Smoke & Mirrors

Smoke & Mirrors
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Yesterday the head of Samsung Electronics’ (005930.KS) visual display business (TV sets) stated that the company’s TV business will be ‘less affected’ by US tariffs than competitors, as most of the TVs (monitors and speakers also) sold in the North American market are assembled in Mexico.  Although the company will make production reallocations for ~10 manufacturing bases around the world based on the newest reciprocal tariffs imposed on April 2, he sees less risk than most.  While we are certainly used to the glass half full perspective typically foisted by display executives, we delved a bit further to see if we could verify this positive implication.
Back in November of 2018 the USMCA was signed during the G20 summit.  A revised version was implemented on July 1,2020 under President Trump.  This agreement essentially allowed duty/tariff-free trade between the US, Canada, and Mexico for products that qualified under the specifics of the agreement.  Any products that are  non-qualifying would be tariffed at whatever the applicable border tariff is at the time of entry.  The agreement itself is summarized in a page or two, however the actual agreement is 34 chapters in length, not including annexes and side letters, and to put that into perspective, Chapter 4 (Rules of Origin) is a mind-numbing 270 pages of rules, regulations, lists, and tables.  That said, it all boils down to two metrics., rules of origin and regional value content,
As noted, Chapter 4 of the agreement (Rules of Origin) is quite detailed starting with definitions that have a distinctively governmental ring (“Reasonably Allocate” is defined as “the means to apportion in a manner appropriate to the circumstances.”) but come down to if a product has a significant portion of its content manufactured in or contains material from the US, Mexico, or Canada, it may be exempt from tariffs.  The use of ‘significant’ left us a bit confused as to whether that meant 10%, 50% or 80%, so we dug deeper and found that in order to know what ‘significant’ really means, one has to be able to calculate RVC.
RVC stands for Regional Value Content.  This can be calculated in two ways.

Simply, Transaction value (TV) less the value of non-originating materials (VNM) over the transaction value
or

Simply, Net cost of goods (NC)  less the value of non-originating materials over Net cost of goods
Of course, this leads to the question of what can be included in the Net cost of goods calculation, and we found that NC is the total cost of goods less:

• Sales Promotions
• Marketing
• After-Sales service costs
• Royalties
• Shipping & Packing
• Non-allowable interest costs (interest greater than 700bps above current Fed rate)

While these sound almost legit, Article 4.7 allows each party to reduce the value of non-originating materials (the bad part of the equation) by subtracting the cost of:

• Freight
• Insurance
• Packing
• Duties
• Taxes
• Brokerage fees
• Non-recoverable scrap

…essentially increasing the portion of complying materials by reducing the value of the non-complying materials, making it easier to be considered ‘significant’.  Additionally, when it comes to intermediate materials, those produced by any of the three countries that are used in production but might not be in the end product, they are considered an originating material even though they are not in the actual final product, further expanding the significant portion of items and materials.  While from a business standpoint all of these exceptions seem almost normal but are stacked toward making products and materials more likely to comply with the USMCA and cross the US border untaxed, but rather than break the agreement, creating a truly cross-border tariff with no exceptions, the current administration has finagled the system into looking like it is putting immense pressure on Mexico and Canada, while it lets a considerable amount of product through untaxed.  We are not encouraging a more stringent trade policy with Mexico and Canada, only commenting on the way the current policy seems to have been imposed.
At this point we stopped digging as the mire of legalese, definitions, qualifications, appendices, and sub-articles, along with 17 pages of procedures and obligations would have required an inordinate supply of Tylenol™ to combat eye-strain.  Nevertheless, it becomes obvious that the agreement was designed to facilitate low or zero duty trade between these three countries for a large number of products.
This brings to point the fact that the tariffs that President Trump has levied on Mexico and Canada are now only applied to non-compliant items, those without the ‘significant portion’ of their being material originating in each country.  This leads one to better understand Samsung’s point that the new tariffs will have only a moderate effect on its TV set shipments to the US, as we expect most of what Samsung assembles in Mexico is already ‘compliant’ under USMCA rules.  There also seems to be considerable leeway in the way some of the rules can be interpreted and even more stretch in the ‘Certificate of Origin’ that importers must supply, which can cover either a single shipment or a number of shipments over an extended period.  We are not sure whether President Trump understands these loopholes, although we expect the current US Trade Representative does, or whether the President is using them to present a ‘big stick’ to the public while trying to negotiate better deals on the side, but it seems to us that the bluster over tariffs on our closest neighbors is a bit more smoke and mirrors than originally thought and is certainly more flexible than it might seem on the surface.