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Rules of Origin, the Canada-U.S. FTA, and the Honda Case

Published online by Cambridge University Press:  27 February 2017


In a regime of universal most-favored-nation treatment for the entry of goods, where a product originates makes very little difference, except for consumer preferences. Buyers may prefer perfumes made in France, watches from Switzerland, cheese from Holland, but cheese from France, perfumes from Switzerland, and watches from Holland will come into the United States, or Canada, or any other country that grants MFN treatment at the same rate of duty, and there is no incentive (for tariff purposes) for anyone to wrap a product made in Patria in the mantle of Xandia.

Research Article
Copyright © American Society of International Law 1993

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1 Trade Agreements Extension Act of 1951, ch. 141, §5, 65 Stat. 72, 73, extended by Trade Expansion Act of 1962, §231, 19 U.S.C. §1861 (repealed), and (with complicated waiver provisions) Trade Act of 1974, §401, 19 U.S.C. §2431 (1988).

2 50 U.S.C. app. §5(b) (1941–76) and regulations thereunder, 31 C.F.R. pt. 500 (China, North Korea, North Vietnam); 31 C.F.R. pt. 515 (Cuba).

3 Trade Agreement Renewing the Agreement of July 4, 1946, Sept. 6, 1955, U.S.-Phil., 6 UST 2981.

4 See Trade Act of 1974, §§501–506, 19 U.S.C. §§2461–2466 (1988).

5 Reciprocal Trade Agreements Act of 1934, ch. 474, 48 Stat. 943, enacting §350 of the Tariff Act of 1930.

6 Note that the problem does not arise (or arises in much less significant dimension) in a customs union, because in such a union, for example the EEC, the members have a common external economic policy, which leaves little or no incentive to get around state A’s restraints by sending one’s goods to B first on the way to consumption in A.

7 Free-Trade Agreement, Dec. 22, 23, 1987, Jan. 2, 1988, Can.-U.S., Art. 301(1), H.R. Doc. No. 216, 100th Cong., 2d Sess. 297 (1988), reprinted in 27 ILM 281 (1988) [hereinafter FTA].

8 Id., Art. 301(2), Ann. 301.2(4)(a), plus sectoral Rules attached to Chapter Three.

9 A reader not accustomed to this particular corner of international trade law may wonder why we use the word “good,” rather than, for instance, the word “product” as used in the GATT. “Good” is the word used in the Harmonized Tariff Schedules, note 13 infra, as well as in the relevant chapters of the Canada-U.S. Free Trade Agreement and the proposed North American Free Trade Agreement and the implementing regulations.

10 For a third possibility, even when no change in tariff classification occurs, see note 17 infra.

11 FTA, Art. 304. Each of the FTA provisions is reproduced in the respective implementing laws: for the United States, United States-Canada Free-Trade Agreement Implementation Act of 1988, Pub. L. No. 100-449, §202, 102 Stat. 1851, 19 U.S.C. following §2112 (1988); for Canada, Canada-United States Free Trade Agreement Implementation Act, 1988 S.C. ch. 65.

12 FTA, Art. 301(2).

13 International Convention on the Harmonized Commodity Description and Coding System, done June 14, 1983 (entered into force Jan. 1, 1988; for the United States Jan. 1, 1989) [hereinafter HS]. See 19 U.S.C. §§3001–3012 (1988) (adopted as tit. I, §§1201–1212, of the Omnibus Trade and Competitiveness Act of 1988, Pub. L. No. 100-418, 102 Stat. 1147). For the 1992 U.S. schedule, see U.S. Int’l Trade Comm’n Pub. No. 2449, Harmonized Tariff Schedule of the United States (1992).

14 David Palmeter, a well-known trade law specialist practicing in Washington, D.C., told the Judicial Conference of the Federal Circuit that his office had counted 1,498 separate rules of origin or rules of preference resulting from these provisions of the FTA. See Country of Origin Rules, 128 F.R.D. 492, 502 (1990).

15 This is because under section I of the Rules for Chapter Three of the FTA, entitled “Live Animals: Animal Products,” no changes within chapters qualify as a transformation for purposes of acquiring North American content. Milk, HS 0401, and cheese, HS 0406, are both listed in Chapter Four, Dairy Products. The example was raised by Palmeter, id. at 502.

