First State-to-State Dispute Under CUSMA on Dairy Quotas—Good News for Distributors and Consumers?

January 12, 2022

Written By Darrel Pearson, Jonathan Fried, Jessica Horwitz and Valerie Hughes

The Panel Report in Canada—Dairy TRQ Allocation Measures, released on January 4, 2022, resolved the first State-to-State dispute under the Canada-United States-Mexico Agreement or "CUSMA" (also known as USMCA). The Report is significant on a number of fronts.

1. The Panel determined that Canada is prohibited under the CUSMA from reserving dairy allocations solely for dairy processors but affirmed that, so long as Canada does not block access to tariff-rate quotas by non-processors, it is free to allocate quotas to whichever entities it chooses. The practical economic impact of this decision on the U.S. and Canadian dairy industries is unknown at this point, as Canada has not yet made public which steps it intends to take to bring its practices into compliance with the ruling.
2. Depending on how Canada implements the decision, the result could have significant implications for U.S. exporters and Canadian retailers, distributors and consumers.
3. The Panel granted leave to a non-government entity—the International Cheese Council of Canada—to submit written views to the Panel. This was never permitted in State-to-State disputes under the old NAFTA and may signal that this type of participation could happen regularly under the CUSMA. This presents important opportunities for industry participants in future dispute settlement processes.
4. In contrast to the chronically deadlocked mechanism under the old NAFTA, this ruling proves that the CUSMA State-to-State dispute settlement mechanism works well and is an efficient means of resolving trade issues. This is important because the usual means of resolving such disputes in recent years—resort to the WTO dispute settlement system—can no longer guarantee binding dispute settlement as a result of actions by the United Sates to force the WTO Appellate Body to shut down.

What Was the Dispute About?

The dispute concerned dairy imports into Canada and whether Canada acted inconsistently with its treaty obligations under the CUSMA in the way it administers tariff-rate quotas (TRQs) on dairy products. A TRQ is a mechanism whereby a country imposes a zero or low customs duty on imports of certain products up to a specified quantity, and once the quantity has been imported, the customs duty on additional imports becomes much higher. In the case of dairy products, these higher rates can be more than three times the value of the product, which effectively makes imports above the initial quota amount uneconomical. Canada granted the United States new TRQ access in 14 categories of dairy products as part of its concessions during the CUSMA negotiations.

The United States challenged Canada’s practice of reserving between 85 percent to 100 percent of its dairy TRQs for Canadian “processors" (i.e., dairy product manufacturers) and "further processors” (i.e., manufacturers of other food products that incorporate dairy). The United States alleged that this practice is inconsistent with Canada’s obligations under the CUSMA—specifically, Article 3.A.2.11(b) of the Agriculture Chapter, which states that in administering an allocated TRQ, Canada (and the United States) “shall ensure that … it does not … limit access to an allocation to processors.” The United States argued that this provision prohibits Canada's practice of setting aside reserved "pools" of dairy TRQ volume for processors, to which non-processors do not have access. Canada countered that its reserved "pools" are not themselves "allocations" and that, in any event, non-processors have access to some quota, meaning that Canada is compliant with CUSMA requirements.

What Are the Practical Implications of Canada's Practice of Reserving Import Quota for Processors?

Canada's practice of restricting materially all of the quota for Canadian processors means that goods imported under the TRQs are almost all lower-value input products, such as industrial-sized blocks of cheese, rather than finished consumer products. This supports value-added economic activity in Canada, instead of in the United States, in processing these inputs into finished goods. The U.S. dairy industry wants to increase its exports of more expensive value-added dairy products, but Canadian processors generally do not have an interest in importing such goods because they compete with their own product offerings. If more of the Canadian TRQ were used for higher-value products, the value of the potential additional revenue for U.S. dairy manufacturers is estimated in the range of US$200 million annually. The United States argued in its submissions to the Panel that Canada's policies constrained the ability of U.S. dairy manufacturers to realize this economic potential.

Canada maintained that reserving allocations for Canadian processors is necessary to ensure predictability and stability of imports. It permits accurate forecasting and matching of supply with demand under Canada's dairy supply management system. Moreover, Canada asserted that it was never Canada's intention during negotiations to concede its right to restrict a substantial proportion of the quota to processors, and that this was made clear to the U.S. negotiators.

What Was the Outcome of the Dispute?

The Panel sided with the United States, determining that the prohibition in Article 3.A.2.11(b) of the CUSMA is intended to ensure access by non-processors to the quota generally, not merely to a restricted sub-allocation. However, the Panel acknowledged that Canada has wide discretion in developing allocation methods to administer its TRQs.

The Panel Report also left intact Canada's supply management system for dairy products. In fact, the United States stated explicitly in its submissions to the Panel that it was not challenging Canada’s supply management system in this dispute.

What Happens Now?

The Panel Report is final and there is no appeal. Canada and the United States have 45 days from issuance of the Report (i.e., until February 3, 2022) to agree on a resolution of the dispute.

