Proliferation of free trade agreements in Asia-Pacific
The 15 member Asia-Pacific trade pact, the Regional Comprehensive Economic Partnership (RCEP) agreement signed on November 15 2020, is expected to enter into force by early 2022.
The pact, consisting of countries from the Association of Southeast Asian Nations (ASEAN) member countries (i.e. Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand and Vietnam) plus Australia, China, Japan, South Korea and New Zealand, will be the world’s largest free trade agreement (FTA) once it enters into force, accounting for approximately 30% of the world’s GDP and 30% of the world’s population.
While the agreement requires at least six ASEAN countries and three non-ASEAN countries to complete the domestic ratification process for it to enter into force, China, Japan, Singapore and Thailand have already completed the ratification process and most others are expected to follow within 2021. Given the sheer size of the trade pact, RCEP is being promoted as an FTA that will support continuous high levels of growth in Asia-Pacific, stimulating economies in a post COVID-19 pandemic business environment.
While the signing of RCEP is certainly a key development in the Asia-Pacific trade environment, it is not the only FTA that was recently signed. In fact, Asia-Pacific countries have been busy signing many other FTAs with key trading partners from around the world. The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), consisting of Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, and Vietnam is one such FTA that went into force on December 30 2018, which provided duty elimination of more than 98% of items. CPTPP being an open-access FTA, the member countries also swiftly approved the bid from the UK to begin the accession process to join CPTPP on June 2 2021, allowing the pact to continue to grow in size and importance.
Other notable Asia-Pacific related FTAs that went into force in the recent years include Japan-EU, Japan-US, Japan-UK, China-Korea, Vietnam-EU, Vietnam-UK and Singapore-EU. These are all new FTAs that will continue to co-exist with the existing Asia-Pacific FTAs such as Intra-ASEAN, ASEAN-China, ASEAN-Japan, ASEAN-Korea, ASEAN-Australia/New Zealand and ASEAN-India FTAs.
In the face of global trade disputes and increased trade risk, having so many FTAs in Asia-Pacific to benefit from is certainly welcome news for most companies operating out of Asia-Pacific, as they provide the much-needed supply chain cost reduction opportunities and transparency in the trade lanes. However, it is also creating new operational challenges for companies in having to juggle so many different FTAs, ensuring favourable outcomes but at the same time maintaining compliance in their FTA operations.
Challenging FTA mechanisms
For companies to benefit from any FTAs, they must first ensure that their goods qualify under the rules of each FTA. Generally, for a good to be considered an originating good, it must satisfy one of the following three basic requirements:
1. Wholly obtained or produced in a member country;
2. Produced in a member country exclusively from originating materials from one or more of the member countries; or
3. Produced in a member country using non-originating materials, provided that the good satisfies product-specific rules (PSR) where PSRs can include the below variations:
i) Value-added rule (i.e. the good needs have more than a certain percentages of regional value content; e.g. 40%)
ii) Change in tariff classification rule (i.e. HS code of non-originating materials need to change into a new HS code of the finished good at tariff chapter, tariff heading or tariff subheading level); or
iii) Specific process rule (i.e. the goods need to go through certain manufacturing processes, applicable mostly for chemical and textile goods)
While most companies may be familiar with these rules, there are differences in the rules and their interpretations between different FTAs and they can quickly get confusing when companies must manage so many different FTAs at any one time.
For example, some of the common mistakes made by companies operating in Asia-Pacific include the following.
When cumulating the value of components purchased from suppliers within the country of export, it is generally not required to check the originating status of these components if they are produced by a licensed manufacturer under ASEAN Trade in Goods Agreement (ATIGA). However, in any other Asia-Pacific FTAs, it is still required that companies check the originating status of these components by referring to the rules of origin of these components under each applicable FTA.
When year-end transfer pricing (TP) adjustments are executed in a way that the exporter provides a credit note to retrospectively reduce the transfer price of the exported goods, this could impact the originating value of the exported goods if value-added rule was originally used for the origin calculation. When TP adjustments are executed, companies need to be revisiting their originating status of their goods.
“Given the sheer size of the trade pact, RCEP is being promoted as an FTA that will support continuous high levels of growth in Asia-Pacific, stimulating economies in a post COVID-19 pandemic business environment.”
When checking the applicable rules of origin for a given FTA or when confirming tariff shift under the change in tariff classification rule, it is necessary to convert the HS codes used today to HS codes used when the given FTA was signed. If HS codes are not converted, then wrong rules could apply or there could be mistakes made in the tariff shift confirmation process.
As in the above, for many companies, the key challenge of utilising FTAs is understanding the requirements that determine whether products qualify for preferential duty rates on a per FTA basis. In this respect, FTAs are not ‘free’ at all; rather, they are conditional agreements that require company investment in both understanding the rules and developing processes and systems to facilitate compliance with the rules.
