Understanding the NAFTA Rules of Origin

Sue Senger | May 23, 2018 | NAFTA
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NAFTA Rules of Origin | International Trade Blog

The North American Free Trade Agreement (NAFTA) was created to ensure that goods traded among Canada, Mexico and the United States receive preferential tariff treatment. The NAFTA grants benefits and reduces tariffs only on goods that qualify under the NAFTA Rules of Origin.

The Rules of Origin listed in Chapter 4 of the NAFTA Agreement are used to determine whether goods originate in a NAFTA territory (either the U.S., Canada or Mexico). The NAFTA Rules of Origin take into account where the goods are produced and what materials are used to produce them. Only originating goods as defined by NAFTA are entitled to receive duty-free or reduced tariff treatment. (These rules should not be confused with the country of origin used for marking, quota, anti-dumping or countervailing cases.)

The Rules of Origin are very complex, and one cannot make assumptions without a careful reading of the rules. For example, the NAFTA Rules of Origin allow goods to qualify as originating if the goods are “wholly obtained or produced entirely in the territory of one or more of the parties.”

Without researching the NAFTA definition, a company may decide that their product qualifies because all components used to produce the finished product were purchased from companies located in the U.S.

This assumption would be a mistake.

According to NAFTA, “wholly obtained or produced entirely” means that all materials used in the production of the product can be traced to the earth (mineral extraction or farming). As the example demonstrates, it is very easy to misinterpret this agreement without an understanding of how the terms are defined.

An Overview of Preference Criteria

Download a Sample NAFTA Certificate of OriginAs defined by NAFTA, originating describes those goods that meet the requirements of Annex 401 of the Agreement. Annex 401, which is now General Note 12 of the Harmonized Tariff Schedule of the U.S., establishes which goods originate under the Agreement and precludes goods from other countries from obtaining those benefits by merely passing through Canada, Mexico or the United States.

There are essentially five ways that goods qualify as originating under the NAFTA Rules of Origin. These five ways are called Preference Criteria and are referred to with the letters shown below:

Preference Criterion A

A good is considered originating if that good is wholly obtained or produced in one or more of the NAFTA countries. It does not include goods or materials that were imported from a non-NAFTA country.

Preference Criterion B

A good is considered originating if that good meets the requirements of a specific rule of origin for that product, as listed in NAFTA Annex 401. There are three possible ways a product can qualify as originating under this rule:

  1. Product must satisfy a specific tariff shift;

  2. Product must satisfy a tariff shift and regional value content requirement; or

  3. Product must satisfy a regional value content requirement with no tariff shift. This qualification process requires referral to Annex 401, Specific Rules of Origin.

Preference Criterion C

A good is considered originating if that good is made up entirely of components and materials that qualify in their own right as goods that originate in a NAFTA country. The goods are produced from materials that may contain non-NAFTA materials, but the materials meet the NAFTA Rule of Origin.

Preference Criterion D

Unassembled goods and goods classified in the same Harmonized System number as their parts, which do not meet the Annex 401 rule of origin (tariff shift), but contain sufficient North American regional value content qualify as originating.

Preference Criterion E

Goods are considered originating if they are certain electronic items or parts qualifying under the provisions of Annex 308.1.

Qualifying Your Goods As Originating

Products of other countries merely being transshipped through or undergoing only minor operations in the NAFTA territory are not eligible for NAFTA benefits. Instead, companies that import these goods must pay the most-favored-nation (MFN) duty rate.

The NAFTA Rules of Origin provide the necessary steps needed to determine if your goods qualify for NAFTA preference. Since there is no way to memorize all the terms of the agreement, you must know how to use the rules to determine whether your goods qualify as originating and have a system set up to review your company’s products.

When your company is qualifying products, the team approach is usually most effective. Teams generally consist of personnel from accounting, engineering, purchasing, sales and transportation depending on the product and criteria for determining qualification.

Preference Criteria A

If your product qualifies for NAFTA using one of these criteria, you would fill in the appropriate letter in column 7 on the NAFTA Certificate of Origin document.

