Archived - Backgrounder
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Goods and Services Tax or GST (and, in this document, where applicable, the Harmonized Sales Tax) applies not only to domestic purchases but also to imports of goods and services. In the case of imported services and intangible personal property, tax collection at the border would be impractical. As a result, specific rules under the Excise Tax Act (ETA) require certain recipients of these imports to pay tax on a self-assessment basis.
A Tax Court of Canada decision regarding the applicability of this rule to cross-border dealings between the foreign and Canadian branches of a non-resident insurance company has raised a number of issues concerning the application of this rule. In addition to its findings relating to the specific transaction at hand, certain comments in this decision had been taken to mean that many taxable supplies (e.g., administrative services) could potentially be treated as supplies of exempt financial services that would not be subject to GST. This would have an impact not only on dealings between branches of the same person (as in the case under decision) but also on supplies between separate persons.
To address these issues, on November 17, 2005, the Department of Finance issued a news release together with a detailed backgrounder outlining proposed changes to the ETA. The backgrounder proposed to clarify the rules that apply to taxable imports of services and intangibles between separate branches of the same person. This clarification would not be limited to financial institutions (FIs). The proposals also contained a new rule, applying only to FIs, which requires an FI with a presence outside Canada (in the form of a branch or a subsidiary) to self-assess GST on certain expenses incurred outside Canada that relate to its Canadian activities. On January 26, 2007, these changes were re- released in the form of proposed draft legislation with explanatory notes.
The Government is now releasing revised draft legislation relating to the clarifying amendment and the new rule for FIs. This revised draft legislation is substantively the same as the previous proposals released on January 26, 2007, but contains several relieving changes that address concerns raised by FIs. Principally, the revised draft legislation would allow FIs resident in Canada that conduct business through foreign branches to elect to use a simpler alternative approach to self-assess tax under the new rules for FIs. The election would permit these FIs to self-assess on the charges of their foreign branches to Canada on a basis that gives a result similar to that for supplies from foreign subsidiaries. More specifically, an FI that makes this election for a particular year would self-assess tax for that year on an internal charge that is generally an amount that is treated, for income tax purposes, both as income or profit in a particular country other than Canada and as a deduction from income in Canada. Eligible FIs (i.e., FIs resident in Canada) would be permitted to elect to use this method retroactively for periods back to the proposed 2005 effective date.
This election effectively allows for global or "top-down" analysis, based on income tax concepts, of business expenses that are related to Canadian activities on which GST is to be self-assessed. The approach outlined in the January 26, 2007 proposed draft legislation, which involves a more detailed cost-based approach, remains an option.
Further, as a result of industry consultations, the revised draft legislative proposals would exclude certain financial derivative transactions from self-assessment under the new rule for FIs. To qualify for this exclusion, all or substantially all of the value of the financial derivative transaction attributable to Canada must represent financial elements, profit margin and employee compensation.
Input Tax Credit Allocation Methods of Financial Institutions
FIs are entitled to claim input tax credits (ITCs) to recover GST paid on inputs used to make taxable supplies (generally, supplies on which they are required to charge GST) but cannot claim ITCs to recover GST paid on inputs used to make exempt supplies (generally, supplies on which they are not required to charge GST). Where an input is used to make both taxable and exempt supplies, the FI must apply a method to allocate the use of that input between taxable and exempt supplies in order to determine the percentage of GST paid on the input that can be recovered as an ITC.
In recent years, questions have been raised regarding which allocation methods are appropriate to use by an FI to determine its ITC entitlement. In order to address this uncertainty and to provide greater clarity and direction to all FIs respecting ITC allocation methods, proposed amendments to the ETA were released on January 26, 2007 to provide more detailed ITC allocation rules for FIs. These rules allow most FIs to use their own fair and reasonable ITC allocation method, provided they follow Canada Revenue Agency (CRA) guidelines in designing their method. In addition, proposed amendments particular to large banks, insurers and securities dealers require them to either use a prescribed percentage or obtain pre-approval of the CRA to use their own ITC allocation methods. These proposed amendments apply generally to fiscal years of an FI that begin after March 2007.
