From soba to udon—Are the noodles in the FTA bowl getting too thick? – LogiSYM December/January 2021
If nothing else, the COVID-19 crisis has forced companies to look for cost savings with significantly increased vigour. Sooner or later, they should be considering the use of Preferential Trade Agreements. These agreements offer companies preferential access to the markets of member territories (“parties”), provided they meet the conditions of the agreement.
So far so good. But that appears to be where the easy part ends. The use of such agreements (let’s for ease of reference call them FTAs for the purpose of this article, as that is the most common colloquial term, although there are many others floating around) has however been continuously disappointing. Perhaps most surprising is how little most companies know or – apparently – care about such agreements.
It is not immediately evident why this is so. Governments have spent considerable time, effort and political capital negotiating such agreements. From simple beginnings, many have relentlessly expanded the scope of what such agreements cover. They have also spent significant resources publicising and socialising such agreements, and dedicated further resources to helping companies use them.
Yet in our daily work at PwC, we come across many companies that seem to be missing out. Some don’t appear to have heard of FTAs at all (which in truth is quite an impressive feat!). Others have simply never considered the use of FTAs, either for their existing supply chains or for planning new ones, based on their assumptions that they won’t help. Yet others have considered and analysed them but are still unable to benefit from them. And then on the flipside, there is also a not inconsiderable set of companies that are reaping benefits but really shouldn’t, much to the concern of the authorities.
This article does not intend to solve all of that (although it would be nice if it did). It does attempt however to address some of the apparent elephants in the room as to why FTAs are either not used, or not used correctly, before thinking out loud as to what perhaps regulators and business can do to reap more rewards from FTA usage.
Problems all around
FTA ignorance cannot stem from them being so new and unfamiliar. By some accounts, the conception of the first FTA dates back to 1860, when tariffs between France and England were removed (wine, brandy and silk in one direction, and coal and iron in the other!) under the Cobden-Chevalier Treaty. The immediate economic impact was small. But the principle caught on and was quickly and widely replicated.
For a long time, and predominantly still, most people and businesses tend to think about FTAs as just that: a way to reduce tariffs on good originating in one party upon entry into another. Although somewhat simplistic, that is not necessarily a bad way to think about FTAs, at least for companies that ship goods across borders. There are however many other companies that do not trade tangible goods across borders but may be able to benefit from provisions on services, investment and government procurement etc. These more recent extension to FTAs have by and large either gone unnoticed, or at least have not been picked up by businesses in a constructive way.
For FTAs to be better considered and used, many conditions need to be met. Some of the most important examples from our experience are:
Knowing and understanding the FTAs:
There is no lack of databases relatively easily available to query. There are also ever more summaries of the key points of such FTAs. And increasingly, technology tools are around to query what a specific FTA may offer and how it could be of value to a particular company. Yet they are all—for now at least—approximations of the true complex nature of FTAs and are unlikely to include exceptional but crucial considerations that have a material impact on the actual value of the FTA provision(s) being considered. The original ASEAN Free Trade Agreement text was a blissful 16 pages of simple text. The current ATIGA, including its annexes, runs into hundreds of pages of legalese. The CPTPP outdoes that by at least a factor ten. Whereas these texts are well intended, for the average reader they simply lose the plot.
Early analysis of options:
All too often, value chain decisions are made irrespective of trade considerations, be it on sourcing, location of manufacturing or services centres, ownership structures, shipping routes, storing options, priority consumer markets and so on and so forth. FTAs are subsequently “overlaid”, to assess whether the value chains that have already been decided offer potential for FTA benefits. Often, they do not, and it is too late, politically or economically, to change earlier decisions on value chain structuring. Employees that may understand FTAs and the opportunities they offer are usually at too low a level in the pecking order to be able to make a difference.
Understanding of the rules of origin:
There are two sides to this. Often, an FTA’s Rules of Origin are simply too complex for anyone to understand, let alone apply. The core rules are usually easy enough. Add 40% value. Change of tariff heading. But the devil lies in the detail, for example, on what value can count as being added, or how the rules interact with one another, can create a web of interdependencies nigh-on impossible to navigate. That results in many companies either giving up or getting it wrong. On the other hand, many companies do not or cannot allocate sufficient, or sufficiently trained, resources, either in-house or external, to allow a proper analysis and evaluation of the options. Even if analyses do happen, they tend to be snapshots in time that rarely consider predictable future developments. Finally, we see or hear of many companies taking shortcuts, “taking a chance” and only looking in earnest if forced to do so. This obviously makes the authorities more nervous and keener to audit, which in turn puts would-be users of FTAs off.
