US-Mexico-Canada Agreement to replace NAFTA

Editor: Michael Dell, CPA

On Oct. 1, 2018, President Donald Trump announced a preliminary agreement with Canada to revise the terms of the existing North American Free Trade Agreement (NAFTA) between the United States, Mexico, and Canada (see “President Donald J. Trump Secures a Modern, Rebalanced Trade Agreement With Canada and Mexico,” White House Fact Sheet (Oct. 1, 2018), available at www.whitehouse.gov. The proposed agreement with Canada follows seven rounds of NAFTA renegotiations among the three nations that took place over the course of 13 months and comes roughly 30 days after the United States and Mexico announced a similar “preliminary agreement in principle” to modernize the rules of NAFTA (see U.S. Trade Representative (USTR) Fact Sheets, “Strengthening North American Trade in Agriculture,” “Modernizing NAFTA Into a 21st Century Trade Agreement,” and “Rebalancing Trade to Support Manufacturing” (Aug. 31, 2018), available at ustr.gov.

The USTR subsequently published the full text of the proposed agreement on Oct. 1, 2018 (available at ustr.gov, which is named the United States-Mexico-Canada Agreement (USMCA), and released details on how the USMCA will achieve stated objectives to modernize previous commitments made under NAFTA, including major changes to trade in agricultural products, automobiles and automotive parts, and textiles; increased thresholds for low-value (de minimis) shipments subject to informal entry procedures; enhanced data protection for biologic drugs; and other provisions as discussed below (see USTR, “United States-Mexico-Canada Trade Fact Sheets” (Oct. 1, 2018), available at ustr.gov.

The proposed USMCA has 34 chapters, which exceeds the 22 chapters in NAFTA, and covers new areas such as labor, the environment, anti-corruption, and regulatory policy, among others. Notably, it also includes 11 annexes and 12 side letters. Four of those side letters specifically grant Canada and Mexico important concessions pertaining to the ongoing U.S. investigation into imported automobiles and automotive parts (see United States-Mexico-Canada Agreement Text, U.S.-Canada 232 Side Letter, U.S.-Mexico 232 Side Letter, U.S.-Canada 232 Process Side Letter, and U.S.-Mexico 232 Process Side Letter). A similar agreement, however, was not reached on the punitive duties currently being imposed on imported Mexican and Canadian steel and aluminum.

As discussed below, the preliminary agreement requires ratification by all three countries. Ratification is likely, and publication of the text provides businesses with a critical opportunity to now analyze the proposed text in advance, assess its impact on their operations, and evaluate necessary changes to business to take advantage of the new rules.

Rules of origin (Chapter 4)

The USMCA proposes major changes to the way automobiles and automotive parts qualify for preferential treatment. The USMCA raises the regional value content (RVC) threshold for automobiles from 62.5% to 75% (USMCA Chapter 4). RVC requirements vary based on the type of vehicle or parts under consideration. For example, while light vehicles would require 75% RVC, heavy vehicles would require 70%. The RVC for auto parts, on the other hand, would range from 65%-75% depending on whether these are considered “core,” “principal,” or “complementary.” While tariff shift rules (where applicable) remain in the proposed USMCA, the tracing list is eliminated. (For origin qualification purposes, the tracing provision allows certain components to be deemed originating, notwithstanding their country of origin.)

The USMCA also adds a new labor value content rule requiring that 40%-45% of auto content be produced by workers earning at least $16 per hour. The specific calculation of the labor value content considers manufacturing costs, technology, and assembly expenditures. Lastly, finished vehicle producers will be required to purchase 70% North American steel and aluminum. Seventy percent of an original equipment manufacturer’s annual purchases of aluminum and steel would have to be from the United States, Mexico, or Canada.

The USMCA also includes stricter rules of origin for other industrial products such as chemicals, steel-intensive products, glass, and optical fiber. For textiles and apparel, the USMCA limits rules in NAFTA that permitted the use of certain non-NAFTA inputs. For a textile or apparel finished product to qualify for preferential treatment, the USMCA requires that certain inputs incorporated into the finished product, such as sewing thread, pocketing fabric, narrow elastic bands, and coated fabric, also be made in the same region as the finished product. For example, if a finished blouse is manufactured in Mexico, these inputs must originate in Canada, Mexico, and/or the United States.

