CETA Opportunities for the Canadian Automotive Industry in Uncertain Times

June 22, 2018

Uncertain Times for the Canadian Auto Sector

On June 1st, the U.S. tariffs under section 232 of the Trade Expansion Act of 1962 were imposed on steel and aluminum products imported into the United States from Canada, Mexico, and the European Union when the exemptions for those countries expired (see “Nothing Goods Happens after Midnight: Canada, Mexico and the EU Hit with Tariffs on Steel and Aluminum”). This prompted Canada, Mexico, and the European Union to announce countermeasures in the form of retaliatory tariffs against a range of U.S. goods, including agricultural products (see “The Morning After: U.S. Allies Taking Retaliatory Measures against Trump’s Tariffs”) and to initiate dispute settlement proceedings at the World Trade Organization. The application of the section 232 tariffs to the United States’ closest allies, neighbours, and trading partners has been highly controversial in the United States, and a bill was introduced on June 21st to lift the tariffs against these countries.

In the meantime, the U.S. administration has directed the Department of Commerce to consider the application of similar tariffs of up to 25 percent on imported motor vehicles and automotive parts. Like the steel and aluminum tariffs, section 232 tariffs on Canadian automotive products would be extremely disruptive to North America’s highly integrated manufacturing industries . While the actual implementation of such tariffs seems unlikely, recent experience suggests that it should be considered a real possibility.

The loss of established supply chain efficiencies throughout North America as a result of the tariffs would drive up U.S. production costs, reducing profitability for manufacturers and/or increasing the consumer prices of new motor vehicles.  Some commentators consider that these measures are being threatened for the purposes of leverage in the troubled North American Free Trade Agreement (NAFTA) negotiations. However, if such tariffs were actually imposed, they would also discourage investment in production facilities and sources of supply outside the United States.

Whether or not the U.S. administration’s objective is to de-globalize and internalize U.S. automotive manufacturing and investment (see e.g., Pete Evans, “Trump pushes Big 3 automakers to build more cars in the U.S.” CBC News, 24th January 2017), this is a foreseeable outcome of the tariffs in the longer term. Consider, for the example, how the uncertainty generated by the negotiations to modernize the NAFTA, including the United States’ demand for a 5-year sunset clause, has already had a chilling effect on U.S. manufacturing investments in Canada and Mexico. This would also be consistent with the U.S. administration’s interventions in late 2016 and early 2017 to prevent Toyota and Ford from investing in production and assembly lines in Mexico.

For Canadian companies, there is currently no alternative to the integrated North American industry or the U.S. market for motor vehicles. In 2017, the total value of Canadian exports of motor vehicles (including gasoline, diesel, hybrid, and electric-powered passenger vehicles under HS tariff subheadings 8703.21 through 8703.80) was valued at almost $60 billion, of which about $57 billion (95 percent) was accounted in exports to the United States.

Nonetheless, manufacturers of finished motor vehicles and automotive parts in Canada will be carefully planning for the worst-case scenario and considering all of the options that might be available to mitigate the harm caused by the tariffs.

It is in this context that the relevant provisions currently in force under the Canada-EU Comprehensive Economic and Trade Agreement (CETA) and the provisions pending under the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) are worth considering. In the event that the United States imposes section 232 tariffs on a long-term basis and/or ultimately withdraws from the NAFTA, these regional trade agreements and the opportunities that they provide will become increasingly important.

Canada-EU Trade in Motor Cars under the CETA

In terms of export opportunities for Canadian-origin motor vehicles, the EU is a mature, sophisticated, and well-supplied market, and EU design requirements may represent manufacturing challenges to Canadian production lines set up to assemble North American cars. While Canada’s exports of motor vehicles to the European Union have increased by more than 100 percent in the last few years — growing from $154.7 million (of $56.8 billion) in 2015 to $326.9 million (of $59.8 billion) in 2017 — they remain very modest in comparison to Canada’s NAFTA exports.

However, the base rate of customs duties that previously applied at 10 percent to imports of Canadian cars into the European Union is gradually being eliminated under the CETA, dropping to “free” as of January 1st, 2024. Under this preferential CETA tariff treatment, EU supply chain and export opportunities may become increasingly viable options for manufacturers in Canada.

Importantly, the CETA also provides important tools to spearhead and drive the growth of Canadian automotive exports to the European Union, including the highly liberal “origin quota” for motor vehicles set forth in Section D of Annex 5-A of the CETA Origin Protocol, and the product-specific rules of origin that are more advantageous to Canadian manufacturers than those set forth in the current NAFTA.

