Value Added Tax in the GCCInsights by industry | Volume 1Automotive chapter

Ninety years in the Middle East

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Deloitte | Value Added Tax in the GCC | Automotive industry

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Gearing up forchange, the viewahead for dealersand buyers

Deloitte | Value Added Tax in the GCC | Automotive industry

Chapter 4 – Automotive industry

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It is almost inevitable that sales of motorvehicles will become subject to VAT in theGCC upon implementation of VAT. Eventhough the anticipated VAT rate of 5% islow by comparison to rates of VAT appliedin other countries (the average VAT ratearound the OECD is 19%), for a region witha penchant for purchasing expensivemotor vehicles, the imposition of VAT islikely to increase the nominal purchaseprice of the region’s favorite luxury brandssignificantly, if for no other reason thanthat the cost of such vehicles is alreadysubstantial.

Of course, the automotive sector in theGCC does not only cover the sale of newcars, and to restrict it in this way would beto significantly underestimate its size andimportance to the economies of theMember States. Some of the regions’largest players in this market are highlydiversified corporates with operationsextending beyond the sale of new andsecond-hand vehicles sales into theprovision of finance, insurance, propertydevelopment and sales to name but a fewexamples. The scale and scope of thesebusinesses can be enormous.

The supply chain feeding the automotiveretail business is also significant andincludes vehicle manufacturers, the localimporters, and then the distributorsthemselves of course. The dealer andproprietary after-sales market in parts,accessories and services comprise a vitalcomponent of the industry overall, as toois the vibrant second-hand vehicle salesmarket and the associated financeproviders. In addition, business andpersonal classified listings make up a largeportion of total vehicle transactions in theregion, so this, together with the normaladvertising, whether radio, TV ornewspaper, spend by the main dealerscould be significant.

In time, the full spectrum of the impactassociated with VAT being applied

throughout this highly evolved and diversesector will come to light. We focus,however, on the impacts likely to be felt bythose in the business of selling vehicles,and those buying them.

Pre-implementation demand pullOne operational issue, in common withthe retail industry as referred to inChapter 3, will be how dealers respond toa likely spike in demand in the run-up tothe introduction of VAT. It has been wellobserved that new introductions or rateincreases typically advance the buyingdecisions of consumers in order to “beat”the inevitable increase in the price of a car purchased from a dealer. Indeed,businesses often make a point of running‘pre-implementation’ specials in order tocapitalize on this demand and bring-onsubstantial stocks to fill showrooms andstorage facilities so as not to disappointeager buyers.

Manufacturers and other up-streamsuppliers to the industry are also likely to be faced with a surge in demand asdealers book relatively large pre-orders.The flip side of this is that there is likely to be a glut of second-hand cars comingonto the market as consumers ‘flip’ themin order to take on their new vehicles.

To some extent the large pre-orders ofnew vehicles will be welcome for thoselooking for an outlet for production during

a period of global economic uncertainty,but they will have to ensure appropriatestock is available, and that lead times andlogistics arrangements are in place toensure stock can be in the right place atthe right time. Manufacturers must alsoassess whether there will be an impact onthe lead times for new/bespoke vehicles,and how this may impact the customerpurchasing decision.

Dealers will need to make sure thatcustomers are not disappointed whentrying to make a more immediatepurchasing decision than normal. Stockingthe right vehicles at the right specificationwill be key – vehicles ordered prior to, butdelivered after, implementation are at riskof being subject to a VAT surcharge.Dealers need to be satisfied thatappropriate resources will be available interms of staffing the sales floor, whilstcoping with (albeit temporary) increasedvehicle storage and preparation needs.This could be a challenge for many,particularly in that at the same time theymay well need to deal with a substantialnumber of second hand vehicles that willneed to be accommodated within themarket.

In many cases car sales depend on theready supply of credit, whether that beworking capital in the case of the dealer,or finance deals in the case of consumers.Dealers will need to consider the likelyimplications of this demand spike withtheir own banking institutions and otherfinance businesses so as to prevent anychoking-off of demand arising simply dueto the lack of availability of finance (asopposed to the lack of credit-worthinessof the borrower). If there are anydealership floor plans in place to financethe stock on hand, these may need to bereconsidered.

And finally, advertising agencies,production houses and media outletsshould expect to see a flood of advertising

It has been well observedthat new introductions orrate increases typicallyadvance the buyingdecisions of consumersin order to “beat” theinevitable increase in theprice of a car purchasedfrom a dealer

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placements from dealers hoping to takeadvantage of the desire to supply vehiclesprior to anticipated price increases.Dealers will need to have thought wellahead about how they want to go tomarket in connection with VAT, however,the messaging may not be all that simpleand will need to be carefully targeted.

