OVERVIEW
The goods and services tax (the "GST") is a broad-based value-added tax levied by the federal government at two rates: 7% and 15%. The 15% rate is only levied on transactions that are considered to be made in one of the provinces that has "harmonized" its sales tax system with the GST, namely, Nova Scotia, New Brunswick and Newfoundland.
The GST is intended to be a tax on final consumption. As a result, the majority of commercial entities are entitled to recover the GST they pay on their inputs. Generally speaking, a commercial entity that is registered under the GST Act is entitled to claim a credit (referred to as an "input tax credit") to the extent it has paid GST on goods and services used in its GST "commercial activities." GST "commercial activities" encompass activities that result in the making of taxable supplies.
The tax is levied on "supplies of property and services." A "supply" is the provision of property or service in any manner. The terms "property" and "services" are broadly defined and include tangible personal property, intangible personal property, real property and services. As a result of these broad definitions, the provision of any property or service in the course of a commercial transaction will in most instances be taxable, unless a specific exemption is found in the GST legislation. For example the GST applies to such things as the sale of goodwill, dividends in kind, barter transactions and most forms of licensing arrangements.
Despite the far-reaching nature of the legislation, there are a number of situations where the GST is not, or need not be, imposed. For example, tax is not imposed on either "zero-rated" or "exempt" supplies. These supplies are defined in schedules to the GST legislation. "Zero-rated" supplies include such things as exports, basic groceries, prescription drugs, medical devices and certain agricultural goods. "Exempt" supplies include such things as the sale of used residential housing, the rental of residential housing, most health care services, many educational services, child care services, legal aid services, financial services and many supplies made by charities, not-for-profit organizations, municipalities and certain public sector bodies.
The reason for differentiating between "zero-rated" and "exempt" supplies relates to the claiming of input tax credits. Suppliers of "zero-rated" supplies are entitled to input tax credits for GST paid on property and services acquired for use in making those supplies. Suppliers of "exempt" supplies, by contrast, are not entitled to claim input tax credits.
Special rules exist for common corporate transactions such as the purchase and sale of a business, wind-ups, amalgamations and corporate transactions involving the issuance of shares or debt. Specific rules also exist for a multitude of particular situations such as the making of multiple supplies, sales to or by non-residents, barter transactions, forfeitures, seizures, bad debts, take-over bids, sales of leasing portfolios and a host of other transactions. It follows that compliance with the GST regime, while perhaps not particularly complex conceptually, can become difficult in practice.
The GST is levied under three separate and distinct divisions of the GST legislation as follows (a fourth division applies to goods physically moved into a harmonized province):
- Under Division II, tax is levied on taxable supplies "made in Canada." This is the tax levied on supplies that occur in Canada -for example, a computer purchased from a retail store in Canada or a haircut purchased from a barber in Canada. While Division II tax is imposed on the recipient of a taxable supply, the obligation to collect and remit GST rests with the person who supplies the goods and services.
- Under Division III, tax is levied on all goods imported into Canada, regardless of whether or not the goods are subject to Canadian customs duties. The tax is levied and collected by Canada Revenue Agency (the "CRA") at the time of importation. All commercial importations are taxed at 7%. Non-commercial importations are taxed at either 7% or 15%, depending on whether the importer is a resident of a non-harmonized or harmonized province.
- Under Division IV, tax is levied on imported services and intangible property. The recipient pays the tax on a self-assessing basis directly to the CRA. Generally speaking, a recipient only self-assesses Division IV tax if it imports services and intangible personal property for use in activities that do not constitute GST commercial activities.
A supply cannot be subject to tax under Division IV if GST is payable under Division II or III. However, the fact that a supply is taxable under Division II will not preclude the supply from being taxed under Division III (and vice-versa).
RECENT DEVELOPMENTS
THE CRA'S NEW TESTS FOR CARRYING ON BUSINESS IN CANADA
The concept of carrying on business in Canada is a key concept when one is attempting to determine whether a non-resident is required to register under the GST legislation, collect tax and file returns. Generally speaking, a non-resident who does not carry on business in Canada is not required to register, file returns or collect tax on any supplies of property or services it may make.
