What are Free Trade Agreements (FTAs)?

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Free Trade Agreements (FTAs)

Free trade agreements (FTAs) are reciprocal agreements used by groups of two or more countries to liberalise trade between them, for example, by reducing tariffs and non-tariff barriers on goods and requiring market access for suppliers of services. FTAs are permitted by the World Trade Organization (WTO) as an exception to the most-favoured nation (MFN) treatment rule if they meet certain requirements.

FTAs have grown rapidly over time both in terms of numbers and in their scope and coverage. This trend has accelerated particularly as a result the failure of the Doha Development Round negotiations at the WTO since 2001. With little prospect of further progress at the multilateral level, WTO members have increasingly turned to FTA negotiations as the principal means to liberalise trade.

What are FTAs?

FTAs are used by groups of two or more countries to liberalise trade between them. Increasingly, they also cover matters not related to trade.

Ordinarily, the WTO requires that preferential treatment granted to one WTO member must be extended to all other WTO members. This is known as the MFN rule. However, the WTO allows exceptions to the MFN rule for preferential trade arrangements. Preferential trade arrangements may liberalise the following without having to extend the same advantages to other WTO members:

  • Trade in goods, through the creation of a free-trade area or a customs union. The formal definitions of free-trade areas and customs unions are set out at Article XXIV:8(a) and (b) of the GATT 1994.
  • For both customs unions and free-trade areas, “duties and other restrictive regulations of commerce” must be eliminated with respect to “substantially all the trade” between members of the customs union or free-trade area. Trade restrictions that are permitted under certain specified provisions of the GATT 1994 do not have to be eliminated (including, for example, those permitted under one of the general exceptions at Article XX,
  • For customs unions only, “duties and other regulations of commerce” applied to countries that are not members of the customs union must be “substantially the same”.

Preferential tariffs

An FTA must eliminate tariffs on substantially all the trade between the parties. This allows some tariffs to be retained on particularly sensitive products. FTAs will also typically seek to limit any other customs fees and formalities in accordance with Article VIII of the GATT 1994 (for example, see Article 2.16 of the Agreement between the United States of America, the United Mexican States, and Canada (USMCA)).

Tariff reductions on particularly sensitive products may be implemented in phases over a specified period. For example, in the EU-Japan Economic Partnership Agreement (EU-Japan FTA) some tariff reductions are implemented in equal annual instalments over a set number of years (see Annex 2-A, Part 2, Section A, EU-Japan FTA). This allows industry some time to prepare for and adjust to the impact of the reduced tariffs. The GATT 1994 allows for phased reductions of this kind if they take place within a “reasonable period of time” (Article XXIV:5(c), GATT 1994), which should exceed ten years only in exceptional cases (paragraph 3, Understanding on the Interpretation of Article XXIV of the GATT 1994).

Some FTAs may also provide for tariff rate quotas (TRQs), under which a certain quantity of a particular good will be subject to a lower (or zero) tariff rate, following which a higher rate will be applied. TRQs are commonly used for agricultural products.

When making commitments on tariff reductions, negotiators will usually use the “HS Codes” of the Harmonized Commodity Description and Coding System as the starting point to classify goods (see WCO: Nomenclature and Classification of Goods).

In relation to those goods that remain subject to tariffs, FTAs will often identify circumstances in which tariffs must not be charged, for example for the temporary admission of goods for certain purposes (for example, see Article 2.7, USMCA), and the re-entry of goods into a customs territory for repair or alteration (for example, see Article 2.8, USMCA).

For more information, see WTO: Market access provisions on trade in goods in regional trade agreements.

Preferential rules of origin

To determine whether imported goods qualify for preferential tariff treatment under the FTA it is necessary to determine where the goods originate. FTAs address this by setting out preferential rules of origin.

Rules of origin are necessary, but if they are too restrictive or complex, they can act as a significant barrier to trade, as the costs of complying with the rules of origin may outweigh the benefits of qualifying for a preferential tariff. Costs of complying with preferential rules of origin include the costs of adjusting supply chains to reduce reliance on imported inputs (or inputs from other countries covered by the FTA), and also the administrative costs of demonstrating compliance. These costs may be exacerbated if exporters have to comply with substantially different rules of origin in different FTAs.

Some goods will originate entirely in the territory of one of the parties to the FTA, including natural goods grown in the territory and products manufactured entirely from those goods. These are referred to as “wholly obtained” or “wholly produced” goods and will be treated as originating (for example, see Articles 3.2-3.3, EU-Japan FTA).

Many other goods will be less straightforward, for example, because the manufacturing process includes contributions from several different countries. The general approach to determine the origin of such products is to identify the place where the last “substantive transformation” of the product took place. There are several different methods that may be used to assess this, including:

  • Change of tariff classification. This method looks at whether the manufacturing processes carried out in a country resulted in a change of tariff classification, as would be the case, for example, when automobile components are imported and then transformed into a completed car. Less significant processes would not result in a change in tariff classification. For more information, see WTO: Background note by the Secretariat, Rules of origin based on the criterion of change of tariff classification, G/RO/W/178.
  • Value-added. This method considers whether a country has contributed a minimum proportion (often 50%+) of the value of the product in question.
  • Specific criteria. For some products, an FTA may specify a particular part of the manufacturing process that will determine the country of origin.

FTAs often also include de minimis or “tolerance” provisions, under which products that do not meet the usual substantial transformation test may still be considered as originating if the non-originating inputs constitute less than a minimal level (often around 10%) of the value of the good (for example, see Article 4.12, USMCA, and Article 3.6, EU-Japan FTA).

FTAs may also provide for different types of “cumulation”, under which goods from other countries may be treated as originating in the territory of an FTA party in certain circumstances. The advantage of cumulation is that it allows manufacturers to use inputs from other countries without losing preferential treatment for their exports.

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