Key legal and business issues facing the automotive sector

PERSPECTIVE

Trade issues in the automotive sector

On-shoring

The tumultuous events that occurred during much of the Trump administration will continue to have effects in 2021. Some of these are longstanding trends that intensified between 2016 and 2020, whereas others are more recent.

The COVID-19 pandemic significantly affected global trade policy, highlighting global manufacturing supply chain vulnerabilities already weakened by geopolitical events of the last several years. The most notable of those, perhaps, is the rising challenge of China’s unique form of state-sponsored economic mercantilism, its challenge to the economic hegemony of liberal democracies, and the response of the U.S., Japan, the EU and similar countries.

The term “on-shoring” is on the lips of manufacturers throughout the world, most of all in the automotive sector. Geopolitical trade instability highlighted by the U.S.-China tariff war, the destabilization of the global trading system and retrenchment into economic nationalism has demonstrated the risk to manufacturers of global supply chains in immediate and concrete terms. While this affects manufacturers with global supply chains across industrial sectors, the automotive sector has unique circumstances and challenges that make the trend toward on-shoring particularly interesting.

In the last two to three years, a number of factors have converged to energize on-shoring. While the trend toward on-shoring began several years ago, the advent of managed trade in North America in the form of the United States-Mexico-Canada agreement (USMCA), replacing the more liberal NAFTA, has emphasized the importance of local manufacture and supply chains. The USMCA features higher domestic content requirements, unique steel and aluminum purchase and manufacturing requirements, relaxed rules for qualifying self produced intermediate materials, and other incentives for automotive manufacturers.

Furthermore, COVID-19 has laid bare the hidden costs and risks of diffuse global supply chains.

Following a period of trade disruption arising from the Trump administration China tariffs (and, more recently, limited tariffs directed at Vietnam and the threat of tariffs directed against EU automotive manufacturing throughout the Trump administration), the pandemic has demonstrated the negative side of relying on a diversified and far-reaching global supply chain. These negatives include rising freight costs, supply shortages and supply shutdowns, as countries managed their pandemic response in different ways and at different times. There is growing recognition that greater predictability arising from shorter lead times, shortened supply chains and controlling one’s own destiny offers real cost savings that until recently could not be quantified in the same way.

In an industry that is razor focused on cost control, two other interesting trends have contributed to the increased momentum of on-shoring – momentum that is expected to continue through and beyond 2021.

The increase in automation has reduced the significance of labour costs as part of automotive production. This is particularly so as advanced research in the form of software, firmware, cybersecurity and intellectual property more generally make up not only greater cost but require heightened supply chain security and shortened supply chains overall.

The concurrent benefits of reducing project-management complexity associated with on-shoring have also been felt, and have been reinforced by government policy seeking to protect valuable intellectual property and ensuring that North American manufacturing remains in a leadership position as the automotive industry changes from fossil fuel based products to electric, hydrogen, and autonomous vehicles.

As Elon Musk recently said, borrowing not very subtly from Mark Twain, “rumours of the demise of U.S. manufacturing are greatly exaggerated.” The policy orientations of the new Biden administration, although differing substantially in tone from the previous administration, will be substantively oriented the same way. Therefore, we expect this trend to intensify in 2021 and beyond, meaning that the automotive industry, from the original equipment manufacturer to the dealer, will become less global and more regional.

USMCA compliance challenges

At the heart of the USMCA negotiations were the automotive rules of origin. Unlike many parts of the agreement, they represent a significant departure from the equivalent provisions in the NAFTA. Overall, they are significantly more restrictive than those in the NAFTA, reflecting the objective of the Trump administration – an objective largely shared by Canada – to encourage higher levels of production in North America while stemming the flow of that production to Mexico.

When the USMCA is fully phased in, a passenger vehicle and its producer will need to satisfy four different origin requirements in order for the vehicle to qualify for duty-free treatment:

  1. The vehicle itself will need to satisfy a 75 per cent regional value content requirement;
  2. Certain “core” parts in the vehicle will need to qualify as “originating” in the USMCA region;
  3. The producer will need to source 70 per cent of its steel and aluminum in North America; and
  4. The producer will need to achieve “high-wage” labour value content requirements, totalling 40 per cent of expenditures.

The complexity of the USMCA’s automotive rules of origin will make their understanding and application a challenge for businesses in the sector, as will a lack of clarity around many of the key elements in the rules. The USMCA parties have addressed some of these compliance issues, as they have now finalized and issued the uniform regulations that govern the interpretation and application of the rules of origin.

Nevertheless, it remains an open question whether North American producers will find it more beneficial in some cases to pay duties at the relatively low U.S. (and Canadian) most-favoured nation (MFN) rates on passenger vehicles and parts, rather than complying with the USMCA rules of origin in order to benefit from tariff preferences. This may or may not change as time passes. Throughout the automotive provisions, both vehicle producers and those providing parts to vehicle producers are required to certify that vehicles and parts meet the requirements of the agreement. This will require an ongoing and expensive process of updates and changes to supply chain agreements throughout the sector, especially to reflect the transition regime, the new labour value content requirements, and the new North American steel and aluminum requirements.

Because automotive supply chains are highly integrated, complex and often involve long-term contractual commitments, they cannot be changed overnight. The USMCA, therefore, provides for a transition period that allows a portion of a producer’s passenger vehicles and light trucks to receive tariff preference without complying with the USCMA rules of origin.

During the transition period, up to 10 per cent of a vehicle producer’s North American production of passenger vehicles or light trucks can be non-conforming with the USMCA’s rules of origin until Jan. 1, 2025, or five years after the agreement comes into force, whichever is later.

As part of these transition mechanisms, content requirements overall, along with content requirements for core parts, steel and aluminum, and labour value are increasing over time in keeping with the transitional phase-in schedule. This is putting considerable pressure on compliance given the unrelenting approach of the USMCA’s final requirements in a few years’ time (which differ considerably for cars and trucks, respectively).

Canada may enact modern slavery legislation in 2021

Although not an issue specifically about the automotive sector, one noteworthy development for all manufacturers to be aware of is the movement toward Canada’s version of legislation that addresses forced labour in global supply chains, and the growing prominence of Environmental, Social, and Governance issues for all companies.

The proposed Modern Slavery Act (currently Bill S-216) would require mandatory modern slavery disclosure by companies subject to the Act, as well as new provisions in the Customs Tariff Act to prohibit importing goods produced using forced labour and goods made by children.

The draft legislation is broad in its application. The proposed application would include most medium and large companies that produce, sell, or import goods.

The proposed legislation imposes disclosure and compliance requirements, significant penalties, and broad search and seizure powers, which the federal government could use to verify compliance with the Act.

The majority of Canadian companies, including automotive companies, likely already have substantial resources in place to comply with the proposed legislation. Nonetheless, there will be additional compliance costs and an increased chance of reputational risk. The process of vetting suppliers and on boarding new ones will require enhanced risk identification and mitigation.

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