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FINAL REPORT OF THE PANEL UNDER CHAPTER 18 OF THE CANADA-UNITED STATES FREE TRADE AGREEMENT


Article 1807
Secretariat File No.
USA-92-1807-01
(Continued)

V. The Panel's Analysis

(a) The meaning of Article 304

26. This brief summary of the arguments of the Parties is not intended to repeat their careful and extensive submissions in the written and oral proceedings, but it identifies the major contending lines of argument sufficiently for purposes of the Panel's own analysis of Article 304. The Panel will refer in greater detail to the Parties' arguments where appropriate in the following paragraphs.

27. Article 31 of the Vienna Convention on the Law of Treaties sets out the basic rule of interpretation which the Parties accept as applicable to the present dispute. Article 31 provides:

"A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in light of its object and purpose."

28. The relevant terms of Article 304 are "direct cost of processing or direct cost of assembling" and these are defined by Article 304 itself by a two-pronged test separated by the disjunctive "or", as follows:

"the costs directly incurred in or that can reasonably be allocated to, the production of goods."

(emphasis added)

29. The first branch of the test ["the costs directly incurred in ... the production of goods"] adds little to the terms themselves being defined i.e. the expression "direct cost" is defined as "the costs directly incurred ...", an elaboration that does not shed much light on what the Parties intended, in this context, by adoption of the concept of "directness". The first branch of the definition does however couple the ideas of "processing" and "assembling" as components of the more general activity of "production".

30. Traceability appears to the Panel to be the essence of the distinction between costs directly incurred in the production of goods, and other costs, under the first branch of the two-pronged test. This is borne out by the definition of "direct costs" set out in some of the standard accounting reference texts, for example:

(a) Cooper & Ijiri - "Kohler's Dictionary For Accountants", (6th ed., New Jersey 1983)

"The cost of any good or service that contributes to and is readily ascribable to product or service output"

(b) Barfield, Raiborn & Dalton - "Cost Accounting - Traditions and Innovations", (Minnesota 1991)

"A cost that is distinctly traceable to a particular cost object"

(c) Rotch, Allen & Smith - Executive Guide To Management Accounting and Control Systems, (4th ed., Texas 1991)

"Direct costs, strictly speaking, are only those costs that can readily be identified or measured by product. Allocated costs, whether fixed or variable, are excluded."

(d) Horngren - "Cost Accounting - A Managerial Emphasis", (3rd ed., New Jersey 1972)

"The terms direct and indirect have no meaning unless they are related to an object of costing. Traceability is the essence of the distinction. The word direct refers to the practicable, obvious, physical tracing of cost as incurred to a given cost object."

31. The second branch of the test ["the costs ... that can reasonably be allocated to the production of goods"] does not use the word "directly". As some accounting definitions indicate, "allocated costs" are sometimes contrasted with "direct costs". It therefore appears that the Parties intended in the second branch of the definition of Article 304 to broaden the meaning that would otherwise flow from the first branch of the definition, and indeed to broaden from their ordinary signification the terms being defined, i.e. "direct cost of processing or direct cost of assembling".

32. The difficulty is that the outer limits of Article 304 are defined by reference to the concept of "reasonableness" without Article 304 ever explicitly indicating the standard by which "reasonableness" is to be assessed. An allocation that is reasonable for the purpose of evaluating the profitability of a product line, for example, may not be a reasonable allocation for the purpose of valuing inventory, or, for that matter, "reasonable" in the context of Article 304. Moreover, traceability, which is important in distinguishing direct and allocated costs, may also be important in establishing that an allocation of interest cost is "reasonable," especially in light of the fungibility of money.

33. Clearly reasonableness was intended by the Parties to be a meaningful limitation. As the United States points out, any cost is capable of being allocated. However, the Parties have provided that only those costs "that can reasonably be allocated for the production of goods" are to be included.

34. In light of the principle of interpretation expressed in the Vienna Convention, the Panel must find the scope of that limitation in the context in which the word "reasonably" has been used, as well as in the object and purpose of the Free Trade Agreement itself. Both Parties appreciated that their bargain would be expressed in the FTA. While the Panel does not deny that in some circumstances it may be helpful to go beyond the Agreement itself, as the Vienna Convention contemplates, this cannot be done for the purposes simply of taking account of the motivation or objectives of one of the Parties. Thus, the Panel does not accept Canada's arguments based on its understanding of earlier United States Customs rulings under various provisions including the Generalized System of Preferences (GSP). Similarly, the Panel is not able to accept the relevance of the domestic practice of the Parties under other agreements that are distinguishable from the FTA in both text and purpose. For this reason, the Panel does not find the practices under the GSP and the U.S. Caribbean Economic Recovery Act to be persuasive. Finally, unilateral explanations such as the Canadian Explanatory Notes to the Agreement or United States Executive Branch documents are not authoritative guides to interpretation.