Predictable implementation of the rules:
One of the biggest bugbears for companies large and small has been the inconsistent and unpredictable implementation and application of the many FTA rules in practice. Between FTAs, within the same FTA but between parties, between different officers within the same party, and even with the same officer on different days, importers can experience a wide range of varying practical requirements that need to be met. Documentation to be presented. What constitutes minimal processing. What is “customs control”. What colour pen to use. Increasingly, just simply knowing whether an originating product will be accorded preferential treatment is not enough, but being able to correctly pre-empt and manage the in practice implementation of such rules is key to reducing the administrative heartburn.
As implied earlier, the increasing complexity of FTAs results in many companies using them inappropriately, be that accidentally or on purpose. That of course does not make the regulators very happy. FTA audits, particularly on the use of preferential tariffs, have become more commonplace and more intrusive in recent times. That, in itself, is not necessarily a problem when it comes to using FTAs. However, the unpredictability encountered by companies on practical implementation of FTA rules when benefits are sought are carried over into the audit world. Hence, a company that may have thought it was doing everything right with the requisite documentation or evidence may find themselves in a position where customs auditors could have a different interpretation of the rules. Coupled with the fact that customs authorities are always looking for further revenues, back-duties and penalties can add up to significant amounts that are not recoverable from customers in retrospect. Especially for smaller companies, this “FTA fear factor” is often insurmountable.
Other trade measures:
FTAs do not operate in isolation. FTA benefits can easily be negated by other taxes or measures that suddenly apply. A simple example is the recent (re-)introduction of punitive tariffs by the US on Canadian originating aluminium products just a month or so after the implementation of the USCMA. The increased use of direct or indirect taxes to capture the developing digital economy can also play havoc with value chain decisions that are driven by FTA utilisation. With no clear hierarchy between the different taxes and measures, many companies simply cannot be asked.
As per usual, pointing out problems and being critical is much easier than being constructive. At the same time, a more open discussion and understanding of the key challenges getting in the way of better use of FTAs is a good and essential starting point.
Nevertheless, let’s have a stab at some suggestions for changes that might have a positive impact, either for the regulators or for would-be users of FTAs in the private sector.
What might the regulators want to consider?
The main purpose of FTAs is, obviously, to facilitate trade. Underlying this objective is the assumption that facilitated trade leads to increased economic activity in a party, thus generating more employment and wealth. Direct evidence for this is hard to present, and popular opinion has consequently turned somewhat against the idea of open trade being a force for good. But there are quite a few things that regulators could do to help themselves and their economies create better argumentation. Here are a few:
The different regulatory bodies involved in the negotiations and implementation of FTAs have different, and often conflicting, objectives and KPIs. The expanded scope of FTAs also means that an increasingly large number of separate regulatory bodies are involved in their negotiation and implementation. Without proper alignment between them, implicit or explicit contradictions within an FTA are becoming more prevalent, either in the legal text itself or in its implementation and application. Accepting that such differences exist but taking a consistent approach for the overall and greater good should be the driver for all affected regulatory bodies, win or lose.
FTAs, both in their scope and in their detail, have become too complex. The noodles in the bowl have become too thick. Although there is much to say for ambition of coverage and concern about loopholes, in practice both appear to be leading to less use of FTAs, not more. It is likely unrealistic that existing FTAs can easily be split into independent components and its rules and exceptions be made simpler. Nevertheless, any move in that direction will likely be helpful. It will make clearer which agreement intends to achieve what, and who (which companies and who in such companies) should be looking at them. Simpler rules, such as rules of origin—less interwoven, combined with a better system of guidelines and rulings on implementation (see below), perhaps combined with a clearer penalty regime, could go a long way in making FTAs more manageable, especially for smaller companies.
There are few things the business world likes more than predictability. Uncertainty kills opportunity, investment and growth. The complexity mentioned above in itself makes predictability harder to achieve, as it invariably leads to multiple reasonable interpretations of rules. Combined with a lack of formal and informal guidance (see below), companies are rightfully concerned that any effort and recourses allocated to utilising FTAs, no matter how sincerely, may end up being wasted. Whatever the regulators can do to reduce unpredictability would help. That should start with recognising that there are problems and attempting to clearly identify them. The reluctance, for example, of creating a clear and comprehensive listing of non-tariff measures and non-tariff barriers, based on the practical experience of businesses (perception VS reality) is not very helpful. Clearer listing of such problems would allow the many requirements that are just a nuisance (colour pen?) to be removed, and pave the way for an open and constructive discussion to take place on what else can be tackled and how.
