Rules of origin: can the EU-UK trade be frictionless?

Following a debate at the Commons held on 26 April 2018, the MPs approved a non-binding motion calling for the UK to remain in the customs union after Brexit. The debate was based on a motion which called on the government to include as an objective in negotiations on the future EU-UK agreement the establishment of an effective customs union.

While the government is under pressure to both leave and remain in the customs union, its proposal for a ‘customs partnership’ received a cold welcome from Brussels. If the customs union (or partnership) option is not pursued, the government will likely aim to secure a frictionless trade in goods and services between the UK and EU by negotiating a free trade agreement (FTA).

But is the government’s aim to secure frictionless trade with the EU possible? Putting politics aside, let us look at a more technical aspect of free trade negotiations – rules of origin (ROO).

What are rules of origin?

ROO allow governments to determine where goods originate from. The country of origin is where goods have been produced or manufactured rather than where they have been shipped from. So why is it important to determine the origin of goods?

The national source of a product is relevant when identifying which customs duties to apply to an imported product. Since governments grant preferential tariffs to certain countries under FTAs or other arrangements, they need to make sure that preferential access applies only to imports from benefiting countries.

If the UK and the EU agree on a lower or nil customs duty under an FTA, ROO would allow them to determine whether goods in fact originate from the UK or the EU and thus qualify for preferential tariff or whether in fact they originate elsewhere, such as, say, China to which a non-preferential tariff applies.

How do rules of origin work?

In some cases, it is not difficult to determine where goods originate from. Some products are grown from local seed, are extracted from local soil (e.g. minerals) or are obtained by hunting or fishing conducted in that country. These are mainly natural products and are referred to as ‘wholly-obtained’ goods.

Many goods, however, are not produced in a single country. They contain details and parts which come from various locations. If some of the parts are manufactured in one country but components are added in another country, it must be determined whether a product can be considered as originating from the country where it was assembled. These types of goods must fulfil the co-called ‘sufficient transformation’ criterion.

There is no fixed set of ROO to determine this. Various ROO are used to identify the origin of a product in such complex situations. The General Agreement on Tariffs and Trade (GATT) under the WTO system does not establish specific ROO.

Countries are free to determine their own ROO and can even apply different ROO under different FTAs. Some governments look at the origins of the materials, others at the country in which the final substantial production phase took place, still others calculate the value added in each country.

What rules of origin are applied by the EU?

The EU is a customs union and so it applies a common tariff to goods imported from third countries (i.e. non-EU countries). However, the EU does not have a set tariff for all third countries – some imports qualify for preferential treatment, while others are subject to full duties.

Each preferential regime has a specific ROO attached to it. There is thus no one set of EU rules that determine origin of a product – in some cases the EU applies preferential ROO, in others non-preferential.

The EU applies preferential tariffs to developing countries, for example under the EU’s Generalised System of Preferences (GSP). The GSP allows developing countries to pay lower or no duties on exports to the EU.

Countries which benefit from the GSP include Bolivia, Ecuador, Georgia and others. These arrangements are non-reciprocal, that is, the preferential treatment is applied to good imported to the EU but not to the EU exports.

Specific arrangements also apply under FTAs which the EU agrees with third countries. For example, the recently concluded EU-Canada Comprehensive Economic and Trade Agreement (CETA) provides that a product originates from the EU/Canada if it: (a) has been wholly obtained (b) has been produced exclusively from originating materials or (c) has undergone sufficient production in the EU/Canada.

In addition, a product must: (a) not have undergone further production or any other operation outside the EU/Canada (other than unloading, transport, preservation and other); (b) remain under customs control while outside the EU/Canada. Whether a similar set of ROO would apply in case of a potential EU-UK FTA is yet to be seen.

When preferential treatment is applied reciprocally, ROOs must be agreed with the other contracting party/parties (e.g. the CETA or other agreements, like the Regional Convention on pan-Euro-Mediterranean preferential rules of origin). Preferential treatment which is applied unilaterally is set by the EU alone (e.g. under the EU’s GSP system).

Why are rules of origin important for the UK?

The EU is UK’s largest trading partner. In 2017, UK exports to the EU amounted to around 44% of all UK exports. UK imports from the EU reached around 53% of all UK imports. Among the biggest UK exports to the EU are chemicals and pharmaceuticals, aerospace and transport.

Let us look at the relevance of ROO in transport sector. A typical car is assembled from more than 30,000 parts. The average car made in the UK uses 20-25 % domestic parts. That means that post-Brexit cars produced in the UK would not qualify as ‘wholly obtained’ goods when determining their origin.

For non-originating materials or components (ie for components coming from eg China) to obtain originating status, it will have to be demonstrated that they are sufficiently worked or processed in the UK, in accordance to ROO agreed between the EU and UK.

The EU may apply so-called ‘cumulation’ which would allow the UK to treat parts and components produced in third-countries as qualifying under the ROO if the EU has an FTA with that third country. It could, however, take years for businesses to readjust their manufacturing processes in order to meet the ROO conditions.

ROO thus seem to place a big question mark next to the ‘frictionless trade’ objective raised by the UK government. Every exporter – small or large – will have to determine whether their goods originate in the UK or abroad according to the complex technical and legal rules.

Customs delays are likely to appear as the application of ROO will require checks. This may become a hurdle to manufacturers who often work on a precise, and often last minute, schedule to avoid storage. Ports like Dover or Calais, through which the UK exports much of its production, currently do not have technical infrastructure to ensure an efficient application of ROO. The sensitive question of the Irish/Northern Irish border will also face this technical requirement.

Disclaimer:
The views expressed in this explainer are those of the authors and not necessarily those of the UK in a Changing Europe initiative.

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