35. The two-pronged definition in Article 304 is immediately followed by a list of thirteen items, the first six items introduced by the word "including", and the second seven items introduced by the words "but not including". In the view of the Panel the Parties intended the lists of inclusions and exclusions to serve as the primary raw material out of which the intended standard of "reasonableness" should emerge.

36. It is convenient to reproduce the lists of illustrations for purposes of comparison:

"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 comparison of the lists yields a number of important messages to those charged with the task of interpretation.

37. Firstly, those who drafted the illustrative lists created two sets of opposable pairs. The first pair relate to real property:

Real Property

including ...

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;

but not including ...

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;

The text of these opposable illustrations is identical except for a differentiation in the use to which the real property is put, a differentiation which contrasts use in production with use in administration. It is common ground between the Parties that the reference in subparagraphs (e) and (l) to mortgage interest was added along with depreciation, property insurance premiums and maintenance, all at the same time, in late October 1987. While this confirms the fact that in subparagraphs (e) and (l) the essential focus of the Parties was on real property as opposed to interest generally, in the view of the Panel the wording of a particular illustration, and the negotiating history of that wording, would not convert an illustration into anything more or less than an illustration of a definition already stated in general terms in the preceding text of Article 304.

38. The second opposable pair deals with royalties:

Royalties

including ...

f) royalty, licensing, or other like payments for the right to the goods;

 

but not including ...

k) royalty payments related to a licensing agreement to distribute or sell the goods;

The included royalties "for the right to the goods" is characterized by the United States as the cost of acquiring "any rights (normally intellectual property rights) that otherwise would preclude the sale of the goods in the open market". 21 However, as (k) precludes royalties under licensing agreements for distribution or sale of the goods, the royalties included in (f) would appear to relate to the production of the goods rather than to their sale.

39. The Parties demonstrated by these two sets of opposable pairs that the same type of payment (mortgage interest, royalties) would reasonably be included or excluded, depending on its relationship (or the lack of it) to the production of goods. The first message, therefore, is that it is the relationship of the cost to production, rather than the form of the payment, or the security for the payment, that is the key to "reasonableness".

40. Secondly, the illustrations are not self sufficient, but must be related in each case back to the two-pronged definition in the opening words of Article 304. If, for example, subparagraph (e) were treated as a "stand alone" definition, money could be raised on the security of a mortgage and used for purposes other than the production of goods, and would be an "included" cost so long as the real property supplied as security for the loan were used for the production of goods. The text of the issue submitted to this Panel states that the mortgage money in question is used for acquisition of the real property mortgaged, but use of the money for acquisition is not a formal requirement set out in subparagraph (e). Nevertheless it is clear from the context of Article 304, read as a whole, that the Parties did not contemplate the inclusion of interest on money raised on the security of existing real estate (even where such real estate is used in the production of goods) if the proceeds of the loan are used for non-production purposes.

41. Thirdly, a comparison of the opposable pairs confirms that the lists are not intended to be exhaustive. No doubt those who drafted Article 304 recognized that real property could be used for purposes other than the two uses explicitly mentioned, i.e. production of goods or administrative functions. Real property could be used, for example, for the location of a sales outlet. Equally, subparagraph (f) specifically refers to "royalty, licensing and other like payments" whereas no such expansive language is used in subparagraph (k). Nevertheless, the Parties did not intend that the only type of royalty to be excluded under subparagraph (k) would be "royalty payments related to a licensing agreement to distribute or sell the goods". Royalties for the use of a corporate logo, for example, would clearly be excluded, yet such a use is not explicitly excluded in subparagraph (k). If the list of excluded costs was not intended to be exhaustive, there is no reason to believe the list of included costs was intended to be exhaustive. The common denominator of both lists is the focus on the relationship of the cost, or the lack of it, to the production of the goods.

42. Quite apart from the fact that the enumerated lists in Article 304 are introduced by the words "including" and "but not including", and are thus prima facie illustrative rather than exhaustive, the drafting of the illustrations themselves thus refute any contention that the illustrations are to be treated as an exhaustive code.

43. Fourthly, the list of inclusions indicates an extended reading of the concept of "production", encompassing not only the cost of the means of production and labor but also the "development, design and engineering costs" under subparagraph (d). In the normal course of events development costs will largely predate commercial production. Labor costs are to be included, not only where the labor is consumed in the production of the goods, but also in such ancillary matters as the storage and shipping of the goods, and management at the location of the process or assembly, according to subparagraph (a).

(b) Interpretation of "interest"

44. Armed with these preliminary observations, we now turn to the text of the question submitted to the Panel, which for ease of reference is reproduced in part as follows:

"To determine ... [the inclusion or exclusion of] 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

(iii) equipment,

used in the production of goods ..."