Goods wholly obtained or produced entirely in Canada, Mexico or the United States that contain no foreign material or parts from outside the NAFTA territory qualify under NAFTA as preference criterion A. Examples of this criterion are:

  • Silver mined in Mexico extracted in the territory.
  • Wheat grown in Canada harvested in the territory.
  • Live animals born and raised in Canada, Mexico or the United States.
  • Goods obtained from hunting, trapping or fishing in Canada, Mexico or the United States.

A manufactured product would be difficult to qualify under preference criterion A. All parts and raw materials used to manufacture the product would have to be wholly obtained or produced in one of the territories.

Preference Criterion B

Even if they contain non-originating materials, goods may originate in Canada, Mexico or the United States if the materials satisfy the rule of origin specified in General Note 12. The rules of origin are commonly referred to as specific rules of origin and are based on a change in tariff classification, a regional value-content requirement, or both.

General Note 12 gives the applicable rule of origin per the Harmonized Tariff Schedule (HTS) number or grouping of numbers, so you must know the HTS number of your goods to find its specific rule of origin and determine if the rule has been met.

Tariff Change

When a rule of origin is based on a change in tariff classification, each of the non-originating materials used in the production of the goods must undergo the applicable change as a result of production occurring entirely in the NAFTA region. This means that the non-originating materials are classified under one tariff provision prior to processing and classified under another upon completion of processing. The specific rule of origin defines exactly what change in tariff classification must occur for the goods to be considered originating.

Example:

Frozen pork meat (HTS 02.03) is imported into the United States from Hungary and combined with spices imported from the Caribbean (HTS 09.07-09.10) and cereals grown and produced in the U.S. to make pork sausage (HTS 16.01). The General Note 12 rule of origin for HTS 16.01 states: "A change to heading 16.01 through 16.05 from any other chapter."

Regional Value Content

Since the imported frozen meat is classified in Chapter 2 and the spices are classified in Chapter 9, these non-originating materials meet the required tariff change. One does not consider whether the cereal meets the applicable tariff change since it was grown and produced in the U.S. Only non-originating materials must undergo the tariff change.

Some specific rules of origin require that a good have a minimum regional value content, meaning that a certain percentage of the value of the goods must be from North America. There are two formulas for calculating the regional value content. The exporter or producer may choose between these two formulas: the transaction value method or the net cost method.

Having two methods gives producers more than one way of demonstrating that the rule of origin has been satisfied.

Transaction Value Method

The transaction value method is generally simpler to use. The transaction method calculates the value of the non-originating materials as a percentage of the transaction value of the good. Because the transaction value method permits the producer to count all of its costs and profit as territorial, the required percentage of regional value content under this method is higher than under the net cost method.

The formula for calculating the regional value content using the transaction value method is:


 

TV - VNM

RVC =

--------------

x 100

 

TV


Where RVC is the regional value content, expressed as a percentage; TV is the transaction value of the good adjusted to an FOB basis; and VNM is the value of non-originating material used by the producer in the production of the good.


The regional value content must be a minimum of 60% when the transaction value is used.

Net Cost Method

This method calculates the regional value content as a percentage of the net cost to produce the good. Net cost represents all of the costs incurred by the producer minus expenses for sales promotion (including marketing and after-sales service), royalties, shipping, and packing costs and non-allowable interest costs.

The percentage content required for the net cost method is lower than the percentage content required under the transaction value method because of the exclusion of certain costs from the net cost calculation.

The formula for calculating the regional value content using the net cost method is:


 

NC - VNM

RVC =

--------------

x 100

 

NC



Where RVC is the regional value content, expressed as a percentage; NC is the net cost of the good; and VNM is the value of non-originating materials used by the producer in the production of the good.