Coming off the fence:
To help deal with the complexity and increase the predictability referred to above, it is essential for authorities to be willing and able to provide guidance and rulings on the correct interpretation of an FTA. Simplifying the legal text would make that even more important. Yet in many territories, “in-principle rulings” appear not to find much favour with the authorities. It is not immediately clear whether this is out of a reluctance to decide, an inability to reach consensus, a fear of abuse by the private sector, a combination of those, or something else altogether. Nevertheless, it is one of the biggest stumbling blocks for companies to make a case to utilise relevant provisions of FTAs. A telling example is ASEAN’s ARISE – its early implementation focused so much on the details of a specific import transaction rather than the point of principle in question, resulting in real or perceived negative implications for the affected importer. Not only was it not used much then, but even its improved successor remains underutilised because companies are too fearful of its repercussions. Meanwhile, the authorities treat this as evidence that if no issues are raised, there must be none! The much-touted argument that rulings cannot be published because they contain companies’ confidential information likewise holds little ground – many lawyers have no problem scrubbing texts of confidential information without losing the essence of what they say.
What might businesses want to consider?
Clearly, there is much that the regulators could do to improve FTA utilisation and ensure that companies would not let the efforts that have gone into negotiating FTAs to waste. However, many companies are well advised also to look at themselves in order to enhance their fortunes on the back of FTA opportunities. Again, some examples:
It is our experience that in many organisations, the analysis of and argumentation for the potential use of FTA is at best ill-defined and at worst entirely non-existent, with accidental allocation of responsibility the most common middle ground. This holds for large MNCs as much as for smaller businesses and is probably less excusable in the former. Consequently, not only are FTAs not well understood, they are also not considered at the right time and at the right level to have a meaningful impact. Creation of a “Chief FTA Officer” position would probably go a bit too far, but the concept is not a bad one. Bearing in mind the ever expanding scope of FTAs, it is also likely that this responsibility needs to be clearly split between and allocated to a range of people, depending on subject matter expertise. Beyond this, allocating an appropriate level of resources, in-house or through third parties, is good business management – cutting corners or not spending at all is sub-optimal at best.
We see many examples of FTA benefits being dismissed for not being significant. Although it is obviously each company’s prerogative to determine what is worthwhile and what is not, in many cases, future and indirect benefits of FTAs tend to be undervalued, while risks of complications and penalties are overblown. Creating a mentality of pursuing the concept of FTA benefits without worrying unduly about the scale of an individual opportunity can carry significant long-term value. A good example is one company that implemented a “no-shipment, however small, leaves any of our factories without a Certificate of Origin” approach which drove thinking and efficiencies that led to multiple-millions of dollars of annual savings for very limited sustained effort.
Just as it is too easy to dismiss opportunities by having too short a horizon, it is easy to lose sight of the fact that significant savings can be at risk if not properly and proactively managed and maintained. Commercial situations change almost daily. Decisions are taken within organisations, for example, by a procurement team, that affect ongoing compliance with FTA rules. This is becoming more of a problem with the front line of governance of FTA compliance being pushed more onto companies than regulators. Development and implementation of appropriate processes and technology to safeguard FTA benefits is not a luxury but tends to be treated as one. Considering the negative impact of falling foul of the rules, monetary, reputationally and perhaps criminally, that is surprising to say the least.
The way forward
As mentioned in the introduction, this article has attempted to address some of the apparent elephants in the room as to why FTAs are either not used or not used correctly, and present some ideas about what perhaps regulators and business can do to reap more rewards from them.
None of the problems listed are new. Yet they are nowhere near being talked about enough in the open to allow even a start to potential resolutions. Some of our thoughts and ideas for a path to improvement may be too unrealistic or ambitious, or utopian even. Yet none of them are predestined to fail without at least a half decent attempt.
Perhaps summarising the recipe:
- Thinner noodles (simpler FTAs);
- More bowls (different FTAs for different subject matters);
- Clearer soup (better predictability);
- Lower calories (reduced materiality thresholds); and
- Better cutlery (more appropriate resourcing).