The White Paper’s Answer to the ‘Brexit Trilemma’ (Part II)

Chloé Papazian (European University Institute/ Dublin City University)

The previous blog on this issue argued that the UK Government’s White Paper published on 12 July 2018 reflects a fundamental trilemma that the UK faces with respect to its future relationship with the EU and its trade policy. Post-Brexit, the UK may be unable to concurrently: (i) regain its internal and external sovereignty allowing the country to take back control on internal regulation and to conduct an independent trade policy, offering more advantageous conditions to its partners around the world; (ii) preserve an open border between Northern Ireland and Ireland; and (iii) maintain its access to the EU Single Market on goods permitting the UK to sustain the complex integrated supply chains between the two territories.

Previously, we focused on the big picture by explaining the peculiarities of the UK Government’s proposals included in the White Paper. To solve the ‘Brexit trilemma’, the UK Government makes various legal acrobatics. It proposes to establish a ‘Facilitated Customs Arrangement’ (FCA) with the EU within which goods will circulate freely without customs duties. Offering a framework going beyond a simple Free Trade Agreement (FTA), the UK Government commits to abide to a common rule book with the EU for manufactured goods, as well as for agricultural, food and fisheries products. The common rule book would ensure complete regulatory equivalence between EU and UK rules and thus remove potential obstacles to trade in goods arising from divergent internal regulations.

To conduct an external policy independently from the EU while avoiding a hard border between Ireland and Northern Ireland, the UK Government proposed in its White Paper to levy both the EU and the UK tariffs at its border. The customs arrangement put forward by the UK is unprecedented. For third-country goods intended for the EU, the UK will levy the applicable common external tariff of the EU. For third-country goods intended for the UK, the country will collect the UK tariff. As argued by the UK Government, the distinction between goods intended for the EU and goods intended for the UK would be straightforward when the goods concerned are finished. For intermediate goods, however, the UK customs authorities may not be able to clearly know the final destination of the goods in 4 percent of cases. In such case, the UK customs authorities would levy the higher of the EU or the UK tariff. A repayment would be provided if the product’s destination was later identified to be the lower tariff’s jurisdiction.

The present blog focuses on three technical elements included in, or implied by, the White Paper underpinning the idea that post-Brexit, the UK Government will not be able to accommodate its three objectives without entirely or partially undermining one.

 

1. Rules of origin between the EU and the UK

The White Paper does not set criteria to distinguish finished from intermediate goods. To avoid potential frauds, the EU and the UK will have to agree on a common definition, as well as on rules of origin. What are rules of origin for? Why would they be relevant in a future EU-UK economic partnership? What would be the possible consequences of such rules of origin for the ‘Brexit trilemma’?

Generally speaking, rules of origin aim to determine the origin of a product entering a country. They serve inter alia to decide which tariff should apply to an imported product: the most-favoured nation tariff included in the importing country Schedule of Concessions and Commitments before the WTO, or a preferential tariff. In the former case, both the exporting and the importing countries are WTO Members and did not conclude a preferential trade agreement (PTA) between them. They therefore trade on WTO-terms. The applicable tariff to the product originating from the exporting product corresponds to the tariff bindings made in the WTO Good Schedules of the importing country. In the latter case, both the exporting and the importing countries are WTO Members, but they also concluded a PTA between them. They thus trade on preferential terms. Parties to a PTA generally negotiate lower applicable tariffs than the ones applicable at the WTO level and enshrined in their respective Schedules. Hence, when a good enters a country, its origin will determine the applicable tariff. In a world of complex global supply chains stretching across multiple countries, identifying the origin of a good may not represent an easy task. A product often contains numerous inputs manufactured in different parts of the world.

Against this backdrop, rules of origin are indispensable to settle the origin of goods. They also constitute a pivotal tool to prevent potential fraud: exporters and importers together may want to benefit from the lower tariff, generally the one concluded on a preferential basis. In a Free Trade Area (FTA) or a Customs Union (CU), tariffs are very low or equivalent to zero. The GATT 1994 sets conditions in this respect. As required by Article XXIV:8(a) and (b) of the GATT 1994, tariffs and other restrictive regulations of commerce must be eliminated on substantially all the trade between the different territories of a CU or an FTA in products originating in such territories. Note that the main difference between a CU and an FTA concerns the trade policy applicable to third countries: while an FTA does not need to adopt a common external trade policy with respect to third countries, each member of the CU must apply substantially the same duties and other regulations of commerce to the trade of territories not included in the union (Article XXIV:8(a) GATT 1994). For instance, the EU Customs Union applies an EU Common Customs Tariff.