It is worth mentioning that the use of the HS to determine whether a transformation leading to a change in tariff classification has occurred is new to U.S. law. Previously, rules of origin were administered in terms of a vague standard concerning “substantial transformation,” contained in regulations of the Customs Service, currently 19 C.F.R. §134.1(b) (1992), raising such questions as whether a wire rod is “substantially transformed” by being drawn into wire, or leather is “substantially transformed” by being cut into patterns for shoes. In Murray v. United States, 621 F.2d 1163, 1168 (1st Cir. 1980), the court of appeals interpreted the term as meaning

a fundamental change in the form, appearance, nature, or character of an article which adds to the value of the article an amount or percentage which is significant in comparison with the value which the article had when exported from the country in which it was first manufactured, produced, or grown.

See generally Paul Asker, Note, Changes in the Rules of Origin in the United States-Canada Free Trade Agreement: A Preliminary Evaluation, 36 Wayne L. Rev. 1545 (1990).

16 Palmeter, note 14 supra, at 502.

17 Under FTA Annex 301.2(4), a third, limited category of goods may qualify for duty-free treatment even though their third-country components did not undergo a change in tariff classification, typically because the completed product and the disassembled parts bear the same tariff classification under the Harmonized System. For instance, if a Canadian manufacturer assembles shovels from handles and shafts imported from third countries, the shovels would not qualify for duty-free treatment under (2) above because the parts and the assembled shovels are classified under the same subheading, 9402.10.00 HS. Nevertheless, the FTA provides that the assembled shovels may receive duty-free treatment upon export to the United States if the value of Canadian and American materials used plus the direct cost of assembling the goods in Canada is equal to at least 50 percent of the value of the shovels upon export. Another version of this special rule provides for duty-free treatment even if the product was imported into the first country in assembled form, when the Harmonized System does not distinguish between the complete article and its parts—for instance, a dentist’s chair and parts thereof. The example of the shovels is drawn from David Senko, Import Practice: Customs and International Trade Law 350 (2d ed. 1991).

18 Finding this rule in the text of the FTA or the official explanations is not easy. If a citation must be given, it is FTA, Ann. 301.2, para. 2. See also the definition of originating material in Article 304.

19 Honda’s manufacturing operations in the United States began with a motorcycle plant in Marysville in 1979. In 1980 Honda announced plans for an automobile plant adjacent to the motorcycle plant, and automobile production began there in 1982.

20 Honda of Canada began production of automobiles in 1986 at its plant in Alliston, Ontario.

21 Honda began manufacturing motorcycle engines in Anna, Ohio, in 1985; in the following year, it began to manufacture automobile engines, including those that became the focus of the controversy described below.

22 In fact, the decision of the U.S. authorities was made in a series of reports of audit, and the outcome may well have been determined substantially earlier. See note 40 infra. The Regulations governing the decision described below were issued in final form on January 21, 1992. Customs Regulations Amendments Relating to the United States-Canada Free-Trade Agreement, 57 Fed. Reg. 2447 (1992) (revising 19 C.F.R. §§10.84, 10.303, 10.305, 10.307, 10.310).

23 Revenue Canada, Customs and Excise No. 4568-6-5/Honda(engine) (BP) (Feb. 27, 1992).

24 Id. at 2.

25 See text at note 18 supra.

26 See FTA, Chapter Three, Rules, sec. XVII, para. 4.

27 Honda of Canada had originally contended that the actual North American content of the engine could be used in computing the North American percentage of the cars, but U.S. Customs held that the FTA required an “all or nothing” rule for such components. See text at note 18 supra.

28 U.S. Customs Service, Memorandum HQ 000160 (Feb. 27, 1992).

29 This position was set out in the U.S. Customs Memorandum 089427, at 3 (Dec. 9, 1991), in which it was held that the “reasonably allocated to” portion of the value-content requirement “does not expand the nature of the costs that can be included to those costs which are not direct.” See also Memorandum HQ 000164 (Apr. 30, 1992).

30 U.S. Customs Memorandum HQ 000164, supra note 29, at 10.

31 Id. at 11.

32 FTA, Art. 304.

33 See U.S. Customs Memorandum HQ 089427, supra note 29.

34 In fairness to Customs, it must be said that some of the indirect costs claimed by Honda of America Mfg. Inc. might well be questioned, if one stepped back from the dense language of the FTA and the regulations, and asked more generally how multinational companies based outside the free trade area should be treated. For instance, the on-site technical assistance for which Honda claimed local content allowance consisted for the most part of guidance and on-the-job training provided by engineers and technicians furnished by Honda of Japan. Similarly, Honda of America claimed, and Customs disallowed as not direct, royalty payments made by the American subsidiary to the parent company in Japan.