The CRA has recently released revised Policy Statement P-051R2, entitled "Carrying on Business in Canada." The policy statement represents a significant departure from the existing jurisprudence with respect to carrying on business in Canada, which was previously accepted by the CRA in a number of technical documents including the previous version of P-051.
The jurisprudence under British tax law, Canadian income tax and provincial sales tax law has considered a number of factors in determining whether an individual or company carries on a business in a particular jurisdiction.
The jurisprudence concludes that it is a question of fact whether or not a business is carried on in a particular jurisdiction and that no one test is determinative of the issue (see <i>Maclaine and Company v. Eccott</i>, [1927] A.C. 424; Geigy [Can.] v. Commissioner, Social Services Tax, [1969] C.T.C. 79).
It appears that the question of fact that must be determined is whether the non-resident is carrying on business with the country in question as opposed to carrying on business in the country in question.
In making the determination of fact, the courts have placed strong reliance on the place where the contract in question is made and the place where the operations take place from which the profits in substance arise. Although these are the two most predominant factors that the courts have considered when determining whether a business is carried on in a particular jurisdiction, numerous other factors have been considered by the courts (such as place of delivery, location of inventory, bank accounts and employees). It appears that in considering these factors the courts are attempting to determine if the total business activities of the person that occur in the jurisdiction are together sufficient to constitute the carrying on of a business in the jurisdiction.
The policy statement sets out a new CRA administrative regime for determining whether an entity is carrying on business in Canada. This regime will be based on 12 factors noted in the policy statement, with the importance or relevance of a given factor in a specific case dependent on the nature of the business activity under review and the particular facts and circumstances of each case.
The CRA's approach represents a fundamental change in their administrative practice and a surprising departure from existing jurisprudence. The CRA has on its own accord, and in direct contradiction of the case law, downgraded the importance of the place of contract and ignored the location of the person's profit-making apparatus.
The CRA is proposing that the place of contract, instead of being one of the dominant factors, become number seven on a list of 12 factors. This position does not appear to be based on new case law (or legislation) and is surprising since there is Canadian jurisprudence suggesting that a company that concludes contracts in Canada is carrying on business in Canada (although a company that concludes contracts outside of Canada may still be carrying on business in Canada).
What is equally surprising is the CRA's proposed treatment of the location of the "profit-making apparatus" of the business. This refers to the location of the place where the operations take place from which the profits in substance arise. Here one is attempting to determine the location of the infrastructure used to carry on the business: where are the managers of the company, the employees, any manufacturing facilities, offices, etc. As noted previously, the courts have treated this as a predominant factor. Normally a company will not be considered to be carrying on business in Canada if it is determined that its profit-making apparatus is located outside of Canada. Notwithstanding the importance of this factor to the courts, the CRA is proposing that the factor be ignored when determining whether or not a business is being carried on in Canada.
The CRA's new approach has created a great deal of concern in Canada since it is not consistent with the jurisprudence and the CRA does not have the authority to create new law. Further the CRA has publicly stated that it will not provide "grandfathering" for non-residents who relied on its old policy that was contained in previous CRA technical documents. These concerns are exasperated by the arbitrary nature of the new policy. Clearly the new policy will create unnecessary confusion and, in many instances, will discourage non-residents from entering into transactions with Canadian suppliers and customers.
Non-compete payments
Recently the Federal Court of Appeal ruled that a non-compete payment made to a shareholder was not subject to income tax, since the "right to compete" did not constitute property (Tod T. Manrell v. The Queen, 2003 DTC 5225). This raises the interesting question of whether such payments are subject to GST. If the payments are made to shareholders who are individuals, then any GST paid is probably not recoverable.
Manrell owned or controlled substantial interests in three operating companies. A third party (3154823 Canada Inc.) agreed to purchase the shares and shareholder debt of the three operating companies for $14.6 million. The share purchase agreement provided for the payment of approximately $4 million to the selling shareholders (including Manrell), as consideration for the delivery and performance of "non-compete agreements."
The GST legislation clearly treats the payment by the third party to the selling shareholders as a payment for services. The issue that arises is whether or not such services are being rendered in the course of a GST commercial activity.