Why are rules of origin instrumental to avoid possible frauds, and how would fraud arise in the absence of clear rules of origin? Take the example of Countries A, B and C which are linked by an FTA and exporters of Country D wishing to export products to Country B. Country A, nevertheless, applies a lower external tariff as compared to Country B. Country D’s exporters may therefore be tempted to pick the lowest tariff jurisdiction (Country A) to export their products as they will then freely circulate between the three countries. To avoid this form of circumvention, the FTA will conclude common rules of origin. For instance, a product entering Country B from Country A will need either to be wholly produced in Country A, or to have undergone sufficient working or processing operations in Country A. In other words, a third-country product intended for Country B cannot enter from Country A to eschew the higher external tariff applied by Country B. A third-country product first imported into Country A and then circulated to Country B would need to be subject to sufficient working or processing operations. Insufficient working or processing operations could relate inter alia to simple packaging operations, affixing of distinguishing signs on products or on their packaging, or operations consisting in classifying, washing, painting or cutting up the goods.

For CUs, the potential for fraud is more complex as the territories which form part of the CU will likely have agreed on a uniform external tariff. Nonetheless, the EU-Turkey Customs Union may constitute a relevant example. Goods covered by the EU-Turkey Customs Union travel freely between the two territories without any customs duties or requirements. For third-country products imported into Turkey, the Turkish customs authorities collect the EU Common Customs Tariff agreed before the WTO at the Turkish borders. The agreement, however, concerns only industrial goods and processed agricultural products. For agricultural as well as coal and steel products, the EU and Turkey made reciprocal trade concessions in the form of reduced tariffs and tariff quotas. They therefore apply with respect to these products, a different external tariff. While the EU levies the EU Common Customs Tariff for agricultural, coal and steel products imported into its territory, Turkey applies its own external tariff. Because Turkey is a WTO Member, the Turkish tariff lines for these products can be found in its Goods Schedules agreed at the WTO level and annexed to the Marrakesh Agreement. As it may seem obvious to the reader, the EU and Turkey needed to agree on a common definition clearly distinguishing agricultural goods from processed agricultural products to avert abuses.

The peculiarity of the future FCA between the EU and the UK relates to the offer made by the UK Government to levy both the EU tariffs and the UK tariffs at its border depending on the destination of the good. Such a legal framework would, according to the White Paper, entirely remove the need for customs processes between the UK and the EU, including customs declarations, routine requirements for rules of origin, and entry and exit summary declarations. The proposal means that the UK would have to apply at its external border the EU preferential and non-preferential rules of origin, as well as its own future preferential and non-preferential rules of origin. On behalf of the EU, the UK customs authorities would determine whether an imported product destined to the EU must receive most-favoured nation treatment or preferential treatment. For this purpose, the UK Government commits to comply with the EU Customs Code and related legislations.

Yet, it appears unlikely that the EU would delegate such a task to a trade partner outside the EU. Furthermore, the EU may fear possible abuses on the part of third-country exporters or UK importers. In particular, should the UK concede lower tariffs either at the WTO level or through a FTA, the EU would need to make sure that a third-country product allegedly intended for the UK undertook sufficient working or processing operations before freely entering the EU. This verification task may take place at the border, thereby reducing the ability for the UK to avoid any routine requirement for rules of origin between the two territories.

Let us take an example to illustrate better the argument. A good coming from a third-country enters the UK territory. UK importers may try to circumvent the EU higher tariffs and therefore could carry out minor working or processing operations on a product before importing it to the EU. In that case, the UK customs authorities would levy the applicable UK tariff. The EU could, nonetheless, request at the UK-EU border a proof attesting the origin of the product. Hence, following the proposal made in the White Paper, the EU and the UK would likely need to agree on rules of origin and fix what can be deemed as sufficient or insufficient working or processing operations on a good coming from a third-country and entering the UK. To prevent potential frauds, the EU customs authorities may establish controls to secure the origin of goods coming from the UK.

Rules of origin within the future EU-UK customs arrangement would therefore create two problems. First, a frictionless border without custom controls on goods circulating from the UK to the EU would unrealistically materialize. It could jeopardise the second objective and commitment of the UK, eg to prevent a hard border between Ireland and Northern Ireland. Second, controls at the border to verify the origins of the products may delay and disrupt integrated supply chains already existing between the two territories. Controls could raise transport and production costs in the two respective economies and hence undermine the third objective of the ‘Brexit trilemma’.

 

2. EU Tariff Rate Quotas

As suggested in the previous blog, after exiting the EU Customs Union, the UK will be a WTO Member on its own. The UK Government will therefore need to negotiate its own Schedules of Commitments and Concessions for goods and services. Negotiating new UK tariff lines may provoke important disruptions to trade not only between the UK and the EU, but also between the UK and its import/export partner countries. So far, however, the most difficult issue to solve relates to EU tariff rate quotas. What is exactly a tariff rate quota (TRQ)? Why are they relevant in a future EU-UK economic partnership? Which possible consequences would challenges related to TRQ have on the ‘Brexit trilemma’?

