Trade & Logistics: Freer Trade … with More Rules

With well over 100 trade agreements, Latin America is the freest trading region in the world, at least on paper. To benefit, very specific requirements must be followed that can challenge even the most organized and diligent companies.

Porous income tax regulations, lax administration, ineffectual enforcement — these are just some of the struggles faced by many a Latin American government in an on-going quest to cover fiscal responsibilities. To provide a steady stream of revenue, most countries have come to rely on customs duties, value-added taxes and other charges levied at the border. These transactional taxes are far easier to administer, capture and enforce than income taxes. Indeed, goods don’t move if the tariffs aren’t paid. So significant are transactional taxes, sometimes referred to as “indirect” taxes, the World Bank estimates that, in some countries, they generate upwards of 40 percent of all tax revenues.
The way in which these revenues are generated is a tax collector’s dream: Starting with the “CIF” value of imported merchandise — i.e., cost, insurance and freight — a cascade of import costs is set in motion. After calculating the first tax (usually a customs tariff) on a product’s CIF value, another tax (usually a value-added tax) is then levied on that resulting basis, and so on. Throw in some port charges, customs fees and other miscellanea, and it becomes apparent that a good portion of tax revenue actually is generated merely by the fact that it’s calculated on top of other tax revenue.
“In general, there is a high degree of complexity in the Latin American tax systems,” says Ed Godoy, an international tax partner for the Miami office of BDO USA LLP.
“Businesses need to know their way around —otherwise they can come across some unwelcome surprises,” he adds.
In Brazil, for example, the costs associated with importing a product made in Asia, Europe or the United States can increase the purchase price by 50 percent or more, readily turning a $100 international sales price into a $150 total landed cost. Double-digit customs tariffs, state VAT, and federal excise taxes are just some of the costs in the tax cascade that can wreak havoc with local competitiveness and profitability.
Faced with such a reality, some companies accept the situation as the cost of doing business in these markets, while others seek to develop strategies to reduce costs here and now. Those adopting the latter approach usually take aim at one or several points along the tax cascade, seeking to enhance competitiveness through proactive planning. For some, the most direct path to reducing landed costs is through a free trade agreement, a process in which product sourcing decisions and supply-chain planning intersect with customs and international trade compliance.
“The Mercosur economic union offers some reduced tax rates which have a direct impact on landed costs,” says Daniel Setz, Brazil country manager for Swiss-based freight forwarder Panalpina. “Mostly the automotive industry is using both Brazil and Argentina as their production grounds, with respective exchange of raw, semi- and finished products, due to capacity constraints, diversification of production sides and use of already-existing infrastructure.”
Meanwhile, free trade agreements also are becoming even more relevant as a cost-saver as international oil prices jump or remain high, says Romaine Seguin, president of the Americas division of UPS, the world’s largest package-delivery company.
“As fuel costs continue to rise or remain at high levels, globally, the costs involved in transporting goods from countries in other regions, such as Asia, are offsetting the advantages of the low labor costs in these markets,” Seguin says. “For businesses looking to expand to markets outside of their country of origin, free trade agreements help to establish frameworks that present a viable operational structure for these businesses due to the cost advantages of selling to neighboring markets. “
However, although a free trade agreement may establish a window for trade between two countries, it does not guarantee that the necessary systems and infrastructure are in place in order to fully realize the potential of this agreement, she says.
“Customs processes, physical infrastructure and several other factors greatly impact the supply-chain costs involved in the transportation of goods between countries in Latin America,” Seguin says.
There are well over 100 trade arrangements within and among the countries in the Americas, and just about every country in the region participates in some type of preferential agreement designed to encourage economic growth and prosperity through trade. Among the principal trading arrangements are the North American Free Trade Agreement (NAFTA), the Common Market of the South (Mercosur), Andean Community, Central American Integration System and several dozen bilateral economic integration accords. In addition, an array of industry and sector-specific agreements between countries allow for duty-free or reduced-duty trade in various products, such as petrochemicals, photographic equipment and others. Considering their numbers alone, the network of arrangements in the Western Hemisphere arguably offers businesses many opportunities to lower total landed costs, increase market competitiveness and enhance profit margins through free trade.
“Companies with an international manufacturing and distribution base for their products are well-positioned to leverage alternative sourcing scenarios to lower landed costs through free trade agreements,” says John Pitt, head of Global Customs at sports apparel and equipment company Adidas.
“There’s no such thing as ‘free trade,’ just ‘freer trade’ with more rules.”
