the company’s final consumers can be found in other TPP members like Singapore and Japan.

“No.  We are a European company, so we didn’t think we could use the TPP.”

This is actually a common answer, but it is not necessarily true.  Many firms can take advantage of the TPP’s benefits, regardless of the location of company incorporation.

Rather than worry about the ownership structure of the company, firms need to consider whether they “substantially transform” products in TPP members or deliver services or hold physical investments in member countries.  This is not unique to the TPP, as the same thing holds true for other trade agreements like the ASEAN Economic Community (AEC), bilateral deals, and future regional agreements.

Admittedly, this can be complicated, but the potential benefits to firms from getting this right can be significant.  Other companies can also get cheaper supplies and inputs from using agreements like the TPP.  Consumers in member countries can receive a greater variety of products at different price points as well.

Go back to the European firm.  The factories in Vietnam and Malaysia make extensive or even exclusive use of raw materials sourced domestically.  These inputs are then used to create the company’s final products. 

Trade agreements come with rules (Rules of Origin or ROOs) that are designed to keep non-member firms from taking advantage of the preferences granted by the deal.  After all, if a non-member could simply trans-ship items through a member and get better benefits, the purpose of the trade deal would be lost for member country firms. 

Companies cannot just engage in simple repackaging, minor assembly, break down bulk shipments into smaller quantities or add several items together in a package to make a different item, to gain access to the agreement either.  Instead, items must be substantially transformed in a member country to qualify under the rules for preferences.

Here is where life can get complicated.  Each trade agreement has different rules for what constitutes substantial transformation.  The two main rules are value content (VC) and change in tariff heading or tariff classification (CTH or CTC). 

For most ASEAN agreements, governments have used regional value content (RVC) rules.  This requires a certain percentage of the final good to be made with content (materials and labor) from member countries.  Generally, the percentage is set at 40% or greater. 

In other words, what matters is not whether or not the company is registered in Holland or Bangladesh, but whether the final good contains at least 40% content sourced from within ASEAN. 

The final item has to be shipped to a member country.  A firm cannot create products with ASEAN content for shipment under ASEAN preferences back into Holland or Bangladesh, since these preferences (benefits like lower tariffs) only apply within member states.

A second method of qualifying for preferences involves a change in tariff heading.  Again, this can be slightly complicated, but put simply if the raw materials and other components or inputs are considered one type of product and end up being exported into other member countries with an entirely different tariff heading, the product can qualify for benefits even if the value content is not above 40%.

As an example, consider the production of beer.  If the agreement allows the use of CTC or CTH rules, the raw materials of water and hops and so forth are transformed into a different product—beer.  Since water, hops and other items are classified differently than beer, the product can be eligible for benefits under the trade agreement.

It does not matter whether the company producing beer is headquartered in the country of production.  What matters is the location of the factory (in a member country), the ingredient sourcing for RVC or transformation in tariff heading rules, and the final destination of the products (for sale in a member country).

What sounds relatively simple can be unnecessarily complicated at the outset, of course, as firms have to comb through agreements to see what rules apply for which products into which markets.  For example, even CTC rules can vary as officials may select different levels of aggregation in tariff headings (2, 4 or 6 digit level changes in tariff classifications are required). 

For the European firm I was meeting, however, no matter how the rules are calculated, production with nearly 100% local content combined with final products that should qualify under CTC rules no matter how such tariff rules are calculated, the company ought to have no problems taking advantage of the TPP once it is signed and enters into force. 

Hence the company ought to be taking an active interest in, and planning ahead for, the entry into force of the TPP.  Despite being a European company in registration and brands, the local factory production from Malaysia and Vietnam should be eligible for the lower tariff rates coming in the TPP.  In the sector for this firm, these benefits—particularly tariff reductions from current levels—should be substantial as well, since this industry faces substantial tariff obstacles in most countries in the region.

Stay tuned for future posts on some reasons why firms do not seem to take advantage of these benefits and why the system as a whole does not benefit from the proliferation of bilateral and regional trade agreements.