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FINAL REPORT OF THE PANEL UNDER CHAPTER 18 OF THE CANADA-UNITED STATES FREE TRADE AGREEMENT
Secretariat File No.
IN THE MATTER OF:
Article 304 and the Definition of Direct Cost of Processing or Direct Cost of Assembling
Ian Binnie, Q.C.
James F. Grandy (Chair)
William B. Kelly, Jr.
Final Report of the Panel
June 8, 1992
1. The Panel was established by the Canada-United States Trade Commission under Article 1807 of the Free Trade Agreement between Canada and the United States (hereafter "FTA") in accordance with an exchange of letters between Canada's Minister for International Trade, Michael H. Wilson, and the United States Trade Representative, Carla A. Hills.
2. The Parties agreed on the following timetable:
January 6 Panel requested by Canada
February 6 Panel selection completed
February 18 Canada files written submissions
March 9 USA files written counter-submissions
March 31 Oral hearing in Washington, D.C.
April 7 Parties file supplementary briefs
May 6 Panel presents initial report
May 20 Parties file comments on initial report
June 8 Panel presents final report
3. The Parties further agreed that the Panel should be composed of Ian Binnie, Q.C.; James F. Grandy (Chairman); William B. Kelly, Jr.; Donald McRae; and Phillip Trimble. Sidney Rubinoff was appointed by the Chair as an assistant to the Panel. 1 A hearing was held in Washington, D.C. on March 31, 1992. At the beginning of the hearing the Chair was asked for a ruling as to the propriety of a Party making the written submissions available to, and having present at the hearing, an outside counsel engaged in the private practice of law. Under Article 1807(4) the Panel establishes its own rules of procedure, including those relating to the conduct of a hearing. The Chair ruled, on the basis of the Model Rules of Procedure, Part VI, para. 1, and after deliberation of the Panel, that outside counsel could be present at the hearing as long as the Party concerned assumed its responsibility to ensure confidentiality.
4. On May 22, 1991, in response to an advice request dated November 7, 1989 from Toyota Motor Sales, U.S.A., Inc. respecting the treatment of interest as a direct cost of processing under Article 304 of the FTA, the United States Customs Service issued an administrative decision in relation to the following issues:
"a. Is the 'mortgage interest' of Article 304 limited to interest associated with real property? Does the definition of 'direct cost of processing' in Article 304 include all interest associated with the manufacturing process, including loans used to finance tools and equipment, payroll, and factory inventory?
b. Is there a requirement that the loan be secured by an asset in order for the interest expense to be considered as a direct cost of processing?
c. Is there a requirement that interest be paid to an institution chartered in the territory of either party in order to be included in the value content calculation as part of the numerator?"
5. In respect of the first two issues the United States Customs Service held that interest expense which is not secured by a mortgage on real property used in production of the goods being exported would not be considered allowable as a direct cost of processing or direct cost of assembling for origin determination purposes. The actual text of the United States Customs Service holding was as follows:
"HOLDING: Mortgage interest, secured by real property, paid to an institution will be treated as a direct cost of processing or direct cost of assembling for the portion of the interest related to the real property used in the production of the goods being exported to the other party. Subsequent interest payments (accruals) related to the real property will be considered allowable as a direct cost of processing or direct cost of assembling for the portion of the interest related to the real property used in the production of the goods being exported to the other party. Interest expense which is not covered by a mortgage, i.e., unsecured loans, inter-company loans and lines of credit, etc., will not be considered allowable as a direct cost of processing or direct cost of assembling for origin determination purposes. Interest expense relating to loans for general and administrative purposes are specifically excluded as a direct cost of processing or direct cost of assembling under the Agreement."
6. Issue (c), which asked whether there is a requirement that the financial institution to which the interest is paid must be chartered in the territory of either party, was not addressed in the holding of the administrative decision of May 22, 1991 but was referred to by the United States Customs Service in the body of the analysis section as follows:
"The final opinion relating to what country such interest must be paid relates to the specific wording contained in the Agreement. In this regard we find the intent to allow such mortgage to be executed within or outside both territories as long as such mortgage meets the criteria of Article 304 for direct cost of processing/assembling paragraph e) and the real property is located within the territory."