Trade in agriculture: Market access (Chapter 3)

Under the proposed USMCA, Canada has agreed to provide limited market access to U.S. exports of dairy, poultry (turkey and chicken), and eggs. Likewise, the United States has agreed to provide limited market access to Canada exports of dairy products, peanuts and peanut products, and sugar and sugar products. New tariff rate quotas will be introduced by both nations to facilitate these concessions. Canada also agreed to eliminate milk price classes 6 and 7 and adopt measures to limit the impact of its surplus skim milk production on external markets such as the introduction of export surcharges.

Other significant provisions

The USMCA includes the following key provisions:

• Establishes procedures that streamline certification and verification of rules of origin.
• A certification of origin is now allowed to be made by the exporter, producer, or importer of the goods.
• Maintains duty-free treatment for originating goods, prohibition of export duties and other charges, and waiver of customs processing fees.
• Adds transparency to import and export licensing procedures.
• Increases de minimis shipment values for Canada and Mexico (Chapter 7):
  • Mexico will provide duty-free entry for shipments valued at or below $100, while maintaining duty-free and tax-free treatment for shipments at or below $50. Shipments at or below $100 will be subject to minimal formal entry procedures.
  • Canada will provide duty-free entry for shipments up to CAD 150 and raise its de minimis level from CAD 20 to CAD 40 for shipments eligible for nontaxable importation under federal taxation regimes (e.g., imported free of import goods-and-services tax). However, provincial taxes, which may apply in the case of business-to-consumer import transactions, are not covered by the negotiated outcomes. Shipments at or below CAD 150 will be subject to minimal formal entry procedures, assuming they otherwise qualify for informal line clearance options.
• Incorporates NAFTA’s Article 303 restrictions on duty deferral and duty drawback into Chapter 2 of the USMCA.
• Includes in Chapter 20, 10 years of data protection for biologic drugs and a robust scope of products eligible for protection.
• Incorporates NAFTA Chapter 19’s dispute settlement provisions into the USMCA.
• Section 232 relief for Mexico and Canada:
  • Two side letters provide Mexico and Canada with relief in the event that the United States imposes punitive tariffs on imports of automobiles and automotive parts under Section 232 of the Trade Expansion Act of 1962, P.L. 87-794.
  • Exclusion from Section 232 duties for the first 2.6 million passenger vehicles imported from Canada and for the first 2.6 million passenger vehicles imported from Mexico.
  • Exclusion from Section 232 duties for light trucks imported from Canada and Mexico.
  • Exclusion from Section 232 duties for the first $32 billion worth of auto parts imported from Canada and the first $108 billion worth of parts imported from Mexico.
• Two side letters establish a mandatory consultation process in the event that the United States imposes Section 232 measures:
  • The United States must provide a 60-day grace period from the date of imposition of any Section 232 duties before they take effect, to allow for consultations.
  • Mexico and Canada have the right to take measures of equivalent commercial effect, including World Trade Organization rights to challenge a Section 232 measure.
  • Importantly, nothing in the USMCA addresses the existing punitive tariffs imposed by the United States under Sec. 232 on Canada- and Mexico-origin steel and aluminum products.

Cultural institution exemptions

Cultural institution exemptions currently in NAFTA are preserved in the USMCA.

Entry into force, expiration, renewal, and withdrawal

Entry into force, expiration, renewal, and withdrawal are described in Chapter 34:

• The agreement will enter into force on the first day of the third month following the notification of the last country to complete its domestic processes required for implementation of the agreement.
• The agreement will automatically terminate after 16 years of entry into force unless each country agrees to extend it for another 16 years.
• The agreement will be reviewed by the countries every six years to determine whether changes are needed.
• Countries may withdraw from the agreement with a six-month written notice. In the event that one country withdraws, the agreement remains in effect for the other countries.

What to expect next?

Once signed by the presidents of the United States and Mexico and the prime minister of Canada, the USMCA must be subsequently ratified by those countries’ legislatures before it enters into force. In the United States, under Trade Promotion Authority (TPA) legislation, the president must provide Congress with 90 days’ notice before signing a trade agreement and provide the legal text of the agreement 60 days before signing. Trump provided Congress with the requisite notice on Sept. 1, 2018, and the release of the text meets the second requirement.

While the president is authorized to negotiate trade agreements, only Congress has the authority to implement them. Prior to a vote in Congress, the TPA legislation requires a series of actions, including an assessment of the agreement by the International Trade Commission, a description of the legal changes that would be required to comply with the provisions of the agreement, and submission of the final text of the agreement to Congress. Accordingly, once the president signs the agreement, an implementing bill must be submitted for congressional approval. Once the implementing bill is introduced, Congress has a maximum of 90 days in session in which to enact it. Under TPA rules, the bill is subject to a simple yes or no majority vote, which means that amendments are not allowed to the agreement’s text. Until Congress passes implementing legislation for the USMCA, NAFTA will remain in effect. Final congressional action was expected before the end of 2018.