All in all, the impact of pre-implementationdemand is likely to put a fair amount ofstrain on dealers and their supply chain.This is not necessarily bad news of course– the opportunity to push sales and see amajor revenue uptick from car sales,bonuses/rebates, accessory andintermediary fees could perhaps offer asilver lining for Q4 2017, although they willneed to be careful with the pricing on anytrade in vehicles.

Stock planning for 2017 is likely to be infull force at this time of year – every dealerand associated businesses should bethinking about the pre-implementationdemand pull, now. Failure to capitalize onthe opportunity could result in a majorrevenue shock in H1 2018 as consumerstake stock of pricing changes and eitherdefer purchasing decisions, or havingbrought forward their purchasingrequirements, are well set for some timein the future.

Adjusting to new cash and pricingrealitiesMost if not all new vehicles are importedinto the GCC having been manufactured inthird countries. As with most VAT regimes,it is likely that the importation of a car willbe subject to import VAT at the time thevehicle is removed from customs controland entered into so-called “freecirculation”. The same goes for otherpurchases made by dealers; VAT will haveto be paid on purchases and theadditional amount will need to be pre-financed until a credit for it can beobtained from the tax authority.The lag between payment and credit can

be substantial, (certainly during the initialphase of operations under the VAT), withthe result that working capital headroommay have to be increased in order to allowfor it. Of course, VAT accounting typicallyallows for the offsetting of VAT on costsincurred against VAT on sales on the samereturn and so finding a better timingbalance between these two elements ofthe value chain is vital. Much can be donein this regard with adequate preparation.

As with any retail supplies, dealers willneed to look closely at the pricing ofvehicles given the likely impact thatpassing on the full cost of VAT may haveon sale volumes. In embarking on thisanalysis, it should be done with the viewthat it is unlikely that dealers will be ableto pass on the full charge of the new VATto private consumers or unregisteredbusinesses in the short-term. This will beexacerbated if the legislation seeks toblock input tax on motor vehicles asoccurs in a number of other countries, as

The impact of pre-implementationdemand is likely to put a fair amount ofstrain on dealers and their supply chain.This is not necessarily bad news ofcourse – the opportunity to push salesand see a major revenue uptick fromcar sales, bonuses/rebates, accessoryand intermediary fees could perhapsoffer a silver lining for Q4 2017,although they will need to be carefulwith the pricing on any trade in vehicles.

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the same issue would then affect allvehicle purchasers.

To the extent that the products arethemselves price elastic, small pricingchanges, and the period over which theyare granted could significantly impactpurchasing decisions. Understanding thelink between pricing changes and thepotential impact on demand can be doneat a variety of different levels of detailbearing in mind that dealer margins arenot necessarily generated wholly orindeed partly at the front-end (i.e. theticket price), but may also be impacted atthe back-end instead (i.e. the bonuses and rebates granted to dealers bymanufacturers for meeting targets) and so vary quite significantly by vehicle andmanufacturer.

The weirder and more wonderfulelements of the motor tradeMotor trade VAT accounting is notoriouslycomplex. So far we have looked at theobvious impacts of VAT, but some of themore challenging aspects of VAT for theautomotive trade can be found in thefollowing paragraphs:

The second-hand/margin schemeGenerally applicable in some form tosecond-hand cars supplies where initialVAT recovery has been disallowed for thepurchaser (bought-in/part-exchangevehicles) as the supplier (very often anindividual consumer) is unregistered anddoes not charge VAT, but has previouslyincurred VAT when the vehicle waspurchased.

To ensure that there is no ‘tax-on-tax’cascading, VAT is chargeable on the profitmargin achieved on sale by the registereddealer, for ‘margin scheme’ cars. Whilstconceptually simple, dealer systems mustbe ready to capture these sales, andcalculate VAT on profit. Sales staff must

also be trained to understand thecommercial impact of their actions.

Indeed, calculations can be complicatedby certain dealer practices, particularlywhere trade-in values are inflated by thedealer, to allow the purchaser to meet theminimum deposit for finance – a practiceknown as ‘bumping’. Ultimately, it will befor the GCC to decide whether a ‘margin-scheme’ will be implemented, or whetherVAT at 5% will also apply to the sale ofsecond-hand cars. The latter may bepreferable for simplicity, but the extra costwould be substantial and, inevitably, woulderode margins, with cars taxed multipletimes as they change hands.