Example:

An electric hair curling iron (HTS 8516.32) is made in Mexico from Japanese hair curler parts (HTS 8516.90). Each hair curling iron is sold for US$4.40; the value of the non-originating hair curler parts is US$1.80. The General Note 12 rule of origin for HTS 8516.32 states:

A change to subheading 8516.32 from subheading 8516.80 or any other heading; or

A change to subheading 8516.32 from subheading 8516.90, whether or not there is also a change from subheading 8516.80 or any other heading, provided there is a regional value content of not less than: (a) 60 percent where the transaction value method is used, or (b) 50 percent where the net cost method is used.

The first of these two rules is not met since there is no heading change, therefore the producer must verify if the curling irons can qualify under the second rule. In the second rule the required subheading change is met (from HTS 8516.90 to 8516.32) so one proceeds to calculate the regional value content. The regional content under the transaction value method is:

($4.40 - $1.80)

----------------------

x 100

= 59.1%

$4.40

The hair curler is not considered an originating good under this method, since the required regional value content is 60 percent where the transaction value is used.

Instead, the producer uses the net cost method. The total cost of the hair curler is US$3.90, which includes US$0.25 for shipping and packing costs. There are no costs for royalties, sales promotion or non-allowable interest. The net cost is therefore US$3.65. The regional value content under the net cost method is:

($3.65 - $1.80)

----------------------

x 100

= 50.7%

$3.65

The hair curler would be considered originating since the required regional value content is 50 percent when the net cost method is used.

Preference Criterion C

Goods can be classified as originating if they are produced entirely in Canada, Mexico and/or the United States exclusively from materials that are considered to be originating according to the terms of the NAFTA Agreement. This provision encompasses goods made of parts and materials that themselves meet the NAFTA rules of origin even though they may contain some non-territorial inputs.

Example 1:

Company A imports whole raw bovine skins (HTS 41.01) into Mexico from Argentina and processes them into finished leather (HTS 41.04). The finished leather is then purchased by Company B in the U.S. to make leather eyeglass cases (HTS 4202.31).

The rule of origin for HTS 41.04 states: “A change to heading 41.04 from any other heading, except from heading 41.05 through 41.15.”

The finished leather originates in Mexico because it meets General Note 12 criterion. Assuming the eyeglass cases do not contain any non-originating materials, they originate since they are made wholly of a material that is originating (because it satisfied the General Note 12 criterion).

Example 2:

Desks are made from Canadian wood (HTS4407.10) grown in Canada and from metal legs (HTS9403.90) and metal drawer hardware (HTS9403.90) made from imported steel (HTS7212.50).

The wood itself is originating since it is wholly grown in Canada. The steel legs and drawer hardware were made from imported steel.

The rule of origin for HTS 9403.90 states: “A change to 9403.90 from any other heading.”

Since the imported steel used to make the legs and drawer hardware are from a heading other than 9403.90, they qualify as originating. The legs and drawer hardware qualify as originating since there is no need to qualify the desk any further. The goods qualify as goods produced in the NAFTA territory wholly from originating materials.

Unassembled Goods and Goods Classified with Their Parts

In some cases, a good that has not undergone the required tariff change can still qualify for preferential NAFTA treatment if a regional value content requirement is met. This NAFTA provision may only be used under two very specific circumstances. However, it may never be used for wearing apparel provided for in Chapters 61 and 62 and textile articles in Chapter 63 of the Harmonized System.

The two circumstances where the provision may be used are where goods do not undergo the tariff change required by General Note 12 because:

  1. The goods are imported into Canada, Mexico or the United States in an unassembled or a disassembled form but are classified as assembled goods pursuant to General Rule of Interpretation 2(a) of the Harmonized System. (This relates to preference criterion D1 on the NAFTA Certificate of Origin, Field 7.)

  2. The goods are produced using materials imported into a NAFTA country that are provided for as parts according to the Harmonized System, and those parts are classified in the same subheading or undivided heading as the finished goods. (This relates to preference criterion D2 on the NAFTA Certificate of Origin, Field 7.)

In the above situations, no tariff shift is possible because of how the goods are classified. Goods in this situation may obtain NAFTA tariff preference if they meet the regional value content requirement of either 60 percent of transaction value or 50 percent of net cost method.

