QuickCounsel

Exporting Canadian Oil and Gas: The Challenge of NAFTA Compliance

By Glenn A. Cranker & Harold K. Andersen, Stikeman Elliott LLP

Overview
Consequences of Non-NAFTA Status
How Canadian Crude Oil and Natural Gas Lose NAFTA Eligibility
The Challenge of Establishing NAFTA Eligibility
Conclusion
Additional Resources

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Overview

One of the most important features of the North American Free Trade Agreement (“NAFTA”) is to eliminate customs duties on “originating goods” of the NAFTA Parties. The Rules of origin specify that “a good shall originate in the territory of a Party where… the good is wholly obtained or produced entirely in the territory of one or more of the Parties”. At first blush, this would appear to indicate that crude oil or natural gas extracted within Canada would originate and qualify for duty-free entry when imported to the United States.

Customs and Border Protection (“CBP”) has not, however, accepted general representations that Canadian crude oil or natural gas is originating and, therefore, qualifies for NAFTA preferential tariff treatment. Before confirming an importer’s entitlement to the Canada rate of free, CBP has required the production of properly completed NAFTA certificates of origin, and in some instances, additional proof no party added non-originating materials to the oil or gas before export. This QuickCounsel provides an overview NAFTA eligibility for Canadian petroleum products and the consequences of non-NAFTA status.

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Consequences of Non-NAFTA Status

The consequences of an importer being unable to substantiate NAFTA eligibility of crude oil or natural gas imported into the United States can be severe. In the case of crude oil, the duty rate jumps from the NAFTA rate of “free” to 5.25¢ or 10.5¢ per barrel. Natural gas will still qualify for a general “free” rate. However, Merchandise Processing Fees (“MPF”) of up to $400 a day will apply to non-originating crude or natural gas pipeline entries.

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How Canadian Crude Oil and Natural Gas Lose NAFTA Eligibility

Producers often blend bitumen and heavy crude with condensates or diluents (“Diluent”) to transport the oil by pipeline. When this occurs, the blended crude will no longer qualify as “wholly obtained or produced” in Canada, and alternative rules of origin will be necessary to qualify the blended crude. The crude oil will qualify for NAFTA status if the person who has supplied the NAFTA certificate can establish that only NAFTA originating Diluents have been used for blending. Alternatively, where non-originating Diluent materials are added or the origin of the Diluents is unknown, the crude oil will qualify for duty-free entry into the United States only if it can be established that the blending of the Diluents with the bitumen or heavy crude resulted in an applicable change in tariff classification set out in Annex 401 of NAFTA.

The classification of goods in the Harmonized System (“HS”), which is common to the three NAFTA countries, is the foundation of the NAFTA rules of origin in Annex 401. Crude oil is classified in subheading 27.09 of the HS, the same subheading that covers certain types of Diluents. The NAFTA rule of origin for goods classified under heading 27.09 specifies that each non-originating material must be classified outside this heading. Accordingly, the applicable rule of origin will not be satisfied where Diluents classified under 27.09 have been used. In such instance, 100% of the blended crude will be regarded as non-originating, even though the percentage of non-originating Diluents may be small.

Although less prevalent a situation, Canadian natural gas will likewise lose its NAFTA status if it is commingled with non-originating natural gas before export. Subheading 2711.21 of the HS covers natural gas in its gaseous state. The applicable NAFTA rule of origin for subheading 2711.21 provides that any non-originating materials added to the Canadian gas must be classified outside that subheading or 2711.11. Accordingly, when non-originating LNG (also classified in subheading 2711.11), is blended with Canadian origin gas before export to the United States, NAFTA eligibility may be lost.