The CETA Origin Quota – A Turbo-boost for Canadian Auto Exports to the European Union?

The CETA origin quotas allow limited quantities of certain kinds of products to receive preferential tariff treatment if they satisfy “alternative” rules of origin that are much more liberal and relaxed — and therefore easier to satisfy — than the product-specific rules of origin that otherwise apply.

To start with, the ‘standard’ product-specific rules of origin under the CETA require that the value of all non-originating materials used in the production of a motor vehicle must not exceed 50 percent of the transaction value or ex-works price of the finished product. In other words, Canadian and/or EU materials must account for at least 50 percent of the vehicle’s value. This provides significant flexibility to automakers, allowing them to incorporate up to 50 percent of the value from outside the CETA region, which lowers their production costs and increases their competitiveness. It also encourages investors from third countries, e.g., Toyota or Mazda, to invest in Canadian assembly lines to supply both Canadian and EU markets.

Pursuant to footnote 5 in the CETA Origin Protocol, this rule of origin will change in 2024, increasing the minimum value of Canadian/EU “originating” materials to 55 percent and, in turn, reducing the maximum value of non-originating materials to 45 percent. However, both thresholds compare very favourably to the current NAFTA rules of origin, which require a NAFTA regional value content of not less than 62.5 percent. (In the negotiations to modernize the NAFTA, the United States has proposed increasing this threshold to 85 percent, together with a U.S. value content requirement of not less than 50 percent.)

Now we turn to the CETA origin quota, which allows Canadian exporters to receive preferential tariff treatment on up to 100,000 motor vehicles per year under relaxed rules that permit the value of all non-originating materials to be up to 70 percent. This means that Canadian/EU “originating” materials must account for only 30 percent of the value. This special threshold allows Canadian manufacturers to produce finished vehicles under highly competitive conditions. Accordingly, to the extent that manufacturers in Canada are in a position to take advantage of this origin quota, it could support market penetration and accelerate the growth of Canadian-built motor vehicles in EU markets. Notably, this origin quota only benefits Canadian exports to the European Union; there is no equivalent quota for EU motor vehicles shipped to Canada.

The Other Side of the Coin – EU Exports to Canada

Under the CETA, the rate of customs duty on EU-origin motor vehicles imported into Canada is being reduced in eight annual increments. The rate of duty that currently applies is 4.5 percent, and it will eventually become “free” on 1st January 2024. Notwithstanding the applicable customs duties, imports of EU-origin motor vehicles have been significant, and they have grown from $5.4 billion of $32.2 billion in 2015 (16.8 percent) to $6.7 billion of $36.2 billion in 2017 (18.5 percent). The vast majority of these imports have come from Germany. To the extent that imports of U.S. vehicles are affected by Canadian countermeasures, there is room for EU imports to supplement domestic production to satisfy Canadian market demands.

While the customs duty applicable to EU-origin parts, components and accessories was eliminated when the CETA entered into force, dropping to “free” on 21st September 2017, this was not a game-changer for Canadian production plants. This is because “parts, accessories and articles” may be imported into Canada from any country on a duty-free basis “for use in the manufacture of original equipment parts for passenger automobiles, trucks or buses, or for use as original equipment in the manufacture of such vehicles” under the special tariff classification code 9958.00.00. This provision has long allowed manufacturing and assembly plants in Canada to import parts on a duty-free basis regardless of their origin. This special tariff code does not apply, however, to after-market components that are offered by suppliers of maintenance and repair services as lower-cost alternatives to Original Equipment Manufacturer (OEM) replacement parts. Thus, the CETA preferential tariff treatment may provide a 6% benefit to Canadian importers and distributors of such articles, offering a more competitive alternative to after-market parts from other countries.

Conclusions

There is increasing uncertainty going forward for the integrated North American automotive industry and its markets. Long-established supply chain efficiencies rely upon NAFTA commitments that are at risk of being “modernized” with less-favourable terms or lost entirely. In addition, the current U.S. administration appears willing to impose measures, including arbitrary tariffs, that would nullify these commitments and cause severe supply chain disruptions. For manufacturers in Canada, opportunities to begin diversifying supply chains and markets beyond the United States — through the CETA, and possibly also through the forthcoming CPTPP and other regional trade agreements — may provide some small relief. Considering the current U.S. administration’s apparent agenda, such opportunities are certainly worth investigating as part of a larger strategy.

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