Financial Intermediary Services In the EU, where a dealer introduces acustomer to a provider of financialservices, such as lending, and receives acommission for doing so, this commissionmay be VAT-exempt. Whilst no VAT ischargeable on the supply of theintroductory service to the financeprovider, dealers suffer a restriction onthe recovery of input tax incurred inmaking such supplies, resulting inpotentially complex ‘partial exemption’calculations, to determine overall VATrecovery – a concept thoroughly examinedin VAT ‘automotive’ case law.

It is, however, unclear whether the GCCwill implement an exemption for financialintermediary services, and the impact istherefore likely only to be assessable, oncethe particulars of the applicable legislationare announced. In Australia, the supply ofsuch services by what are referred to as‘Financial Service facilitators’ would betaxable in similar circumstances. Thiswould mean that VAT would be due on theintermediary fee – but that VAT is thenunlikely to be recoverable by the financehouse – leading to further erosion ofmargin.

Stock-in-trade and demonstrator carsRecovery of input tax on demonstratorvehicles has often been restricted on thebasis that those vehicles are madeavailable for non-business/personal use,such as by sales staff. Where VAT recoveryis restricted, some tax authoritiesassumed that the eventual sale of thevehicle would become subject to thesecond-hand margin scheme. It will beinteresting to see whether the GCCapplies the exemption for the sale of items on which initial VAT recovery wasrestricted, or treats these as taxablesupplies. It is important to remember that,as an exempt sale, like financial services,there is a corresponding input taxrestriction.

Reliefs for adapted vehicles for thedisabledCars adapted for use by disabled personsmay qualify for VAT relief, such as theapplication of the ‘zero-rate’ of VAT.However, in territories where similar reliefshave been applied - such as in the UK -abuse of such schemes has occurred,mostly perpetrated by criminal gangs and fronted by individuals who meet thecriteria for relief. Tax authorities havepreviously penalized dealers for failing toensure that the purchaser is genuinelydisabled, and the vehicle is for their ownpersonal use. Again, it remains to be seenwhether the GCC states will apply a reliefto such vehicles. However, with a potentialVAT advantage of 5%, the incentive toperpetrate such dishonesty is likely to below.

It is no secret that motorvehicles have historicallybeen treated unfavorablyby tax authorities

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And what about purchasers?It is no secret that motor vehicles havehistorically been treated unfavorably bytax authorities. The restrictive nature ofrecovering VAT on motor cars is largelyrelated to the fact that the system has,historically, been open to abuse, withsome individuals and companies havingsought to recover the input tax charged infull as a business expense, despitesignificant ‘non-business’/private use. Thepotential for abuse was particularly

apparent in the UK court case ofFagomatic, where the owner of a cigarettevending machine business sought torecover the VAT in full on the purchase ofa Lamborghini, purportedly used only forbusiness purposes.

Whilst the situation in Fagomatic is aparticularly unique (and perhaps extreme)case, the basic rule for a business seekingto recover VAT on the purchase of a motorcar has been, quite simply ‘don’t’, unlessthe ability to evidence sole business use isstrictly unequivocal. Again, with referenceto the region’s love of expensive cars,Fagomatic may once again rear its head,albeit in another guise, and is therefore an important lesson.

With the introduction of VAT in the GCC,on the expectation that the region willfollow the European model, and OECDbest practice, it is likely that businesses will experience a largely restrictiveenvironment in which to recover VATcharged on the purchase of company

motor cars, which would result in anincreased cost to the P&L.

Preparing for changeEven a demand driven second half of2017 sales bonanza for new vehicles mayonly offer a modest amount of comfort tothose charged with preparing anautomotive business for its new VATobligations in 2018, and this could well beoffset by a glut of second hand vehicles onthe market.

Concerns over whether their systems,processes and people will be able to copewith VAT on January 1 2018 are likely to bea major focus for program managers upuntil that time. Unless they do, accuratelyaccounting for VAT on sales on or afterthat date will become a major headacheand at worse, stop sales in their tracks.

Early preparation is key, not only for VATpurposes, but for stocking and aftersalespurposes. The trade will shortly besubmitting its 2017 sales plans. Ensuringthat the impact that VAT is likely to have on customer purchasing decisions bothbefore and after its implementation hasbeen factored into factory orders, will behugely important to businessesattempting to smooth revenues during the changeover period.

Early preparation is key, not only forVAT purposes, but for stocking andaftersales purposes

Deloitte | Value Added Tax in the GCC | Automotive industry

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