Oh, Canada!

I do a lot of NAFTA work. For years, there have been unanswered questions concerning the ability of producers or exporters to allocate non-originating good to domestic customers and originating goods to customers in other NAFTA countries. That would maximize the benefit to the customers but might result in otherwise dutiable merchandise never being the subject to duty. The Canadian International Trade Tribunal recently got a crack at part of that question in Tara Materials, Inc. v. President of the Canada Border Services Agency, Appeal No. AP-2009-016 (Aug. 3, 2010).

Tara exports artists’ canvases from the United States to Canada. Apparently, it dual sources fungible fabric used to make the canvases and some of it comes from outside of North America. In an on-site verification by CBSA, it was determined that Tara’s production resulted in goods that are originating 72% of the time and non-originating 28% of the time.

In these circumstances, the NAFTA permits the producer to employ an inventory management system to determine the origin of the material used to produce any given finished item. This is set out in Article 406 of the NAFTA, which states in part that: “where originating and non-originating fungible materials are used in the production of a good, the determination of whether the materials are originating need not be made through the identification of any specific fungible material, but may be determined on the basis of any of the inventory management methods set out in the Uniform Regulations.” In other words, NAFTA  personified does not care if canvas number 1 is really originating and canvas number 10 is really non-originating, so long as only 72% of the canvases are treated as originating.

The U.S. regulations implementing this provision are at 19 C.F.R. Pt. 181, App. § 7(16). The origin of the fungible materials may be determined based upon an inventory accounting methodology set out in Schedule X. Those methodologies include specific identification, First In First Out, Last in Last Out, and averaging. 

In Tara, everyone agreed that finished canvases produced from originating fabric are originating and that finished canvases made from non-originating materials are not originating. The disagreement relates to the application of the Schedule X to fungible goods.

Under the averaging methodology, the producer determines the ratio of originating to non-originating materials in inventory. Schedule X states that the ratio can be applied to determine the origin of materials withdrawn from inventory. However, with respect to fungible goods, the determination applies to “each shipment” of fungible goods. "Crap!," you say. That means each shipment must be treated as nearly 30% non-originating, and that makes certification a hassle. It also creates grief for the customer. 

Tara countered that it had selected the averaging methodology applicable to fungible materials, not fungible goods so the “per shipment” limitation applicable to finished goods did not apply to its products. As a result, Tara claimed the right to allocate 100% of its originating goods (or 72% of its production) to exports to Canada, where they benefit from NAFTA treatment. The remaining 28% would be sold to U.S. customers, who do not necessarily care about the NAFTA status of the goods. 

The tribunal disagreed and held that the two regulations address two distinct segments of the production and distribution process. Section 7(16)(a) deals with production while section 7(16)(b) deals with the finished goods. Thus, the two determinations are applied in succession. Schedule X requires that the latter determination be applied to shipments.

The regulations with respect to fungible goods apply only where the goods are combined or mixed in inventory. In this case, found that the originating and non-originating canvases were mixed in inventory.

Thus, the remaining question was whether § 7(16.1) requires the use of the same inventory accounting methodology for materials and for goods. That is required where “both fungible materials and fungible goods are withdrawn from the same inventory.” According to Tara, it maintained inventories of materials and finished goods in separate rooms. Consequently, it may choose to apply the specific identification methodology to its finished goods and is not bound by the application of the averaging ratio to shipments. 

CBSA disagreed, arguing for an expansive definition of inventory that encompassed both materials and finished goods. The Tribunal refused to accept Tara’s narrow definition because it is unlikely that producers would ever physically mix production materials and finished goods. Rather, the Tribunal found it sufficient that Tara had finished goods and materials in the same warehouse. As a result, § 7(16.1) applied, forcing Tara to apply the averaging methodology to each shipment of finished goods.

This certainly not the best result for producers. Companies would like to have the maximum flexibility in allocating their originating goods to customers who can most benefit. Nevertheless, this decision, assuming it remains the final word, does provide a solid basis on which producers can determine how to manage their NAFTA systems.