Resolution could mean that Canada will eliminate the practice of reserving pools for dairy processors and provide broader access to those TRQs. This would benefit U.S. exporters and Canadian retailers, distributors and consumers, as it would increase competition at the distributor and retail level for dairy products in Canada. Such an outcome could have a negative impact on the share price of Canadian dairy processors, although it is possible that markets already priced this in as foreseeable following the conclusion of the CUSMA negotiations.

Alternatively, Canada and the United States could agree that Canada can continue its practice of reserving quota for processors only and, in return, Canada would pay the United States compensation for the loss of access to those TRQs. However, the United States is unlikely to agree to this approach because U.S. farmers and exporters are keen to access additional allocations gained during the CUSMA negotiations. Therefore, such an outcome would be politically unpalatable in the United States.

A third possibility is that Canada could discontinue its practice of reserving pools for dairy processors but modify its allocation methodology in a manner that has the effect of ensuring that similar quantities of quota continue to be granted to processors. In doing so, Canada would need to navigate carefully through a number of other commitments under the treaty, such as ensuring that procedures for administering TRQs are "fair and equitable," that each allocation is made in "commercially viable quantities" and "to the maximum extent possible, in the quantities that the TRQ applicant requests." In addition, Canada would not be able to "introduce a new or additional condition, limit, or eligibility requirement" on the utilization of a TRQ unless specific conditions are met. Although modifying the allocation method may be the most politically desirable for Canada, the United States can be expected to scrutinize any new approach carefully and will not hesitate to challenge anew any element that it considers falls afoul of the CUSMA obligations.

If the parties are unable to agree on a resolution of the dispute by February 3, the CUSMA allows the United States to retaliate against Canada, such as by imposing tariffs on imports of Canadian products into the United States until such time as the dispute is resolved. Canadian exporters should take note that such retaliation is not necessarily limited to dairy products, and could have an impact other sectors of the Canadian economy. This issue is therefore one that all Canadian exporters should monitor closely.

What Role Did Industry Participants Play in the Dispute Settlement Process?

Unlike under the NAFTA, the CUSMA permits industry participants to make submissions in State-to-State disputes. The International Cheese Council of Canada (ICCC), a not-for-profit association of small and medium-sized cheese importers and their suppliers, sought leave under CUSMA Rules of Procedure to submit written views to the Panel in the dairy dispute. The Panel granted leave after seeking the views of the disputing parties.

In its submission, the ICCC outlined the negative effects on its members and the Canadian economy of granting the majority of quota to domestic processors and limiting quota for distributors. It explained that due to a lack of sufficient quota, importers have been unable to fulfill orders, expand market share and create jobs in Canada. The ICCC also asserted that Canada’s actions in reserving a large proportion of the TRQ to processors violated its obligations under the CUSMA.

Canada countered the ICCC's assertions in written reply submissions, arguing that the ICCC submission contained factual inaccuracies and misleading claims and that its legal arguments were flawed. It asked the Panel to refrain from addressing the ICCC submission in its Report or to reject the ICCC’s arguments. The United States, in contrast, explicitly relied on statements in the ICCC submission to support some of its arguments.

The Panel did not explicitly reference the ICCC’s submissions in the Panel Report so it is impossible to know whether they influenced the outcome. Nevertheless, the fact that leave was granted suggests that participation by non-government entities may become a common feature in future CUSMA State-to-State disputes. This could be useful to future panels because of the unique perspective that non-governmental actors and industry stakeholders may have with respect to the often fact-based and complex issues that arise in these disputes. It also presents important opportunities for industry participants in future dispute settlement processes.

What Does this Dispute Demonstrate About the CUSMA Dispute Settlement Mechanism?

This dispute demonstrates that the CUSMA State-to-State dispute settlement mechanism is a reliable and efficient means of resolving trade irritants between Canada, the United States and Mexico. Unlike the mechanism under the NAFTA, which included loopholes allowing responding parties to avoid disputes by declining to nominate panelists, the CUSMA system has addressed those flaws such that if a party does not name panelists, another party will. In addition, this dispute proved that the system works efficiently; the dispute took about six months from the composition of the panel to the issuance of the Final Report.

This is good news given that the WTO dispute settlement mechanism—on which Canada has relied in several trade matters over the years including many against the United States—can no longer guarantee binding dispute settlement. Although the system is still functioning at the panel (first instance) level, the Appellate Body is no longer able to hear cases because the United States has blocked appointments of Appellate Body members (judges) because of its dissatisfaction with, among other things, the Appellate Body’s interpretive approach. Thus, if a party is successful at the WTO panel stage, the losing party can appeal the matter, but there is no one to hear the appeal. So far, 21 WTO panel reports have been “appealed into the void.”

Bennett Jones has extensive experience in advising businesses, governments and other organizations on the impacts of free trade agreements and related disputes. To discuss the implications of this ruling for your organization, please contact a member of the Bennett Jones International Trade and Investment group.

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