Indirect tax in 2018

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EY - Armando F. Beteta

By Armando F. Beteta
Executive Director, Indirect Tax
+1 214 969 8596

Introduction

As one of its main priorities, the current United States (US) administration established a renegotiation of the North American Free Trade Agreement (NAFTA) between the US, Mexico and Canada. Accordingly, as soon as President Trump took office, five renegotiation rounds were scheduled for 2017 and two more, at least, are expected for 2018. Nonetheless, the level of uncertainty is still high on whether a successful renegotiation will be reached or even if the agreement will actually remain in place.

Background on NAFTA

NAFTA entered into force on 1 January 1994 and created one of the world’s largest free-trade areas.

Under NAFTA, import duties on all covered goods traded within the US, Canada and Mexico were gradually phased out and, as scheduled, on 1 January 2008, all remaining duties and most quantitative restrictions on imports were eliminated.

Products manufactured in a NAFTA country that meet applicable rules of origin may be considered “NAFTA originating.” This has led to a high degree of integration for production and supply chains for items manufactured and sold in NAFTA countries.

NAFTA has been credited with creating a number of positive outcomes for its signatories. It has created a regional market of 480 million people, with a combined gross domestic product (GDP) of more than $20 trillion. North America (Canada, US and Mexico) exports $2.3 trillion in goods worldwide, representing 18% of global exports.1 From a regional perspective, trilateral trade tripled to reach $1 trillion in 2016.2

The complexities of renegotiation and potential withdrawal

All three countries have agreed that NAFTA should be renegotiated, but the focus of each country in the negotiations is different.

From the US perspective, the focus has been mainly based on trade imbalance and the loss of manufacturing jobs. Particular emphasis has been placed on certain industries, such as automotive, which has been directly impacted by these two factors, according to the current US administration.

Overall, in 2016, the US-Canadian goods trade deficit was approximately $12 billion and the US-Mexican goods trade deficit was around $63 billion. In July 2017, the US released a summary of NAFTA renegotiation objectives, outlining a variety of topics for renegotiation, including rules of origin, government procurement, sanitary, phytosanitary measures and technical barriers to trade, barriers to trade in services, intellectual property issues, digital trade and environmental issues.

Canada, on the other hand, has agreed to renegotiate NAFTA but is focusing on other objectives, such as protecting NAFTA’s record as an engine for job creation and growth, modernizing the agreement, cutting red tape for business and harmonizing regulations — measures that are all aimed at making NAFTA more progressive, particularly with respect to labor, the environment and gender.3

Mexico’s objectives are similar to Canada’s. Specifically, Mexico aims at having more, not less, trade, strengthening North American competitiveness, advancing toward more inclusive regional trade, taking advantage of the 21st century economy to embrace innovation and promoting certainty for trade and investment in North America, among others.4

The evident discrepancies between the NAFTA objectives of the US, Mexico and Canada have created a complicated renegotiation process. In this regard, while there has been improvement in some areas, such as customs procedures, e-commerce and telecommunications, no agreement has been reached on topics such as government procurement, the dispute settlement mechanism and regional integration via rules of origin.

In order to promote local sourcing and manufacturing, the United States Trade Representative (USTR) has proposed an increase in the “regional value” content for the rules of origin for motor vehicles. The proposal is to increase the regional value content for automotive vehicles to 85%, with 50% of that content sourced from the US.

It is common to find this type of proposal in other trade renegotiations (for example, under the Economic Complementation Agreement 55, Mexico and Brazil agreed to eliminate the tariff shift requirement for all traded products and to increase the regional value content). However, the US proposal to have 85% North American content, with 50% consisting of US content, is unprecedented, and achieving that level may be unrealistic. This proposal has far-reaching implications for the whole NAFTA process.

While it is possible that the NAFTA parties may overcome this type of complexity during the renegotiation process, such discrepancies could derail the overall process. It must be noted that under NAFTA’s Article 2205, any country may withdraw from the agreement six months after it provides written notice of its withdrawal to the other NAFTA countries. If one of the countries withdraws, the agreement would remain in force for the remaining countries.

What’s next?

The sixth round of negotiations of NAFTA concluded on 29 January 2018, in Montreal, Canada. While all parties conveyed an overall optimistic outcome from this round, USTR Robert Lighthizer noted that progress seems to be moving slowly, in part due to the trilateral nature of the negotiation.

While improvement was made in specific areas (i.e., transparency, anti-corruption, customs procedures and trade facilitation, digital trade and telecommunications, as well as sanitary and phytosanitary measures), it is also noticeable that particular sensitive topics addressed in previous rounds continue to be stalled. It is important to remember that the fourth round of negotiations was marked by proposals put forward by US negotiators on a number of sensitive topics, including the previously mentioned changes to the rules of origin for automotive vehicles, as well as proposals to expand the auto parts tracing list and to add a sunset provision for expiration of NAFTA every five years.

During the sixth round, Canadian negotiators put forward a creative proposal to respond to the US position by suggesting to take into consideration not only the value of materials used in the production of vehicles, but also the value of software, as well as the research and development costs incurred in the NAFTA countries to increase the regional value content. Such an approach was rejected by the US at the conclusion of this round, citing that it could lead to less regional value content compared with the current rules. However, it is our understanding that Mexico is likely to review the new proposal further in order to determine if it remains a viable option.

The next round of negotiations (round seven) will take place in Mexico City from 26 February to 6 March 2018. There is an expectation by the parties to move forward and finalize the renegotiation process prior to Mexico’s presidential election, which will take place on 1 July 2018. However, due to the complexity and nature of some of the sensitive topics that are still unresolved, negotiations could extend into 2019.

The outcome of the renegotiation is still, therefore, far from clear. Nevertheless, companies operating in the region should be prepared for the potential impact on their businesses.

As a first step, companies should better understand their NAFTA footprint in order to quantify their current use of NAFTA benefits. By leveraging their customs data, they can then determine their vulnerability to NAFTA changes or the potential termination of the agreement. Specific questions should also be addressed regarding current regional value content requirements for the origin qualification of products, as well as potential changes to sourcing that may be required to preserve NAFTA status.

A strategic and proactive approach should allow companies to better deal with uncertainties developing from the NAFTA negotiation.


1 Information provided by Mexico’s Secretary of Economy, with data from the International Monetary Fund (IMF) and the World Trade Organization (WTO).
2 According to Mexico’s Secretary of Economy, based on import data from Statistics Canada, Banco de México, U.S. Department of Commerce and the World Bank.
3 As stated by Canadian Minister of Foreign Affairs Chrystia Freeland at the opening conference of the renegotiation rounds.
4 As stated by Mexico’s Secretary of Economy, Ildefonso Guajardo.