Free trade agreements (FTAs) within Asia have eliminated customs duties on more than 95 per cent of crossborder trade. Despite this seemingly good news, preferential tariff rates are not being claimed by eligible businesses. Many small and medium-sized enterprises (SMEs) choose to pay higher custom duties — even when their goods could qualify for FTA benefits.

This trend is likely to continue under the Trans-Pacific Partnership (TPP), if the trade pact is formally ratified.

SMEs & FTAs

A recent survey conducted by the Asian Development Bank analysed the responses of over 800 companies that were considering participation or already participating in bi-lateral, regional and intraregional Asian FTAs. SMEs consistently gave three reasons for non-participation: (1) overly complicated rules-of-origin (ROO); (2) lack of access to information and support services regarding ROOs; and (3) inconsistent administration and enforcement procedures by different customs regimes. Across the region, less than 25 per cent of the surveyed SMEs were claiming, or intended to claim, preferential status.

FTA compliance adds fixed costs and delays to cross-border value chains, particularly in developing countries. For many SMEs, the added expenses of trying to understand, manage and effectively leverage ROOs outweighs the savings gained through preferential rates. Ironically, the “free trade” process has spawned a new crop of non-tariff barriers.

Two types of ROOs have been especially vexing to SMEs: regional value content (RVC) requirements, and process specific rules (PSR).

Complex ROO

The RVC ROO requires claimants to track direct and indirect costs comprising a finished good. To qualify for a FTA, the claimant must verify what percentage of the good’s overall value is attributable to an eligible member FTA country. In ASEAN Trade in Goods Agreement (ATIGA), the threshold is 40 per cent. Under the TPP, the RVC range is generally between 35 and 55 per cent.

When claiming RVC, manufacturers must methodically track raw materials, components, labour and other overhead costs, as well as accurately designate the country-of-origin per each item. These RVC calculations include “Build Up” formulas for adding up eligible costs, and “Build Down” formulas for segregating nonqualifying elements from RVC thresholds, in addition to “Net Cost” calculations.

Consider a bill-of-materials for a washing machine assembled in Malaysia. The finished washing machine will likely consist of more than 1,000 parts, components and sub-components sourced from multiple countries. Under most FTAs, the RVC ROO allows for “accumulation”, meaning a claimant can add up the values of inputs from other FTA member countries to meet the required RVC threshold.

The costs associated with managing a complex RVC accumulation scenario often prevent an SME from claiming preferential rates. Large MNEs, like BMW or GE, however, generally do not have this constraint, as they can spend lavishly on IT platforms and allocate special resources for RVC control centres. Given the massive economies-of-scale employed by big MNEs, preferential tariffs usually produce substantial savings.

Another advantage enjoyed by MNEs involves the leveraging of inter-company sales between related parties. MNEs can easily obtain cost-related information from related suppliers, which is vital for RVC claims. SMEs, on the other hand, often do business with un-related suppliers and manufacturers and cannot obtain sensitive cost breakdowns on purchased goods, thereby making an RVC claim impossible to validate.

Yarn-forward rule

SMEs often struggle with PSRs. The “yarn-forward” PSR states that a TPP nation seeking preferential rates on textile products must use yarn originating from other TPP countries. This ROO will be particularly onerous for SMEs that fabricate wearing apparel in, for example, Vietnam, which sources the majority of its yarn from China—which is not a TPP member.

Because of high levels of corruption in Vietnam and the fact that it shares a land border with China, it is commonly assumed that yarn used in Vietnamese textile products will be of Chinese origin— transshipped across Vietnam’s northern border, despite any claims to the contrary.

The TPP yarn-forward rule provides a loophole known as the “Short-Supply List” clause, which allows a claimant to source yarn from outside the trade territory if there are no other available TPP suppliers. Here, the challenge to a risk-averse TPP claimant be will be how to identify a valid short-supply list claim from a fraudulent one.

Extreme care will need to be taken to effectively trace and validate the true origin of yarns in TPP value chains. Once again, MNEs will be better positioned than SMEs to manage this because of IT resources, related party structures and strong leverage over suppliers due to the typically large volume of their purchases.

What SMEs want

Increasing the number of participating SMEs in the TPP (or any other FTA), will require the following:

• Harmonisation and simplification of ROOs across multiple countries

• Increased access to free information, guidance and institutional support

• Access to open-sourced templates, tools, matrices and software for ROO management

• Increased transparency and consistency in enforcement of ROO validations by member countries

Achieving these changes will need to be driven by collaborative networks of key stake holders, not top-down government initiatives, which have been largely ineffective. Big Data, the cloud, and other IT-enabled solutions will need to play a key role.

One particular ROO that SMEs would prefer is the so- called “Change in Tariff Classification (“CTC”) rule. The CTC rule allows a good to qualify for preferential treatment if it undergoes a change in tariff number classification from its original state (raw material, components), to its finished state (a substantially transformed good). Current FTAs publish extensive lists of harmonised tariff number changes that confer preferential treatment. Wider adoption of the CTC test would make preferential rates attainable to many SMEs and reduce the complexities and cost barriers associated with RVC compliance.

The bottom line

At over 7,000 pages in length, the TPP adds more, not less, complexity to the ROO process. The CTC rule appears throughout the TPP document but not nearly enough to encourage more SME participation. Rather than harmonise or simplify the RVC process across member states, each TPP country has elected to use a variety of build-up, build-down or net-cost RVC methods, further muddying the compliance landscape.

About the Author

Alex Capri is a Visiting Senior Fellow in the NUS School of Business. He teaches graduate and undergraduate level courses in International Value Chains, Strategic Operations and Global Trade Management. His research and writing focuses on risk management and strategic planning, sustainable supply chains and trade compliance.

From 2007-2012, Alex was the Asia Pacific Partner-in Charge for KPMG’s International Trade & Customs practice. Over the past 15 years, he has advised MNEs in more than 50 countries and in some of the most challenging business environments in the world.