7. After the May 22, 1991 administrative decision was announced, Canada invoked the dispute settlement mechanism under Chapter 18 of the FTA. On January 6, 1992 Canada requested the establishment of a Panel under Article 1807 to consider the treatment of interest in the calculation of territorial content under the rules of origin. On January 22, 1992 the United States interpretation of Article 304 set out in the administrative decision dated May 22, 1991 was incorporated in United States Customs Regulations S.10.305 (a)(3)(iv).
III. Terms of Reference
8. The Parties agreed to the following terms of reference in an exchange of letters on February 7, 1992 and February 14, 1992:
"To determine whether the definition of 'direct cost of processing' or 'direct cost of assembling' set forth in Article 304 of the United States-Canada Free Trade Agreement ("Agreement") includes interest payments on debt of any form, secured or unsecured, undertaken to finance the acquisition of fixed assets such as:
(i) real property
(ii) a plant, and/or
used in the production of goods in the territory of a Party and that are subject to a determination based on the criteria specified in the Annex 301.2 to the Agreement.
In the context of this determination, it is agreed that the interpretation contained in the U.S. Customs Service's administrative decision of May 22, 1991 (ENT-3-02-CO:RA:C, MS REF-04) will be examined by the Panel. It is further agreed that the question relating to the territory where interest is paid, contained in paragraph (c) of the Issues section of that administrative decision, is not before the Panel."
IV. Arguments of the Parties
9. Since there were no facts in dispute the Parties addressed the interpretation of Chapter 3 of the FTA, and in particular the definition of "direct cost of processing or direct cost of assembling." Article 304 provides as follows:
"direct cost of processing or direct cost of assembling means the costs directly incurred in, or that can reasonably be allocated to, the production of goods, including:
a) the cost of all labor, including benefits and on-the-job training, labor provided in connection with supervision, quality control, shipping, receiving, storage, packaging, management at the location of the process or assembly, and other like labor, whether provided by employees or independent contractors;
b) the cost of inspecting and testing the goods;
c) the cost of energy, fuel, dies, molds, tooling, and the depreciation and maintenance of machinery and equipment, without regard to whether they originate within the territory of a Party;
d) development, design, and engineering costs;
e) rent, mortgage interest, depreciation on buildings, property insurance premiums, maintenance, taxes and the cost of utilities for real property used in the production of the goods; and
f) royalty, licensing, or other like payments for the right to the goods;
but not including:
g) costs relating to the general expense of doing business, such as the cost of providing executive, financial, sales, advertising, marketing, accounting, and legal services, and insurance;
h) brokerage charges relating to the importation and exportation of goods;
i) costs for telephone, mail, and other means of communication;
j) packing costs for exporting the goods;
k) royalty payments related to a licensing agreement to distribute or sell the goods;
l) rent, mortgage interest, depreciation on buildings, property insurance premiums, maintenance, taxes and the cost of utilities for real property used by personnel charged with administrative functions; or
m) profit on the goods."
(a) Submissions of Canada
10. Canada argued that the text immediately following the word "means" at the commencement of the paragraph supplies the definition and that the subparagraphs that follow, i.e. (a) to (f) and (g) to (m), simply provide illustrations of the general definition. 2 Canadian and United States legal precedents were cited to the effect that the use of the term "includes" is normally illustrative and enlarging rather than limiting or exhaustive.
11. Canada then submitted that, as the mention of mortgage interest in 304(e) is only an illustration of the type of interest cost that could be treated as a cost of production, other interest costs in respect of the acquisition of real property, plant and equipment used in production are equally costs of production. "They are much more closely associated with the costs in the included list than with those in the excluded list" 3 Canada noted that the costs on the excluded list relate to the general costs of doing business such as advertising, marketing, accounting and legal expenses. 4 It was argued that interest costs incurred in respect of the acquisition of real property, plant and equipment are not a general business expense in this sense. As to the question of form, it was Canada's view that it is the use to which the property is put, not the form of security given for the loan, that is decisive. 5
12. To allow mortgage interest costs for real property used in production, while disallowing equivalent costs arising from non-mortgage financing, would be to prefer form over substance, would lead to anomalous results and would distort normal commercial practice. There often are good reasons for choosing other forms of debt. Canada did not believe the Parties intended to restrict the financing options of companies investing in either country.
