Dixons is ditching its extended warranty scheme for a ‘service agreement’ to avoid a tax bill of at least 10m. It’s legal but is it right? Rival retailers, the Office of Fair Trading and the Treasury want to find out. Natalie Cheary investigat

The Office of Fair Trading (OFT) feared it would happen and Dixons has justified that fear. Literally weeks after the 15 per cent rise in Insurance Premium Tax (IPT) on electrical retailers’ extended warranties, Dixons has revised its warranty scheme so it is no longer an insurance policy and, therefore, is exempt from the IPT charge.

It is a change that could save Dixons over 10m on its annual tax bill. And it will not only be keenly studied by rivals still paying the increased IPT, but also by the OFT, which has started looking into the new “service agreement” scheme, and the Treasury, which is losing the additional tax money that Dixons is avoiding paying. A Treasury spokesman says: “If there are any suggestions of {retailers} getting around the new level {of tax} Customs & Excise will be looking at those suggestions very carefully.”

A spokesman for Customs & Excise says that there is little concern about the move as he believes the amount of VAT Dixons will be able to recover will be limited.

According to a Verdict Research report, electrical retailers on average generate eight per cent of turnover from warranties. And the suspicion is the profit margin is even more significant. Therefore, the rise from 2.5 per cent to 17.5 per cent introduced in Kenneth Clarke’s final Budget in November, and implemented in April specifically to target retailers which “reduce their VAT bills when selling insurance with their products”, was a severe blow to retailers such as Dixons and Comet. Dixons has now turned the tables by opening an IPT loophole.

Within an hour of Clarke making the announcement last November the Dixons share price fell by 19p, knocking an estimated 87m off its market value. The reason for the City’s panic was that Dixons is estimated to have made 40m of its 135.2m full year profits last year from the sale of warranty schemes.

At the time Dixons chairman Sir Stanley Kalms said any IPT increase would be passed on to consumers – and according to analysts the price of the post-Budget agreements are, on average, six per cent higher than those for extended warranties. A series of post-Budget confidential talks between John Major’s Government and electrical retailers failed to have the IPT increase reversed.

And so the Dixons Stores Group, the market leader with 19 per cent of the audio visual equipment and household appliances market, dropped warranties in favour of “service agreements”, in a move which frees it from the hefty IPT charge. The change was made in the middle of May, six weeks after the tax increase was introduced, NatWest Markets retail analyst John Richards estimates it could save Dixons 10m.

A second analyst, predicting that Dixons will increase its annual profits to 200m when it reveals its annual results next month, estimates the increased IPT would have cost Dixons between 15m and 20m had the company not switched policies.

Whereas a warranty is an agreement between the consumer and an insurance company, a maintenance contract is an agreement between the retailer and the consumer. The absence of an insurance company, with the exception of one year’s theft cover, means IPT is not payable and the alternative 17.5 per cent VAT can be reclaimed on parts bought for repair work by the retailer.

“At the onset of the IPT increase, the expectation was that companies like Dixons, Comet and Thorn would have a substantial problem as profits would be squeezed by a significant amount. Dixons [has altered its policy] as a means of clawing back the potential loss,” says Richards. He estimates Dixons will save a third of the potential loss through the switch to service contracts, subject to VAT instead of IPT, with another third recovered through the price increase on each contract.

Comet, whose parent company Kingfisher accounts for 6.2 per cent of the electrical market, has not yet followed suit. Comet’s own warranty scheme remains based on its traditional agreement between Landmark Insurance and the customer, as does Tandy’s.

A spokesman for the OFT says there is “dialogue” taking place between it and the British Retail Consortium (BRC). It is looking at revising the Code of Practice for Extended Warranties on Electrical Goods, the self-regulatory code drawn up by the industry in 1995 to prevent statutory restrictions on the selling of warranties, on order to ensure that consumers will not lose out as a result of the Dixons move.

Dixons insists the change to the warranty has been made to “simplify the procedure by keeping [the services] internal”. Corporate affairs manager Ruth Docherty adds that the “emphasis is now on Mastercare (part of Dixons Stores Group) rather than an external insurance company…therefore giving Dixons more control”. The only insurance element of the agreement is theft cover for the first year through Cornhill Insurance, which is subject to IPT.

Docherty claims that “the customer is winning here,” because “by making the change, we do not have to pass the full impact of the IPT increase on to the customer”.

Director General of Fair Trading John Bridgeman has asked the BRC to “revise the Code to ensure that consumers paying in advance for uninsured maintenance contracts receive adequate protection” in the event of company collapse, like Rumbelows in 1995.