A TRQ constitutes a border measure applied by a WTO Member limiting the quantity of a given product that can be imported into its territory at a low or zero tariff. TRQ does not correspond to a quota in the strict sense of the term, nor to a quantitative restriction. TRQs of WTO Members are included in their Schedules of Commitments. They generally concern sensitive products such as food, agricultural products and raw materials. They are never levied on finished goods. When a WTO Member has a TRQ in place for a specific good, it allows a limited quantity of the product concerned to enter the country at a low or zero tariff rate. Once this quantity has been reached, a higher tariff rate applies to the imported product.

The EU 28 Member States has around 100 TRQs encompassed in its good Schedules. They all relate to food, and other agricultural goods (eg beef, cheese, butter, sugar, some vegetables, cereals and fruits). TRQs permit somehow to both satisfy third-country exporters by giving them access to the domestic market at a low or zero tariff rate and to protect domestic producers and farmers by applying higher tariffs after exhaustion of the limited quantity.

Once the UK leaves the Customs Union, the EU and the UK should have separate TRQs encompassed in their respective Schedules of Commitments. Until the end of 2017, it was not clear how EU TRQs would be divided between the EU and the UK. On October 2017, a common letter from the EU and the UK to the WTO Members shed light on the future approach. According to the letter, the EU’s (excluding the UK) and the UK’s (excluding the EU) TRQs would be calculated through “an apportionment of the EU’s existing commitments, based on trade flows under each tariff rate quota.” Hence, for every EU TRQ, an assessment of the past trade flows should be conducted to determine which quantity should be attributed to the two respective territories. The letter does not, however, set a clear methodology to follow. To measure the average past trade flows between the UK and the EU on a product subject to a TRQ, which years should be included in the calculation, and how many years should be considered? Should the average past trade flows be based on, for example, the past three or six years? For purposes of data availability, should the trade flows be evaluated between, for instance, 2010 and 2015? What would occur if trade data is not available on a given product, or if the division of past trade flows between the EU and the UK is not clear? Many challenges await the EU and the UK on this thorny issue.

The UK White Paper remains silent on the issue of TRQs. Their division between the EU and the UK will, however, likely create two problems, thereby threatening the UK Government endeavours to solve its ‘Brexit trilemma’. First, the division may not always lead to accurate results and may significantly disrupt the value chains existing in the agri-food sector between the two territories. Second, despite the commitment made by the UK Government to remove borders between their territory and the EU territory, and to maintain an open border in Ireland, such division is susceptible to re-introduce border checks through the backdoor. For management purposes, import licenses are required on all goods subject to a TRQ. Hence, to avoid frauds on products as sensitive as agricultural goods, food products and raw materials, both sides may establish border checks to verify whether the goods freely circulating between the UK and the EU originate from these two territories, or from third-countries.

 

3. Diagonal cumulation of local content (paragraph 23(c) of the White Paper)

A third technicality that could to undermine the UK Government’s objectives relate to paragraph 23(c) of the White Paper. In this paragraph, the Government suggests that to preserve the pre-Brexit global supply chains existing between the EU and its FTA partners, diagonal cumulation of content should be permitted between the EU, the UK and its FTA partners.

Without entering into too many details, diagonal cumulation incentivizes countries part of a diagonal cumulation system to use input materials from one another. Indeed, in a diagonal cumulation system, input materials from Country A exported to Country B and incorporated into a new product are deemed as originating from Country B when the new product is later exported to Country C. For such a system to work, Countries A, B and C will need to have an FTA with one another and have agreed on the same rules of origin. So far, unlimited diagonal cumulation only exists within the Pan-Euro-Mediterranean (PEM) origin system and only covers industrial goods. This PEM system includes the EU, the EFTA States (Switzerland, Norway, Liechtenstein, and Iceland), Turkey, the Faroe Islands, some countries of the Mediterranean (Egypt, Lebanon, Faroe, Algeria, Morocco, Jordan, Israel, Syria, the territories of the West Bank and Gaza Strip, Tunisia), and of the Western Balkans (Albania, the Former Yugoslav Republic of Macedonia, Bosnia and Herzegovina, Montenegro, Kosovo (1244/99) and Serbia).

Undoubtedly, through paragraph 23(c), the UK Government indicates its intention to form part of the PEM origin system. Yet, the paragraph seems to imply that the UK Government plans to conclude FTAs with EU FTAs partners (eg Canada, Mexico, Ukraine etc) and to propose a diagonal cumulation system between them. As put forward by the White Paper, “Diagonal cumulation would allow UK, EU and FTA partner content to be considered interchangeable in trilateral trade.” On the one hand, the UK Government’s proposal would be beneficial for both the UK and the EU: it preserves integrated supply chains existing within the PEM system and strengthens global supply chains. On the other hand, it weakens the possibility for the UK to establish an external trade policy independent from the EU. To obtain diagonal cumulation, many provisions of the FTA between the UK and its future partner – having already an FTA in place with the EU – would have to mirror the EU FTA.

 

In conclusion, despite the legal acrobatics put forward in the UK White Paper to reconcile the three ends of the UK Government, it seems unlikely the Government will find the right legal framework which will resolve the ‘Brexit trilemma’.

Chloé Papazian