13. Canada cited examples of United States practice under the Generalized System of Preferences (GSP) and the Caribbean Basin Economic Recovery Act (CBI) 6 where the Regulations made no express mention of interest costs, yet the United States Customs Service had consistently ruled that interest costs related to debt incurred to acquire equipment for the production of goods were included in the "direct costs of processing operations". Canada said that while these U.S. cases do not bear directly on the interpretation of the FTA, the Canadian negotiators were aware of them and had a "reasonable expectation" that interest on the acquisition costs of equipment would be regarded as a direct cost of processing for purposes of origin under the FTA.
14. Canada noted that the Analysis section of the United States Customs Service administrative decision of May 22, 1991, in discussing capital assets, stated that under Generally Accepted Accounting Principles (GAAP) interest payments could be capitalized in the cost of a capital asset up to the time it was placed in use and the capitalized cost of the asset would then be depreciated over its useful life and could be allocated to the cost of production of the goods. 7 Canada said that according to the United States Customs, subsequent interest payments (accruals) related to that asset would be allowable as a cost of processing or assembly, based on a proper allocation between direct costs and general and administrative expenses. Canada contended that this accounting analysis favoured Canada's position but was not reflected in the Holding section of the May 22, 1991 administrative decision, and argued that the underlying rationale of the Holding section must have been that such interest was excluded only because of the erroneous view that the list of costs following the word "includes" in Article 304 is exhaustive.
15. In any event Canada considered that the May 22, 1991 administrative decision erred in its reliance on GAAP because the GAAP principles are designed to serve a completely different purpose than the FTA value test. GAAP are largely concerned with the integrity of the reporting of the financial results of a business enterprise. This objective is completely different from the objective of the FTA value test which is a measure of "value added".8
16. With respect to the negotiating history of the FTA, Canada argued that "the best evidence of the intent of the Parties is the text of the Agreement. More important still, the text is the only evidence of what they actually achieved jointly as distinct from what they might have desired individually".9
(b) Submissions of the United States
17. The United States submitted that the plain and ordinary meaning of Article 304 was that interest expenses and other costs of financial services were expressly excluded from the definition of direct cost of processing or assembling. This was the general rule of Article 304 stated in subparagraph (g). Only one exception was provided for, namely mortgage interest for real property used in the production of goods, a specific and carefully limited exception. 10
18. The United States argued that the ordinary meaning of "financial services" in subparagraph (g) included the provision of credit. While Chapter 3 contained no definition of financial service, Article 1706 defined it as "a service of a financial nature offered by a financial institution excluding the underwriting and selling of insurance policies". While Article 1706 is not directly applicable to Article 304, it is evidence of what the drafters of the FTA understood by the expression "financial services". 11 The United States also cited the definition of financial services in the Draft Final Act of the Uruguay Round of Multilateral Trade Negotiations which included "lending of all types including consumer credit, mortgage credit, factoring and financing of commercial transactions". Thus, in the view of the United States, the ordinary meaning of the term "financial services" was that it covered interest expenses on funds borrowed. 12
19. The United States argued that the fact that a cost, such as interest, could be allocated to the production of a good did not in itself qualify that cost to be allowed as a direct cost of production or assembly of the good. In order to be allowed as a direct cost of processing a cost must not only be allocable to the cost of producing the good, it must also be a cost of production within the meaning of the FTA. Financial services costs, being expressly excluded from the definition of direct cost by subparagraph (g), may not be counted even if such costs could otherwise reasonably be allocated to the production of that good. 13
20. The United States submitted that the narrow and exceptional circumstance in which interest could be an included cost is defined by three important limitations: it must be mortgage interest, for real property, used in the production of goods. 14 Acceptance of the Canadian submission would wrongly allow this exception to swallow the rule. If subparagraph (e) had really been intended to suggest that all interest could be included, the Parties would not have burdened subparagraph (e) with three such specific limitations. In the United States view subparagraph (e) is only tangentially concerned with interest. Its true subject matter is real property and the various costs related to real property. These are included in the direct cost of processing or the direct cost of assembly as a special "real property" exception to the general prohibition in subparagraph (g).