Speaking six weeks ago Bridgeman predicted the shift to service contracts: “This [IPT rise] will make maintenance contracts more attractive to retailers and manufacturers but monies paid to such schemes may be much less secure in the event of business failure compared with insurance policies.”

No-one is seriously expecting Dixons, Comet or Tandy to collapse in any newly purchased policy’s lifetime, but there are more than three electrical retailers on the high street and, as usual, many are likely to take their lead from Dixons.

The Association of British Insurers (ABI) has estimated that its members have, as a result of the IPT rise, already lost about 25 per cent of their 964m gross premiums on extended warranties to “unregulated, uninsured warranty schemes”. It predicts that the sale of such agreements is “likely to increase as more contracts come up for renewal”. ABI spokeswoman Suzanne Moore estimates that the loss could escalate to as much as 50 per cent.

BRC economist Pamela Webber believes more companies will switch to selling maintenance contracts. Her view is that it is “unfair that retailers are charged one thing and independent [brokers] another” as the consumer may lose out if they fail to shop around.

The BRC feels that the IPT on warranties, whether sold by electrical retailers or insurance brokers, should be “levelled out at whatever percentage. We do not agree with the principle that the rate of tax should depend on the supplier rather than the policy type,” says Webber.

The rise in IPT has handed a competitive advantage to other players in the warranty market such as banks and insurance companies, which faced an IPT increase of only 1.5 per cent to four per cent. James Duffell, spokesman for Norwich Union, one of the few insurance companies independent of retailers which sells extended warranties, believes “more and more people are now aware of the different ways to buy insurance”.

Duffell adds that the price increase on retailers’ warranties has been “good for business” and that it has highlighted the importance of shopping around for a policy. Both Barclays Bank and Midland Bank will be making the most of the situation with plans to sell their own extended warranties later this year.

The IPT increase clearly discriminates against electrical retailers – but they are being penalised for past practices. The controversial sale of extended warranties by electrical retailers has been the subject of two separate OFT inquiries.

Bridgeman will review the Code of Practice for Extended Warranties nearer the end of the year “to allow the tax changes to work through”. The Code is administered by the BRC, the Association of British Insurers and the Radio, Electrical & Television Retailers’ Association and was signed by electrical retailers over two years ago.

It was introduced to ensure that the selling of extended warranties became more transparent. But a Marketing Week investigation last year (MW July 26 1996) raised doubts about the implementation of the Code. The Code states that retailers must display details of the warranties they sell, refrain from pressure selling and provide a copy of the BRC Code on request.

In March, the OFT said it believed that prices had become more transparent but that “pitfalls” remained in the selling of the warranty schemes. It said: “In most cases extended warranties are still significantly more expensive than the likely cost of repairs over the warranty period. And they are likely to be even less of a good buy if proposed (IPT) tax changes are passed on to buyers.”

The third-biggest player in the market is Tandy, which has almost 500 stores throughout the UK and does not sell IPT-free maintenance contracts. Managing director Andrew Fryatt insists the rise has yet to have an effect on the high street chain, although he accepts that it is “still very early days”.

He adds that he expects the rise will “have an impact on the profitability” of larger retailers, which are “dependent on extended warranties”. However, if retailers can get around the tax penalty imposed by the Government seven months ago, they will certainly save money in the long run.

Big players get price break

If the imposition of the Insurance Premium Tax has been a nightmare for electrical retailers in the UK, the result of the two-year Monopolies & Mergers Commission inquiry into price fixing may provide some recompense for the bigger players.

The MMC has found that there is price fixing in the electrical retail industry. It has decided that price uniformity is more than coincidence, that it is inspired by the manufacturers and that it is against the best interests of the consumer. Even sources at the manufacturers believe it is inconceivable that the Department of Trade & Industry, which has had the report since the day before the general election, will not enforce the MMC findings.

President of the Board of Trade Margaret Beckett is due to announce her decision before the end of June.

“Any move to change the system within the market because it is not competitive would not be based on true fact,” says Sony spokesman Simon Goodman. “This is a competitive market with hundreds of brands and falling prices – we will continue to make that point to the DTI.”

The MMC, ignoring the appeals of the manufacturers and effectively declaring that it has been leaning on retailers, appeared to be opening the door to smaller electrical retailers. As a result, both Dixons and Comet saw their share prices fall before the City realised that they were in fact the most likely victors in any price war triggered by the abolition of recommended retail pricing.

Pamela Webber, the British Retail Consortium’s economist says: “It will have a larger effect on smaller retailers as there will be a lot of competitive discounting. Whereas the consumer will gain, the small retailers will suffer. Some of the big US retailers might also move into the market.”

Tom O’Sullivan

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