Example:

A non-originating bicycle kit is imported into a NAFTA territory. The classification for the bicycle kit is the same classification for assembled bicycles. If a regional value content requirement is met for the assembly plus any originating parts used in the assembly, the bicycle qualifies for a reduced tariff under NAFTA.

Intermediate Material

For the purpose of calculating the regional value content of final goods, the NAFTA rules of origin allow producers to designate any self-produced originating material used in the production of the final goods as intermediate material. As long as the intermediate material qualifies as an originating material, its entire value may be treated as originating in determining the regional value content of the finished goods.

NAFTA Rules of Origin Seminar

The NAFTA negotiators created the intermediate material designation to treat vertically integrated manufacturers in nearly the same manner as manufacturers who purchase materials from independent suppliers. Without this special designation, vertically integrated manufacturers may not be able to meet the definition of originating. This provision covers all goods and materials except automotive goods and components described in Annex 403.2; specifically, engines and gearboxes.

An intermediate material is a self-produced material, designated by the producer, that meets the rules of origin and that is incorporated into the final good. A self-produced material is defined as a material produced by the same party that produces the final goods and which is used in the production of those final goods. An intermediate material may be composed of originating and non-originating submaterials.

After determining that an intermediate material satisfies the applicable rule of origin, the total cost to produce that intermediate material is treated as an originating cost. The producer would not include the value of the non-originating material used to produce the intermediate material as part of the value of the non-originating materials when calculating the regional value content of the final goods.

By designating an item as an intermediate material, the producer may treat self-produced materials similarly to the way the producer would treat an originating material purchased at arm’s length for purposes of determining the value of the non-originating materials of the final goods.

If the intermediate material must satisfy a minimum regional value content to qualify as originating, the net cost method must be used to calculate that regional value content.

A producer may make any number of intermediate material designations provided that no material subject to a regional value content requirement may be designated as an intermediate material if it contains submaterials also subject to a regional value content requirement that were also designated as intermediate materials.

Where a single producer designates intermediate materials that qualify as originating solely based on a tariff change (that is, without having to satisfy a regional value content requirement), subsequent designations can be made with previously designated intermediate materials.

Determining the Value of Intermediate Material

There are two methods for determining the value of an intermediate material:

  1. The total cost incurred with respect to all goods produced that can be reasonably allocated to that intermediate material; or

  2. The aggregate of each cost that form part of the total cost incurred with respect to that intermediate material that can be reasonably allocated to that intermediate material.

The two methods allow producers to select the one that best fits their production and accounting practices. The value of the intermediate material should be approximately the same using either method. However, the net cost method must be used for intermediate materials subject to a regional value content requirement.

The NAFTA Agreement lists those costs that may not be included when calculating the regional value content of the intermediate material using the net cost method:

  • Sales promotion, including marketing and after-sales service costs.
  • Royalties.
  • Shipping and packing costs.
  • Non-allowable interest costs.

Although these costs are excluded in the net cost calculation, they do form part of the total cost of the material. Accordingly, costs such as royalties are excluded when calculating the net cost for purposes of determining whether the material satisfies a regional value content requirement (and thus originates and can be designated an intermediate material), but are included in the total value of the material once its origin has determined. The total value of an intermediate material may be counted as an originating cost.

The Accumulation, De Minimis, and Fungible Goods and Materials Methods

Accumulation

When producers determine the regional value content of goods, the entire value of the materials used to produce the goods that they acquire from suppliers is considered as wholly originating or wholly non-originating as appropriate.

The accumulation provision allows the producer or exporter of goods to choose to include as part of the goods’ regional value content any regional value added by suppliers of non-originating materials used to produce the final goods. Accumulation allows the producer to reduce the value of the non-originating materials used in the production of the good by taking into account the NAFTA inputs incorporated into those non-originating materials.

This applies when a producer is unable to satisfy a regional value content requirement base on:

  • His own processing costs, or
  • The value of originating material used to produce a good.