The CRA apparently does not believe this is the case. In a recent private ruling, the CRA held that in a fact situation identical to Manrell, the payment was not subject to GST. The CRA noted the following:
"A commercial activity of a person, as defined in subsection 123(1) of the Act, means, in part, a business carried on by the person or an adventure or concern of the person in the nature of trade. Here, the individual shareholder is agreeing not to compete. The individual [the shareholder] was not engaged in the business; rather, it was XYZ [the corporation] that was carrying on the business. Therefore, by agreeing not to carry on a business, the individual cannot be considered as making a supply in the course of a commercial activity. On the contrary, the individual is agreeing not to carry on a business."
The CRA also notes that the supply under the non-compete agreement is not an adventure or concern in the nature of trade.
However, the CRA was very careful to limit the ruling to the situation where a shareholder enters into a non-compete agreement with respect to activities carried on by the corporation. The ruling notes that payments under a non-compete agreement may be taxable if made to the person who is actually carrying on the commercial activity covered by the non-competition agreement.
AMALGAMATIONS VS. WIND-UPS
Frequently, commodity tax advisers are asked whether there is a GST advantage to amalgamating two companies as opposed to winding-up one company into the other. The preferred choice is an amalgamation.
Once an amalgamation occurs, each of the predecessor companies ceases to exist and a new company is formed. Section 271 of the GST legislation deems the new corporation formed on the amalgamation to be a separate corporation from each of the predecessor corporations. Further, when two corporations merge or amalgamate, the transfer of property to the new company is deemed not to be a supply of property, and thus no tax consequences arise. The section applies regardless of whether or not the assets are used in GST non-commercial activities. Thus, section 271 can be used to avoid non-refundable tax on re-organization involving companies who carry on GST non-commercial activities, such as companies who provide financial services.
With respect to property and services acquired or imported by the predecessor corporations, the amalgamated corporation is deemed to be the same corporation as, and a continuation of, the predecessor corporations. This allows the amalgamated company to claim input tax credits in respect of property or services acquired by a predecessor corporation, where the predecessor corporation did not claim the input tax credit prior to the amalgamation. The amalgamated company will be entitled to claim the input tax credit even if the property or service is not transferred to the amalgamated company (provided all of the other conditions for claiming the input tax credit are satisfied).
A wind-up results in the subsidiary ceasing to exist and the parent continuing in existence. Section 272 of the GST legislation applies to the winding-up of a corporation. It applies only in circumstances where a corporation is wound up into a parent that owned 90% of the issued shares of each class of capital stock. If section 272 applies, any transfer of assets to the parent resulting from the winding-up is considered not to be a supply. In other words, tax is not exigible on a qualifying wind-up.
In the same manner that the amalgamated company is treated as the same corporation as the predecessor corporations, the parent company is treated under section 272 as the same corporation and a continuation of the subsidiary in respect of property or a service acquired, imported or brought into a participating province by the parent corporation as result of the wind-up.
In situations where both section 271 and section 272 apply, there is a distinct GST advantage to amalgamating as opposed to winding-up a corporation. This advantage flows from the treatment of the property and services acquired as a result of the re-organization.
In an amalgamation, the amalgamated company can claim input tax credits for property or services previously acquired by a predecessor corporation (assuming the predecessor did not itself claim the input tax credit), even if the amalgamated company does not acquire the property or service.
However, on a wind-up, the parent will only be entitled to claim the input tax credit if the parent, as a result of the wind-up, acquires the property or services. This is obviously a significant advantage for amalgamations, especially when one realizes that the parent on the wind-up will never acquire services previously rendered to a subsidiary.
THE CRA VOLUNTARY DISCLOSURE PROGRAM
Approximately four years ago the CRA developed a new voluntary disclosure ("VD") program for income tax and GST. The VD program is administered by the appeals branch of the CRA (the old voluntary disclosure program was administered by the audit branch of the CRA). The CRA is reporting a phenomenal increase in the use of the VD program during the last two years.
The following four conditions must be satisfied before a disclosure will be accepted by the CRA:
- The VD must include information that is at least one year overdue. If the information is less than one year past due, the voluntary disclosure must not be initiated simply to avoid the late filing or instalment penalties.
- The VD must involve at least one penalty. This condition is always satisfied for GST purposes since late-filed remittances are automatically subject to a 6% penalty interest.