The cost of compliance can be considerable, and it falls heavily on the exporter, with benefits accruing to the importer. If the exporter is somehow non-compliant, there can be significant commercial implications as the importer may be subject to recovery of underpaid duties and to penalties. Unfortunately, despite the signing of RCEP, rules of origin in Asia-Pacific will not be subsumed into a single unified rule. Companies must continue to work on a per FTA basis, which will increasingly put more strain on their operations as the number of FTAs and models that they must handle continue to increase.
Increasing scrutiny on FTA compliance
It is also worth highlighting that the challenging nature of having to manage so many different FTAs equally applies to the government authorities in charge of FTAs. In most FTAs, in order to export goods as being ‘eligible’ for a certain FTA, the exporter must apply to the exporting authority in charge of FTAs to be issued a Certificate of Origin as a proof of eligibility. In the past, when there were fewer FTAs within Asia-Pacific, the exporting authorities used to scrutinise each application in detail, quite often asking for additional documentation to confirm the originating status of the goods.
However, as the number of FTA applications soared as the trade volume and the number of FTA signed increased, many of the exporting authorities quickly became overwhelmed with the task of issuing the certificates of origin within a reasonable timeframe.
As a result, it appears that most exporting authorities have taken on a risk-based approach where a certain ‘high risk’ applications will be scrutinised in detail while others receive a more cosmetic review. This has given rise to some applications getting certificates of origin despite companies making some of the common errors in the origin calculations such as those stated in the above and yet receive preferential treatment upon importation.
To crack down on such inappropriate issuances of certificates of origins, most FTAs have a mechanism called ‘origin verification requests’ where customs authorities of the importing countries can raise requests to exporting authorities to re-confirm the originating status of the imported goods so that such inaccurate use of FTAs can be flagged.
However, possibly due to the fact that most agreements also stipulate that importing authorities should not arbitrarily deny FTA privileges, it appears that the number and the frequency of such origin verification requests are still quite limited, allowing for inappropriate use of FTAs to continue to slip through the control framework.
Some customs authorities in Asia-Pacific, however, have started taking a more direct approach in stemming such inaccurate use of FTAs. India is an example where it has amended its customs regulation to put more onus on the importer to verify the originating status of the imported goods. CAROTAR 2020, issued in September 2020 has made it clear that the importers will be held responsible in facilitating certain origin information if the importer will claim preferential rate for the imported goods when filing their import declarations.
Japan is another country where the customs authority is asking more questions on the originating status of imported goods by requesting importers to furnish more origin related information. Potentially, this trend of customs authorities making importers more liable in confirming the originating status of their declared goods may spread across other Asia-Pacific countries, which would mean that companies operating in Asia-Pacific must tighten up its origin determination procedures so that they can withstand any scrutiny from importing customs authorities in the future.
Technology-enabled FTA managed services
The challenges for these companies may be to strengthen their existing FTA operating models so that they can extract maximum duty savings opportunities from their supply chain but at the same time operate in a way that can withstand possible future scrutiny from the authorities.
Given the number of FTAs available in Asia-Pacific and the amount of products/materials that the companies would want to exploit them for in their supply chain, it would likely not be sufficient for companies to continue to rely on limited internal resources and manual operations in conducting FTA-related activities.
Thankfully, the evolution of technology is resulting in a steady stream of opportunities for companies to transform their trade function. For many organisations, trade data still reside in antiquated, disparate systems across multiple functions, creating a lack of visibility and control.
Having the right technology that can automatically pull such trade data from internal/external systems to conduct origin/duty calculations, and outsourcing certain repetitive and transactional activities such as HS coding, origin reviews and supplier solicitations to the right people with the right skills will be key to a successful transformation of companies’ FTA operations.
It may be said that by getting the right balance of technology and experienced professionals, companies can continue to stay ahead of the competition through increased FTA usage and enhanced FTA compliance.
Yoichi Ohira is a partner of EY based in the Tokyo office. As the EY Japan Indirect Tax Leader, he helps manage EY customs and global trade, consumption tax and outbound VAT/goods and services tax (GST).
Having managed global indirect tax in industry for more than a decade, Yoichi has extensive experience leading indirect tax planning projects for multinational companies, including designing and assisting in implementing supply chain strategies around FTAs, customs valuation planning, utilisation of indirect tax relief measures and VAT/GST/Japanese consumption tax (JCT) optimisations. He works across sub-service lines to provide multidisciplinary services such as customs and TP harmonisation, supply chain management (SCM) improvement and due diligence/post-merger advisory.
Adrian Ball is a partner in the global trade practice in Singapore. With a focus on international trade and indirect taxes, he advises companies in addressing market access for their products. He supports clients in the handling of audits and investigations throughout Asia and has represented clients in the settlement of such matters with trade authorities, also supporting clients on litigation matters. He was previously based in Hong Kong SAR, Indonesia and the UK.
Adrian’s areas of particular experience include addressing strategic and operational issues facing companies as they operate their business and move goods throughout Asia. This includes advising on the tax and trade aspects of manufacturing and supply chain operations, addressing cross-border valuation of goods, and the use of free trade agreements.
© 2021 Euromoney Institutional Investor PLC. For help please see our FAQ.