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The Challenge of Establishing NAFTA Eligibility

When a producer of crude oil or natural gas transfers the product into a pipeline at the well, the producer should be in a position to provide a NAFTA certificate of origin attesting that the oil or gas has been wholly obtained or produced in the territory of Canada. If the crude is blended with Diluents to improve pipeline flow, the producer must have adequate records to establish that only originating materials have been added. Alternatively, where the producer or shipper is unaware of the origin of the Diluents or has knowledge that they are non-originating, NAFTA certification is possible only if the person has determined that the Diluents make an acceptable change in tariff classification as required by Annex 401. For example, if only butane or naphtha are blended, both are classified outside heading 2709 and would make an acceptable tariff shift.

In certain cases, a shipper may not have knowledge of the origin or tariff classification of Diluents. For example, originating and non-originating Diluents may be stored in a common tank. In such instance, it may be possible to qualify a portion of the blended crude under the fungible goods rules in NAFTA by following an acceptable inventory management method.

• Traders and wholesalers purchasing crude oil downstream are faced with even more difficult challenges before they will be in a position to provide NAFTA certificates of origin. Where a person signing a NAFTA certificate is not the producer, the person must declare that:
• The certification is based on his own knowledge that the good meets the applicable rules of origin;
• The certification is based on a written representation of the producer; or
• The person has obtained a certificate of origin from the producer.

Often a wholesaler or trader who purchases oil or gas in the pipeline will have no knowledge of the producer and will be unable to obtain written representations or certificates of origin from the producer. In such instance, it will be extremely difficult for the wholesaler to certify NAFTA eligibility based on its own knowledge that the crude oil meets the applicable rule of origin. If the wholesaler does issue a certificate based on an unsubstantiated belief of NAFTA eligibility, the CBP upon subsequent verification may decide to reject the certificate. In which case, the importer who relied on the faulty certificate and declared the Canada duty rate of free may be assessed additional duties, MPF, interest, and possible penalties.

One can reasonably expect that the importer would seek reimbursement from the person who incorrectly certified NAFTA eligibility. Parties to purchase and sale arrangements in respect of crude oil or natural gas where NAFTA eligibility may be an issue should be comfortable that the nature and extent of their contractual arrangements are sufficient in a number of respects. Such contractual arrangements should either provide for the necessary written representations or for the provision of the certificate of origin, and the indemnification provisions in such contractual arrangements should be operative in the event of a breach of such written representations or if the information set out in the certification of origin is false. Consideration should also be given to additional potential credit exposure for non-NAFTA eligible product and the inter-play of certain industry standard contractual rights in that respect, including set-off.

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Conclusion

Industry has proposals before the governments of Canada, the United States, and Mexico to liberalize the rules of origin and allow greater blending of Diluents without tainting NAFTA eligibility. However, amendments to the rules of origin will require tripartite approval and no quick fix is likely.

For the time being, Canadian exporters of crude oil and natural gas who complete certificates of origin must be satisfied that they have adequate documentation to substantiate claims of NAFTA eligibility. Duly completed certificates of origin from producers are recommended. Additionally, when an exporter has reason to believe that Diluents have been added to Canadian bitumen or heavy crude, the person completing the NAFTA certificate of origin should be aware of the origin of the Diluents, their tariff classification and whether commingling of originating and non-originating materials has occurred. Likewise, before claiming preferential tariff treatment, an importer into the United States must take reasonable care to assure that NAFTA certificates of origin have been correctly completed and that the exporter has adequate knowledge and documentation to substantiate the certification.

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Additional Resources

ACC Resources

• ACC Webcast (2011): Liquefied Natural Gas (LNG) Primer 101
• ACC Quick Reference (2010): Cross Border Checklist: Doing a Deal in Canada
• ACC Article (2010): Overview of Oil & Gas Law in Canada

Web Resources

• NAFTA Rules of Origin (2011)
• NAFTA Certificate of Origin (2011)
• NAFTA – Originating Crude (American Petroleum Institute, 2011)
• Rethinking NAFTA Certification of Canadian Heavy Crude Oil (Canadian Association of Petroleum Producers, 2010)

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