Rules of Origin

Rules of Origin (RoO) are the criteria used to determine the national source of a product. Think of them as a product's “passport,” proving where it was made. This isn't just a fun fact for a label; it's a critical mechanism in international trade. Why? Because access to benefits like lower tariffs or freedom from quotas under a free trade agreement (FTA) depends on a product proving it “originates” from a member country. For instance, for a car assembled in Mexico to be sold in the U.S. without tariffs under the USMCA, it must prove it's “North American” according to the agreement's specific Rules of Origin. This gets complicated quickly. If that car's engine is from Germany and its microchips are from Taiwan, RoO provide the complex legal framework to decide if it still qualifies. For companies, navigating these rules is a high-stakes game that directly impacts their costs and competitiveness.

At first glance, RoO might seem like a topic for trade lawyers, not investors. But for a value investor digging into a company's long-term health, understanding their impact is crucial. These rules can be the difference between a thriving business and one struggling with unforeseen costs. The core issue is how RoO affect a company's cost of goods sold (COGS) and, by extension, its profit margins. A business that masterfully designs its supply chain to comply with RoO for its key markets can ship goods with zero or low tariffs, giving it a powerful price advantage over competitors. This ability to optimize for trade rules can be a subtle but potent part of a company's moat, or durable competitive advantage. Conversely, a company with a rigid supply chain is exposed to significant risk. A political shift leading to a new trade agreement or a crackdown on RoO enforcement could suddenly slap tariffs on its products, crushing margins and sending the stock price tumbling. As an investor, you should assess how exposed a company is to these geopolitical shifts. A prime example is the electric vehicle (EV) industry. The U.S. Inflation Reduction Act provides tax credits to consumers, but only for EVs that meet strict RoO for battery components and minerals. An EV company that can meet these sourcing requirements can offer its cars at a much lower effective price to consumers, directly boosting sales and its stock's potential. A company that fails to do so is left at a major disadvantage.

While the specifics are notoriously complex, the methods for determining origin generally fall into two main categories.

This is the straightforward case. A product is “wholly obtained” if it was entirely grown, born, or extracted in a single country. Think of wheat harvested in France, coffee beans grown in Colombia, or oil drilled in Texas. There's no ambiguity about their “passport.”

This is where it gets tricky. For most manufactured goods, from t-shirts to iPhones, parts and labor come from multiple countries. The product must undergo a “substantial transformation” in one country to claim that country's origin. There are three common ways to prove this:

• Change in Tariff Classification (CTC): The product's customs code, known as a Harmonized System (HS) code, must change during production. For example, a company might import wood pulp (one HS code) into Vietnam and manufacture it into paper (a different HS code). This change in classification can “transform” the product, making it Vietnamese in origin.
• Value-Added (or Regional Value Content): This rule requires that a certain percentage of the product's final value must originate from the country or trade bloc. For example, an FTA might stipulate that to be considered “European Union” origin, at least 50% of the car's ex-works price must be attributable to EU parts and labor.
• Specific Manufacturing Process: Sometimes, an agreement specifies a critical process that must be performed in the origin country. For textiles, this might be the “dyeing and printing” of fabric. For a chemical, it might be the specific chemical reaction that must occur locally.

When analyzing a company that manufactures or sells goods internationally, use RoO as a lens to assess hidden risks and advantages. Ask these questions:

• Where does the company sell, and where does it make its products? Check for FTAs between these key countries. A company producing in Vietnam to sell to the EU benefits from their bilateral trade agreement.
• How diversified is its supply chain? Read the “Risk Factors” section of the company's annual report (like the 10-K in the U.S.). Heavy reliance on a single country for a critical component is a red flag.
• How sensitive are its profits to tariffs? Mentally “war-game” the scenario: If a 15% tariff were suddenly applied to their main product, how would it affect their ability to compete and generate cash?
• Does management talk about this? Listen for mentions of supply chain optimization, tariffs, or trade policy on investor calls and in presentations. A proactive management team will have a clear strategy and be able to explain it.