This statement often is heard from trade officials, academics and corporate executives when discussing the benefits and burdens of free trade agreements, and it certainly resonates with anyone tasked with figuring out how a business can benefit from them. Indeed, the surge in regional free trade agreements over the past two decades has added a high degree of complexity to the global trading system, with the boundaries of free trade increasingly defined by a litany of requirements, provisos, reservations, exceptions, exemptions, exclusions and a host of other conditions. Free trade, it turns out, is highly regulated.
In view of this, for most companies the most relevant and important part to understand in a trade agreement is arguably the one on rules of origin. Rules of origin ensure that a third party is unable to unduly benefit from the preferential treatment members of an agreement grant to one another. At their core, rules of origin dictate what type and level of growth, processing or production activity an item must undergo for it to qualify for preferential access to the markets of member countries.
In most cases, goods receive preferential access to the markets of member countries, provided that they are wholly obtained, grown or extracted within one or more of the agreement’s parties. Products such as grains, livestock, ores and organic chemicals are common examples. Preferential access also may be accorded if goods are processed such that they “shift” from one customs classification code to another within one or more of the member countries. Chemicals mixed to make paint, or car parts assembled to create an automobile, are examples in which a tariff shift might occur.
Although the tariff-shift requirement is a staple of almost every free trade agreement, many Latin American trade agreements also provide for — and in some cases require — a third rule of origin. Known as the “substantial transformation” rule, this requirement can be employed for a product if the more basic rules of origin are not met.
To measure whether something has been substantially transformed within the member countries, generally a value-content calculation is employed. The value content can be expressed in three main ways: as the minimum percentage of value that must have been added in the exporting country (domestic or regional value content, “RVC”); as the difference between the value of the final good and the costs of the imported inputs (import content); or as the value of parts, whereby originating status is granted for products meeting a minimum percentage of originating parts out of the total. If the RVC is at or above a threshold defined by the agreement, then the good is determined to originate and may benefit from preferential access to the other members’ markets.
If Product Y in the example were manufactured in Mexico from both Mexican and globally sourced components, with its high regional-value content, it could possibly qualify for preferential access to the United States under NAFTA, Chile under the Mexico-Chile FTA, and Colombia under the “Group of Three” trade agreement, among other FTAs to which Mexico is a party. Of course, as many agreements also contain specific rules of origin, it is important to consider whether additional requirements must be satisfied for Product Y.
“Meeting the rules of origin of the most stringent of the agreements out there does not mean that every other agreement will be satisfied,” cautions Jeremy Page, a customs and international trade attorney with Chicago-based Page Fura P.C. “Every agreement has to be analyzed independently, given the specific and oftentimes unique origin rules.”
Specific rules of origin are incorporated into FTAs to ensure that certain operations are performed and a level of value is added within the member countries. The fine print often requires that a certain amount of additional effort or value be added within the member countries. A particular manufacturing process might need to occur, for example, in addition to a certain value threshold being satisfied or a tariff classification changed. Occasionally, the rule is not presented in terms of an “either/or,” but in a combination of local operations and value add.
“Some of the greatest challenges are the complexities of the rules in Latin American agreements, and they can place a tremendous administrative burden on companies for the opportunity offered,” Page says.
Further discipline is required in preparing the necessary documentation to present to customs authorities in the country of import once a product qualifies. Depending on the agreement’s rules, this documentation might include manufacturer affidavits, sworn declarations of origin, and almost always a certificate of origin.
“The fact-gathering, analysis and reporting requirements demand a certain degree of diligence that some businesses are just not capable of supporting on a sustained basis,” Page says.
Even with the complexity and associated bureaucratic burdens of an FTA, there can be substantial benefits available to participants that make the effort to decipher and apply the rules. Considering that multiple and high-rated transactional taxes, such as customs duties and value-added taxes, are applied to most imports into countries in Latin America, qualifying for a trade agreement can immediately free up working capital while driving significant and sustained savings into a company’s supply chain. Businesses that are proactive in the use of the many trade agreements available in the Americas can find themselves exactly where they want to be: at holding a competitive advantage over their industry competitors.

—With additional reporting by Latin Trade staff in Miami.

Mark A. Ludwig, a contributing editor to LatinTrade and the moderator of LT CFO Events, is the founder and president of Variant Advisors, a customs and international trade consulting firm.

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