- The disclosure must be voluntary. Normally, a disclosure will not be considered voluntary if it is made after, or in response to, a CRA enforcement activity. For example, a disclosure will not be considered voluntary if it is made after a computer-generated notice requesting a supplier to file, remit or register in respect of the GST/HST.
- The disclosure must also be complete. If the disclosure is not complete, the taxpayer may be assessed full interest and penalties, plus prosecution, may result.
If the voluntary disclosure is accepted, the CRA will normally assess the tax and interest but will not assess the 6% penalty interest and will not initiate any criminal prosecutions.
If the transaction is a "wash transaction" (recipient entitled to full input tax credits), the CRA will waive the 4% wash penalty. As a result, the supplier will only be assessed the tax and will not be assessed any interest or penalties. The supplier should be able to recover any tax that is assessed by invoicing its customer for such tax.
It is the CRA's policy that the voluntary disclosure program is a fairness program and therefore should be limited to penalties. However, the CRA will waive interest if it is perceived to be punitive.
The CRA's policy also allows for no-name disclosures. Here the taxpayer's lawyer or accountant makes a written submission setting out the facts and the basis for the disclosure. The CRA appeals officer will then determine whether the situation qualifies as a voluntary disclosure (subject to the CRA confirming that no enforcement action has been taken against the taxpayer).
PROVINCIAL RETAIL SALES TAX
OVERVIEW
Retail sales taxes are levied in Prince Edward Island, Ontario, Manitoba, Saskatchewan and British Columbia under provincial legislation. The Province of Quebec has adopted a value-added tax that is very similar to the federal GST, while Alberta does not levy any sales taxes.
The provincial retail sales taxes are primarily a tax on tangible personal property; however, some services are also subject to the tax, such as telecommunication services, certain installation services and, in certain provinces, professional services.
In most provinces the definition of "tangible personal property" is significantly broader than might ordinarily be expected. For example, in Ontario and British Columbia natural gas and manufactured gas are considered to be tangible personal property. All of the provinces consider computer software to be tangible personal property.
RECENT DEVELOPMENTS
Ontario
Effective July 2004, Ontario established new rules aimed at modernizing its retail sales tax regime on transfers of assets between related corporations. These rules generally provide that no tax will be payable on such transfers provided that: (i) the assets transferred are "eligible property" (i.e., tax has been paid by the transferor or by a related party); (ii) both the transferor and transferee are "wholly-owned" (i.e., shareholdings of not less than 95%) by the same person; and (iii) the "wholly-owned" condition is met for at least 180 days following the transfer. The effect of the new rules is to remove the previous one-time limitation on the use of this exemption and to introduce the concept of "eligible property" in an attempt to ensure that retail sales tax is paid at least once by a member of a corporate group.
Similar rules have been enacted for transactions where the transferor receives shares of the transferee (or where a partner receives a partnership interest) in exchange for the transferred assets, as well as rules for potential pro rata reductions in applicable retail sales tax where the strict tests for exempt transfers are not otherwise met.
Ontario also enacted its long-awaited legislation relating to the retail sales tax treatment of computer programs and services. The new legislation is complex but ultimately attempts to clarify the distinction between taxable and non-taxable computer-related services.
British Columbia
For transactions taking place after February 17, 2004, British Columbia has amended its retail sales tax on bundled purchases of taxable and non-taxable goods. Generally, these new rules provide that tax will apply to the taxable component of the sale only, subject to certain exceptions where the taxable portion is less than 10% or more than 90% of the total bundled selling price. British Columbia has also clarified its rules relating to the provision of goods incidental to a non-taxable service and the exemption for production machinery and equipment.
On October 20, 2004, British Columbia announced that it would be reducing its retail sales tax rate from 7.5% to 7%, applicable to transactions occurring on or after October 21, 2004.
Finally in its February 2005 Budget, British Columbia announced the introduction of new exemptions and refunds for certain "alternative fuel" vehicles and high efficiency equipment, as well as new environmental levies on tires and batteries.
Manitoba
Beginning on July 1, 2004, Manitoba began applying retail sales tax to various services, including legal, accounting, architectural, engineering and security services.
Saskatchewan
Effective for all taxable sales or leases made after April 1, 2004, Saskatchewan increased its retail sales tax rate from 6% to 7%.