45. The Panel approaches these terms of reference on the footing that "interest" is to be understood to mean bona fide interest incurred under a loan agreement entered into on arm's length terms in the ordinary course of business, (which of course includes the normal practices associated with the commencement of production as well as with subsequent stages of production). Transactions that do not satisfy these criteria create a particular set of problems that will be addressed later.

(c) The treatment of mortgage interest

46. The starting point for the Panel's analysis is the text of subparagraph (e) in which the Parties explicitly agreed that it would be "reasonable" to include

"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"

(emphasis added)

In order to fully understand what the Parties meant by this illustration it is necessary to consider the content of what the Parties have compendiously described as "real property". The term has a well known significance under the law of both Canada and the United States as including more than land. In the United States, its meaning is readily ascertained in such widely available standard legal works as Corpus Juris Secundum (1985 edition) at volume 36A p. 587 which states:

"1. Definition and Nature and Requisites of Conversion into Realty in General

The law recognizes that, under certain circumstances personal property becomes a part and parcel of real property and thereafter assumes the status of real property. In fact it is an ancient maxim, which in the language of antiquity is expressed 'quicquid plantatur solo, solo cedit,' that whatsoever is fixed to the realty is thereby made a part of the realty to which it adheres, and partakes of all its incidents and properties."

(emphasis added)

47. At p. 620 of the same authority consideration is given to the status of buildings:

"Buildings. The character of a building and its adaptability to the purposes for which the land is used have been held to be factors to be considered in determining whether or not it constitutes a fixture. Ordinarily, however, buildings placed on the land have been regarded as part of the realty, occasionally without reference to any actual fastening to the ground, on the theory presumably that they are accessory to the realty as being necessarily, or at least presumptively, built for the purpose of improving it, although buildings of light construction, especially if not firmly attached to the land, have occasionally been regarded as personalty, as being evidently annexed for temporary purposes only."

(emphasis added)

It appears to the Panel that industrial and manufacturing plants would ordinarily meet this test to qualify as "real property".

48. As to machinery and equipment, Corpus Juris Secundum (1985 edition) vol. 36A at p. 620 goes on to state:

"Machinery or apparatus in buildings. The test of the character of the article annexed, as related to the use to which the realty is devoted, has been applied in connection with machinery or apparatus in a building, it often being said or held that when a building is erected for, or permanently adapted or devoted to, a particular purpose, anything annexed to the building for the carrying out of that purpose may be considered as accessory to the realty itself, while such articles annexed merely for the purpose for which the building happens at the time to be used are not to be so regarded.

It has sometimes been said that the chief test in the determination is whether the machinery is permanent and essential to the purpose for which the building is occupied or employed. In this test no distinction is made between machinery placed in a factory erected for a specific manufacturing purpose and like machinery placed in a building constructed for an entirely different purpose, but thereafter converted to a use for which the machinery is essential."

(emphasis added)

Once again, to the extent machinery and equipment is "permanent and essential to the purpose for which the building is employed", and is attached in some way to the building or to the soil on which the building is erected, it becomes as much part of the "real property" as the land itself.

49. Canadian law is to the same effect. Generally available legal dictionaries include Dukelow and Nuse The Dictionary of Canadian Law (Carswell 1991) which states:

"REAL PROPERTY. 1. Includes messuages, lands, rents and hereditaments whether of freehold or any other tenure whatever and whether corporeal or incorporeal and any undivided share thereof and any estate, right or interest other than a chattel interest therein. 2. The ground or soil and everything annexed to it, and includes land covered by water, all quarries and substances in or under land other than mines or minerals and all buildings, fixtures, machinery, structures and things erected on or under or affixed to land. 3. Includes any estate, interest or right to or in land, but does not include a mortgage secured by real property."

(emphasis added)

Support for the underlined words may be found in Haggert v. Town of Brampton (1897) 28 S.C.R. 174, at p. 182, where the Supreme Court of Canada held manufacturing machinery and equipment to be real property as between mortgagor and mortgagee in the circumstances there under consideration.

50. In light of the ordinary legal meaning of the term "real property" in both the United States and Canada, it must be accepted that a mortgage secured on "real property" would include not only the land, but plant and equipment sufficiently annexed to the land to become "fixtures", and that the Parties to the FTA have already expressly agreed that interest paid on the whole of the debt so secured would reasonably be included as an allowable cost under Article 304.

51. The United States made various arguments based on the different accounting treatment accorded in some circumstances to "land" as distinguished from buildings and other equipment. The Panel accepts the United States point that "land" as such is not depreciated. However, the Parties chose to employ in subparagraph (e) the concept of mortgaged "real property", which clearly includes manufacturing plants and fixed production equipment which are depreciated, as well as land which is not depreciated. These accounting arguments therefore do not provide any basis for differentiating non-mortgage interest from mortgage interest in respect of real property in its entirety.

To Continue with The treatment of non-mortgage interest


21 U.S. Second Submission, p. 16.