35 U.S. Customs had one more argument, which, with all respect and a good deal of effort, we fail to comprehend. It seems that in calculating the value of components of the engine, Customs included only the value of the foreign parts and did not include either the value of any of the U.S. or Canadian parts of those components or the cost incurred by Honda in the United States or Canada in making those components. U.S. Customs Service, Memorandum HQ 000131 (Dec. 12, 1991). We are unable to understand this ruling either from the text of the FTA or from the purpose of encouraging production and sourcing in North America.

36 Quoted in William C. Symonds, Paul Magnusson & John Pearson, Gunfight at the Customs Corral, Bus. Wk., Mar. 2, 1992, at 54, 54.

37 For instance, Paul Martin, a Liberal Member of Parliament and son of the Minister for External Affairs in the government of Prime Minister Pearson, said, “We are being subjected to economic arson by the United States, and this government has supplied the kerosene and the match.” Quoted in 9 Int’l Trade Rep. (BNA) 298 (Feb. 19, 1992). Simon Reisman, who had been the chairman of the Canadian delegation that negotiated the FTA (as well as the Canada-U.S. automotive pact a generation earlier), said, “The Americans are bastards. They’re behaving like real thugs these days in protecting their interests.” Quoted in Clyde H. Farnsworth, U.S.-Canada Rifts Grow over Trade, N.Y. Times, Feb. 18, 1992, at A1.

38 “It is not surprising,” U.S. Trade Representative Carla Hills said, “that differences of interpretation arise in administering some aspects of such a complex agreement.” Quoted, e.g., in N. Am. Trade Rep. on Free Trade, Mar. 9, 1992, at 8.

39 But when the bureaucrats notified their boss, the Commissioner of Customs, she held up the operative memorandum for eight months and sought guidance from the Deputy Secretary of the Treasury. See Paul Magnusson, James B. Treece & William C. Symonds, Honda: Is It an American Car?, Bus. Wk., Nov. 18, 1991, at 105, 108. The rulings in the Honda case were signed by the Director, Office of Regulations and Rulings, or the Director, Commercial Rulings Division, and addressed to the Regional Director, Regulatory Audit Division, U.S. Customs Service, Northeast Division, Boston.

40 There is also some suggestion that the outcome was determined in advance. See, e.g., Honda: Is It an American Car?, note 39 supra, at 105, published in November 1991; also, even earlier, 17.5. Says Honda Skirted Customs Fees, N.Y. Times, June 17, 1991, at D1, apparently based on a leak from the Customs Service or the Treasury Department, which in turn led to a hearing before the Senate Finance Committee, Enforcing Rules of Origin Requirements under the United States-Canada Free Trade Agreement, 102d Cong., 1st Sess. (July 30, 1991). The representatives of the U.S. Treasury and U.S. Customs who testified at the hearing insisted that the audit was still under way and that no decision had been reached. As early as July 1990, a congressional staff member reported to the House Ways and Means Committee that Customs had found Honda to be evading duties on imports from Canada, a statement subsequently denied by Customs.

41 The Japanese Government protested the decision, but so far as is known did not actively intervene in the case.

42 In the Matter of Article 304 and the Definition of Direct Cost of Processing or Direct Cost of Assembling, No. USA 92-1807-01, Canada-U.S. Trade Comm’n Panel, Final Report (June 8, 1992).

43 The Chapter Eighteen dispute settlement process is similar to, but not the same as, the by now well-known Chapter Nineteen dispute settlement process, used for review of antidumping and countervailing duty rulings by the respective administrative agencies of the two countries. Chapter Eighteen proceedings also provide for binational panels chosen from rosters maintained by the two countries, but only representatives of the government participate directly. Chapter Eighteen panels do not sit as reviewing authorities, and generally make their nonbinding reports to the Canada-United States Trade Commission, i.e., to the trade ministers of the two countries.

44 The same words appear in §202(c)(3)(A) of the U.S. FTA Implementation Act, note 11 supra.

45 NAFTA, done Dec. 8, 11, 14 and 17, 1992, Art. 403(5), (6), reprinted in 32 ILM 289 (provisions cited here) and 605 (1993).