Accumulation allows the producer to include any regional value added in the NAFTA territory by other parties that produced non-originating materials that were subsequently incorporated into the final good. The conditions for using accumulation are:

  1. Producers/exporters who choose to use accumulation must use the net cost method to calculate any regional value content;

  2. Producers/exporters of goods must obtain information on net cost and the regional value content of non-originating materials used to make their goods from the producers (suppliers) of those materials;

  3. All non-originating materials used in the production of the goods must undergo the tariff classification change set out in General Note 12, and the goods must satisfy any applicable regional value content requirement entirely in the territory of one or more of the NAFTA countries, and

  4. The goods must satisfy all other applicable requirements of the rules of origin.

De Minimis

Although requiring a change in tariff classification is a very simple principle, it requires that all non-originating materials undergo the required change. If even a very low percentage of the materials do not undergo the tariff change, the exporter would not be able to classify the goods as originating.

To overcome this obstacle, NAFTA contains a de minimis provision that allows goods to qualify as originating even when a small percentage (seven percent in most cases) of the transaction value of the goods does not undergo the required change. In addition, where failure of materials to undergo a required change in tariff classification triggers a requirement for a minimum regional value content, the calculation of that content is waived if the value of all non-originating materials used in the production of the goods is not more than the specified de minimis amount.

Exporters who want to use this option must read Article 405 of the NAFTA Agreement. Many additional requirements and exceptions are listed.

Fungible Goods and Materials

Article 415 of the NAFTA defines fungible goods as goods that are interchangeable for commercial purposes and have essentially identical properties. When a producer mixes originating and non-originating fungible goods so that physical identification of originating goods is impossible, the producer may determine origin of those goods based on any of the standard inventory accounting methods (e.g., FIFO, LIFO) specified in the Uniform Regulations. These provisions apply equally to fungible materials that are used in the production of a good.

For example, Company X of Mexico supplies clips to airplane manufacturers throughout North America. Some of the clips X supplies originate in Mexico and others are made in China. All of the clips are identical construction and are intermingled at X’s warehouse. On January 1, Company X buys 3,000 clips of Mexican origin; on January 3 it buys 1,000 clips of Chinese origin. If Company X uses FIFO inventory procedures, the first 3,000 clips it used to fill an order are considered Mexican regardless of their actual origin.

The NAFTA Agreement provides many options for exporters to qualify their goods for preferential duty treatment.

Accessories, Spare Parts, and Tools

This section addresses how to determine if your products qualify for NAFTA preference when you sell them with accessories, spare parts or tools. I will also explain the differences between packaging and shipping materials and how they affect NAFTA determination.

If it is standard procedure to ship accessories, spare parts, and tools along with a product or products that qualify as originating under NAFTA, then those accessories, spare parts, or tools are also considered originating. You can disregard those accessories when determining whether all the non-originating materials undergo any General Note 12 tariff change.

This provision applies provided you invoice the accessories, spare parts, or tools along with the goods, and the quantities and value are customary for the goods. However, if the goods are subject to a regional value content requirement, you must take the value of the accessories, spare parts, or tools into account as originating or non-originating materials in calculating the regional value content of the goods.

Example:

An exporter sells a pump originating in Canada with rubber suction and discharge hoses made in Taiwan. The hoses from Taiwan are invoiced and packed with the pump and are customarily sold with pumps of this kind. Since the pump originates, the exporter can consider the rubber as originating for the purposes of satisfying the required change in tariff classification. However, the exporter must count the value of the hoses as non-originating materials when calculating the regional value content.

Packaging for Retail Sale

In the NAFTA, packaging and packing are used in different contexts. Packaging is the material that remains with the goods in retail sales; packing is the extra material used for shipping purposes.

If packaging materials are classified with the goods, you can disregard them when determining whether all the non-originating materials used in the production of the goods undergo the applicable change in tariff classification set out in General Note 12. However, you must take the retail packaging into account as originating or non-originating materials when calculating the regional value content of the goods.

