Is it possible for the UK and the EU-27 to conclude a free trade agreement (“FTA”) by January 1st. 2021? There are many reasons why the answer to this question is likely to be “no”, but let’s concentrate on one: rules of origin.
The UK and EU seem to agree that they want tariff free access for their goods to each others markets. While the EU and UK have spoken about bespoke and unique arrangements, there are only two arrangements that meet this requirement and are also compatible with WTO rules: these are the free trade agreement, and a customs union. As the UK has explicitly ruled out a customs union, that leaves a free trade agreement.
In order to be lawful under WTO rules, free trade agreements have to meet the requirements of Article XXIV of the GATT in relation to goods, and Article V of the GATS in relation to services. If the FTA meets these requirements, then trade between the parties to the FTA does not need to conform to the Most Favoured Nation principle, under which Contracting Parties are required to offer one Contracting Party terms that are no worse than they offer to other Contracting Parties. Suspension of MFN is what permits parties to the FTA to suspend tariffs (or other restrictions) between them, one of the major reasons for entering into an FTA. However, in order for that trade to be tariff-free, each party to the FTA has to agree that all duties “are eliminated on substantially all the trade between the [members] in products originating in such territories”. Parenthetically, it is important to note that all duties must be “eliminated” i.e., reduced to zero on “substantially all the trade”. This is normally taken to mean all industrial goods, with agriculture usually being too politically sensitive to include.
Therefore in order to get the duty-free preference under an FTA, each party has to show that the goods they export to others are “originating” in the territory, and this is proven through “rules of origin” or ROO.
As a trade concept, ROO divide into two types: non-preferential and preferential. FTAs are based on preferential ROO, and it is these we will focus on, and immediately things become fuzzy. While we know that parties to FTAs must agree on ROO to understand how to confer duty-free treatment, there are really no international rules as to what preferential ROOs must be, nor how they are to be applied.
It is generally accepted that preferential ROO fall into three types, applied on a standard reciprocal basis by all parties to an FTA:
- a “value added” criteria, under which a producer has to show that a certain percentage of the value of the products is produced, or “originates” in the exporting country. These are flexible rules that allow parties to focus on manufacturing processes for individual products so as to rule out transhipment or simple assembly of goods from third countries;
- a “change in tariff” (CTH) heading criteria, which is a more crude test focussing on differences between the tariff headings of the components, and tariff headings of the finished goods, usually requiring the finished good to be a different tariff heading than all of its components; and
- specific operations that either confer or do not confer origin, e.g. a certain manufacturing step that is so vital to the product that everyone agrees that if that step is undertaken in an FTA member, then the goods originate in the member.
But there is no further guidance as to how to establish and apply these tests.
The EU in its negotiating mandate states that it will aim towards its normal position on ROO in FTAs. While there will be some disagreement on this, the EU usually has a mix of all three tests in its FTAs, with the predominance of goods governed by the value added test.
The important point is that the EU sets its FTA ROO on an “item by item” basis, these are then the subject of intense discussions between the parties and their industries, and usually run to hundreds of pages of detailed text. The UK seems to agree with this approach in its negotiating mandate.
If the EU and UK follow this “normal” “item by item” path, it is almost impossible to conceive of the negotiations between the UK and EU taking less than 11 months.
Is it therefore possible that the UK and EU will come up with some plan that shortens this highly negotiated process? The answer has to be that of course that is possible. So, for example, they could agree that a CTH test is used for all goods. The application of this crude test for all manufactured goods would produce howls of protest on both sides of the Channel, because major supply chains would (i) never meet the test and so lose the preference; or (ii) have to be changed significantly to meet the test, with the related costs of retooling.
Alternatively, the EU and UK might agree, for example, that a “value added” test was a single, low percentage of value added, say 30% for all goods. While this would be better for business than a CTH test for all goods, it would also be seen as a relatively blunt tool requiring changes in supply chains.
There is also an interesting legal question as to what this percentage “should” be. As noted above, the international trading rules don’t give us too many specifics on what ROO are to contain. So can parties agree to “flex” the percentages? In principle, yes, but parties may baulk at setting what they might see as a percentage of value added that is advantageous to the other, although as the rule will be applicable to production in both jurisdictions, it is a hard argument to follow. More importantly, some people claim that FTAs the EU has signed with third countries contain provisions requiring the EU to give those third countries the benefit of any better arrangement it signs with any other country. While we have not located any such clauses, as applied to ROO, such provisions should not stop the EU negotiating lower percentages of value added since these rules are reciprocal, favouring EU manufacturers in exactly the same way as the third countries.
There is an argument for simplicity as compared to flexibility, since if ROO tests are too complex to meet, manufacturers will simply decide to bear the tariff, rather than the cost of meeting the ROO, thus defeating the whole reason for the FTA in the first place. This was, for example, a significant issue under NAFTA where many goods traded do not claim the preference, and where a very significant percentage of goods fail audits where they do claim the preference, resulting in back payment of duties.
So unless the EU and UK come up with some innovative approach to ROO that allows business to make use of tariff preferences under an FTA, then there is little chance that the FTA can be completed by 31st. December 2020. If the UK Government sticks to its position around any further extension of the Implementation Period, it is looking likely that the UK and EU will be trading on WTO terms as from 1st. January 2021. Sound familiar?