46 See North American Free Trade Agreement: Report of the Advisory Committee for Trade Policy and Negotiations 12–14; Report of the Industry Policy Advisory Committee (IPAC) 407; Reports of the Industry Functional and Sectoral Advisory Committees (IFACs/ISACs), e.g., Customs Matters at 6–11, Transportation Equipment (ISAC 16) at 8–11 (all submitted Sept. 1992).

47 NAFTA, Art. 415.

48 Id.

49 See text at notes 9–18 supra.

50 NAFTA, Art. 405.

51 See Customs Regulations Amendments, note 22 supra, 57 Fed. Reg. at 2448, rejecting the suggestion that a de minimis exception be built into the definition of originating goods in 19 C.F.R. §10.303, on the ground that the FTA does not provide for a de minimis test on third-country content.

The thrust of the de minimis rule in NAFTA (Art. 405), hedged about with 13 exceptions, is that even if the good does not undergo a change in tariff classification, it can qualify for duty-free treatment if it contains no more than 7% “non-originating” material. For instance, a chair made from domestic wood, fabric and glue may qualify, even if it contains, say, imported nails.

52 NAFTA, Art. 401(a). In addition, NAFTA changes “goods harvested in the territory of either Party or both Parties” of the FTA into “vegetable goods, as such goods are defined in the Harmonized System, harvested in the territory of one or more of the Parties.” Id., Art. 415.

53 Id., Arts. 401(b), 413(a).

54 As under the FTA, see note 17 supra, when the unassembled components of a good do not undergo a change in tariff classification because the component parts and the finished product bear the same classification, the good may be considered to have North American origin if the value of the materials originating in North America plus the direct costs of assembly meet the stated value-content requirement. NAFTA, Art. 401(d).

55 By way of comparison, the Free Trade Agreement between Israel and the United States, signed in 1985, takes up 19 pages of typewritten text, plus 41 pages of annexes, declarations, tables and side letters. The Annex on Rules of Origin occupies eight pages. See Free Trade Area Agreement, Apr. 22, 1985, Isr.-U.S., 24 ILM 653 (1985).

56 These are goods listed in chapters 61–63 of the Harmonized System, which receive special treatment (i.e., protection against duty-free trade) in the Canada-U.S. Free Trade Agreement as well. These goods include articles of apparel and clothing accessories, knitted or crocheted articles; articles of apparel and clothing accessories, not knitted or crocheted; and other made-up textile articles, needlecraft sets, worn clothing and worn textile articles, and rags.

57 See EC Council Regulation 802/68, Art. 5 (June 27, 1968), 1968 O.J. (L 148) 1, as amended by Council Regulation 1318/71 (June 21, 1971), 1971 O.J. (L 139) 6.

58 NAFTA, Art. 402(2).

59 Agreement on Implementation of Article VII of the General Agreement on Tariffs and Trade, done Apr. 12, 1979, TIAS No. 10,402, GATT, Basic Instruments and Selected Documents, 26th Supp. 127 (1980).

60 See, e.g., When is a Rose not a Rose? Or, Rules of Origin under NAFTA, Bus. Mex., Oct. 1992, at 6, 7.

61 No provision was made for resolving the Honda case in the event the North American Free Trade Agreement fails to be ratified.

62 NAFTA, Art. 403(1). For nonautomotive goods, where there are likely to be more unaffiliated participants in the chain of manufacture, the roll-up/roll-down rule was retained under both the transaction value and the net cost methods. Id., Art. 402(4) (roll-up); Art. 402(9) by implication (roll-down).

63 Nonallowable interest costs would not be based on distinctions such as those that gave rise to the controversy in GM-Suzuki, p. 384 supra, but would simply be interest costs exceeding stated interest rates as published by the respective governments.

64 If we counted correctly, the October 7, 1992 version of NAFTA contains 564 pages of text, plus 553 pages of notes, annexes, reservations and exceptions. The annex to the chapter on Rules of Origin alone is 169 pages long.

65 FTA, Art. 301(3); NAFTA, Art. 412.

66 See U.S. General Accounting Office, Implementation of the U.S.-Canada Free Trade Agreement 28–31 (GAO/GGD-93-21, 1992).

67 Governor Bill Clinton, Expanding Trade and Creating American Jobs, Remarks at North Carolina State University, Raleigh, N.C. (Oct. 4, 1992).

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