21. The United States did not concede that the lists are "illustrative" in the sense that the categories of enumerated items exemplify other categories of items. The United States argued that the Canadian submission ignored the list of exclusions and failed to consider what is the result when there are two conflicting "illustrative" examples, one general (exclusion of financial services) and one specific (inclusion of mortgage interest on real property used for the production of goods). In the United States view, an exception to a general rule must be construed narrowly. 15
22. The United States said that the drafters of the FTA were determined to ensure that where goods were made in part from third-country materials there would be substantial input of Canadian or United States labor or materials, avoiding the so-called "bookkeeping input" that had been included in the value content calculation under the Automotive Products Trade Agreement ("the Autopact") between the United States and Canada. Hence profits were specifically excluded under the FTA in Article 304(m) although they were included as domestic content under the Autopact. The United States contended that the intent of the FTA was to promote the use of North American labor, materials and parts, referred to by the United States as "hard costs". Accordingly it was intended that, to the fullest extent possible, costs other than "hard costs" would be excluded. 16
23. The United States argued that just as profits are the cost of equity capital, interest is the cost of debt capital. If the cost of one form of capital is excluded, the cost of the other form of capital should likewise be excluded. Moreover, to include interest costs as direct costs of production would involve double counting, that is, both the interest cost on money borrowed to acquire the plant and equipment and the depreciation expense on that plant and equipment would be counted. 17
24. With respect to GAAP, and the reliance on GAAP by the United States Customs Service in its administrative decision of May 22, 1991, the United States contended that accounting theory and practice do support the conclusion that interest expenses are neither directly incurred in nor reasonably allocable to the cost of production, and that this is the same for financial accounting methodology as well as for cost accounting methodology. The United States noted that the Financial Accounting Standards Board (FASB) generally prohibits the capitalization of interest for inventories that are routinely manufactured or otherwise produced in large quantities on a repetitive basis. 18 It was not unreasonable for the Parties to have created an exception in Article 304 for mortgage interest on real property because accounting theory and practice do not treat land (as distinct from buildings and equipment) as a depreciable asset. Mortgage interest, in the United States submission, represents a proxy for the contribution of real property to the cost of production. 19
25. The United States relied on the negotiating history of the FTA as evidence of the intent of the Parties. The United States chief negotiator for Article 304 in his presentation to the Panel during the oral hearing on March 31, 1992 explained that the Canadian negotiators had approached the United States negotiators late in the process, in October, 1987, with a request for the inclusion of mortgage interest on real property used in the production of goods together with depreciation on buildings, property insurance premiums and real property maintenance costs. Canada had not asked for a general reference to interest costs. Canada's request related only to mortgage interest on real property used in the production of goods. The United States had agreed to that request because by the end of October 1987 "we were running out of time" and in light of the non-depreciation of land costs and "in the interest of consummating an agreement" the United States accepted the amendment. 20 If Canada had intended in October 1987 the broad inclusion of interest it now seeks in the present proceeding Canada would have asked for it in very different language.
To Continue with The Panel's Analysis
1 Jack Weiss served as an assistant to Phillip Trimble, Anthony Van Duzer served as an assistant to Donald McRae, and Riyaz Dattu served as an assistant to Ian Binnie.
2 Canada First Submission, pp. 10-17.
3 Canada First Submission, p. 17, para 45.
4 Canada First Submission, p. 17, para. 46.
5 Canada First Submission, p. 17, para. 47-48.
6 Canada First Submission, pp. 20-22, para. 56-64.
7 Canada First Submission, p. 25, para. 75.
8 Canada First Submission, p. 25, para. 72-73.
9 Transcript of Oral Hearing, p. 39.
10 United States First Submission, p. 9.
11 U.S. First Submission, pp. 10-11.
12 U.S. First Submission, p. 11.
13 U.S. First Submission, p. 14.
14 U.S. First Submission, p. 14.
15 U.S. First Submission, p. 16.
16 Transcript of Oral Hearing, pp. 83-84.
17 U.S. First Submission, pp. 25-26.
18 U.S. Second Submission, pp. 32-35.
19 U.S. First Submission, pp. 19-20.
20 Transcript of Oral Hearing, pp. 80-81.