Example:

Leather footwear (HTS 6403) is made in Mexico. The shoes are wrapped in tissue paper and packed in cardboard boxes described with the brand logo for retail sale. Both the tissue paper and the cardboard box are of Brazilian origin.

The General Note 12 for 64.03 reads:

A change to heading 64.01 through 64.05 from any heading outside that group, except from subheading 6406.10, provided there is a regional value content of not less than 55 percent under the net cost method.

Although the exporter can disregard the tissue paper and cardboard box for purposes of the tariff change, the exporter must count the value of the packaging as non-originating when calculating the regional value content.

Packing for Shipment, Transshipment and Operations

This section describes how exporters must take packing materials and transshipment into consideration when determining NAFTA qualification.

Packing for Shipment

Exporters should disregard packing materials and containers in which goods are packed for shipment when determining whether the non-originating materials used in the production of the goods undergo an applicable change in tariff classification as set out in General Note 12. They should also ignore packing materials when determining whether the goods satisfy a regional value-content requirement.

Example:

Company X makes chairs (HTS 9401.69) in Mexico from Swedish furniture parts (HTS 9401.90). Company Y of Canada buys chairs from company X for C$10.90; this price includes C$0.90 for Guatemalan crates used to hold each chair during international transit.

General Note 12 origin criterion for HTS 9401.69 is:

  • A change to subheading 9401.10 through 9401.80 from any other chapter; or
  • A change to subheading 9401.10 through 9401.80 from subheading 9401.90, whether or not there is also a change from any other chapter, provided there is a regional value content of not less than:
    • (a) 60 percent where the transaction value method is used, or
    • (b) 50 percent where the net cost method is used.

The value of the Swedish parts is C$4.10. Under the transaction value method, the regional value content is:

($10.00 - $4.10)

----------------------

x 100

= 59%

$10.00

The chair does not originate because it does not have a minimum regional value content of 60 percent. Note the packing and shipping costs (C$0.90) were deducted from the transaction value prior to calculating the regional value content.

Transshipment

Goods that qualify as originating will lose that status if they subsequently undergo any operation outside the NAFTA region, other than unloading, reloading or any other operation necessary to preserve them in good condition or to transport the goods to Canada, Mexico or the United States.

Example:

Surgical instruments made in the United States (wholly of originating materials) and cotton gowns and bandages made in Mexico (from fibers and fabric wholly grown and produced in Mexico) are sent to the Dominican Republic where they are packaged together and then sterilized for use in operating rooms. Upon their return to the United States, the medical sets are not eligible for preferential treatment under the NAFTA because they underwent operations in the Dominican Republic that were not necessary to preserve the goods in good condition or to transport them to the United States.

Operations That Do Not Confer Origin

Article 412 provides that goods shall not be considered to originate if they are merely diluted with water or another substance that does not materially alter the characteristics of the goods. Thus, mere dilution—even if it results in a change in tariff classification—is not sufficient to confer origin. However, dilution coupled with another process may be sufficient to materially alter the characteristic of the goods and thereby confer origin.

Article 412 also indicates that goods will not be considered to originate if a preponderance of the evidence establishes that any production or pricing practice has been used to circumvent the intent of the Chapter 4 origin rules. The rules of origin are designed to ensure that the processing and costs incurred with respect to the products are commercially significant and appropriate to the goods, as defined by the tariff change rules and, when applicable, the value content rules.

Final Thoughts and Resources

If you have any doubt about whether or not your goods qualify under the NAFTA rules of origin, importers, exporters and producers of goods can (and should) obtain advance rulings from the Customs Administrations of Canada, Mexico and the United States. Learn more about this option in my article, NAFTA Rules of Origin—Advanced Rulings.

In addition, I have written a series of articles that address the correct way to fill out the NAFTA Certificate of Origin. And you can download a free NAFTA Certificate of Origin in PDF format from the Shipping Solutions website.

Finally, check out the NAFTA information available at the International Business Training (IBT) website:


This article was consolidated from a six-part series of articles first published in 2002-2003. It has been updated to include current information, links and formatting.

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