A similar process is required under the laws of Mexico and Canada. In Mexico, the USMCA must be submitted to the Senate and for revision by the Foreign Relations Ordinary Commission to be considered and ratified. A two-thirds majority of the Mexican Senate must vote in favor of the agreement to ratify it. Notice of an agreement to terms between the United States and Mexico was provided on Aug. 27, 2018, which is significant, because it gave Mexican President Enrique Peña Nieto’s administration enough time to sign the USMCA, which was a priority of his administration, before he was to leave office on Dec. 1, 2018. Andrés Manuel López Obrador, Mexico’s president-elect, supported the revised agreement but said he might seek to renegotiate its terms if it was not signed before he took office.

Peña Nieto, along with Trump and Canadian Prime Minister Justin Trudeau, signed the agreement on Nov. 30, 2018.

In Canada, after being introduced in the form of an implementing bill by the government, the USMCA must first be put to a vote in the House of Commons and Senate after a full review by Parliament pursuant to parliamentary subcommittees’ reports and debate. This process will likely take several months. Supplemental legislation would then need to be drafted and passed where required, although much of this would already exist under the NAFTA or CUSFTA (Canada-United States Free Trade Agreement) legislation.

Once the agreement is signed by the leaders of all three nations and then ratified by the respective legislatures, the USMCA will enter into force no sooner than three months from the date of the last country’s notice. The ratification process was therefore likely to continue into 2019 before becoming effective.

Actions for businesses

With publication of the text of the new USMCA, businesses can begin to model the impact of the proposed changes on their operations. For those in the automotive, textile, and other industries, changes announced to the existing rules of origin will make qualification for benefits under the agreement more difficult. On the other hand, e-commerce retailers and consumers and intellectual property rights holders such as drug manufacturers, among others, likely stand to benefit under the terms of the preliminary agreement.

Based on the above, companies should further evaluate their current NAFTA footprint to quantify benefits presently recognized under the existing agreement and assess qualification benefits anticipated under the USMCA. By leveraging their customs data, companies can determine whether they are adversely impacted by the proposed changes. Specifically, companies should understand how their products satisfy existing RVC requirements and then explore potential changes or alternatives to sourcing that may be required to preserve originating status under the terms of the proposed USMCA. Also, products subject to an increase of RVC, changes to the applicability of qualification by tariff shift, and, for the auto industry, the elimination of the tracing requirement all merit a closer look at origin qualification options and special methodologies. For example, use of the self-produced (intermediate) materials rules to aid NAFTA qualification has been effective in industries that have been subject to similar rules under NAFTA.

The following key actions should be considered:

• Assemble relevant data from Canada, Mexico, and the United States.
• Identify the company’s most significant products manufactured in North America, considering:
  • Customs data — to determine categories, amounts, and highest duty savings.
  • Sales data — to determine highest volumes, values, and sales forecasts.
  • Products that do not currently qualify.
  • Bills of material (e.g., product-specific data necessary for determining eligibility for trade benefits).
• Identify applicable rules of origin (set forth in NAFTA Annex 401), how the existing rule is currently met, and how it will change under the proposed USMCA (USMCA Chapter 4).
• Model the impact of proposed changes (per product) and explore solutions:
  • Would your company need to replace nonoriginating components to comply with a stricter tariff shift rule or an increased RVC requirement?
  • How close are you to reaching the current RVC rule?
  • Would you need to use a special provision, such as the self-produced (intermediate) materials rule, to assist in meeting qualification requirements?
• Be prepared for increased enforcement such as free trade agreement audits by local customs authorities.
• Review your company’s import transactions into Canada to reevaluate taxable importation status with respect to both federal and provincial regimes and to further determine any contingent requirements with respect to registration of your business in Canada, including any obsolescence of currently held registrations under the new de minimis value rules.
• Continue to monitor the impact of the Section 232 U.S. tariffs and Canadian and Mexican retaliatory tariffs and surtaxes and take advantage of drawbacks or remissions of such tariffs or surtaxes where applicable.

EditorNotes

Michael Dell is a partner at Ernst & Young LLP in Washington.

For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP. Ernst & Young previously published versions of these items as Tax Alerts.