The Government is now releasing revised draft FI ITC allocation legislative proposals that contain several relieving modifications to the proposed draft legislation released on January 26, 2007. These proposed modifications would:
- provide an avenue for a large bank, insurer or securities dealer, whose proposed method was not given pre-approval by the CRA, to use that method if it can establish that it has met all documentary requirements set out in these proposals for pre-approval of its method, that the CRA has not acted fairly and diligently in considering the FI's method, that the FI's method is objectively fair and reasonable and that, where the CRA has suggested modifications to the FI's method, the method that would result from these modifications would not be objectively fair and reasonable;
- clarify that, if the CRA directs an FI (other than a large bank, insurer or securities dealer) to use an allocation method, the FI would, upon an assessment by the CRA, be able to challenge the direction in the Tax Court and the CRA would bear the burden of proving in court that the CRA's proposed method is fair and reasonable; and
- provide the CRA and FIs more flexibility in the use of the pre-approval process and permit the CRA to extend the deadline for pre-approval at the request of an FI.
A New GST Rebate for Registered Pension Plan Trusts
The intended GST treatment of registered (for purposes of the Income Tax Act) pension plans is that GST paid on pension plan-related expenses should be recoverable as an ITC where the pension expense relates to the commercial activities of a sponsoring employer of the plan. Conversely, ITCs should not be available where the pension plan-related expense is in respect of the investment activities of a pension entity (a pension plan trust or corporation).
In order to give effect to this tax policy, the CRA generally permits an employer engaged in commercial activities to claim ITCs to recover GST paid on pension plan-related expenses relating to the collection of pension plan contributions, the payment of plan benefits and maintenance of pension plan records and other expenses generally referred to as "employer expenses" (these expenses typically make up about one-third of pension plan-related expenses).
Where a pension plan-related expense relates to the activities of a pension entity and its financial assets, such as expenses incurred for the management of pension fund investments, the CRA administrative policy does not allow the employer to claim ITCs to recover GST paid, whether the expense is paid by the employer or the pension entity. This is because the service or good for which the expense is incurred is ultimately used by the pension entity which, under the GST, is a separate person from the employer and is treated as an FI. As a result, to the extent that the pension entity provides exempt financial services in managing its investments and providing pension payments, it cannot recover GST it pays on related expenses (generally referred to as "plan trust expenses").
Questions have been raised concerning the legislative basis for the CRA's administrative policy and, in particular, whether employers can claim ITCs for plan trust expenses or would qualify for ITCs where their pension plan agreement provides that it is the pension entity, rather than the employer, that pays the employer expenses. The current GST treatment was further complicated by the fact that employers who participate in sponsoring a multi-employer pension plan could not avail themselves of the same treatment. As a result, these pension plans are governed by a different set of rules that allow a multi-employer pension plan trust (but not a corporation) to claim a rebate of 33% of the GST paid on its expenses (this rebate provides multi-employer pension plan trusts with a level of GST recovery that approximates the proportion of single-employer pension plan-related expenses that would be eligible for ITCs under general rules in the ETA and CRA administrative policy described above). In addition, there are some uncertainties respecting the treatment of related employer pension plans (plans in which more than 95% of the plan members are employed by a related group of employers) as these plans, which have more than one employer, do not fall within the meaning of "multi-employer pension plan" in order to be entitled to the 33% rebate.
These issues have given rise to concerns with respect to potential inequities due to different rules applying to various pension plan structures and arrangements. To address these concerns, and to provide a common treatment for all employer-sponsored registered pension plans, the Government announced consultations in a January 26, 2007 press release on a proposal to replace the current ITC and rebate rules for pension trusts with a single rebate system. The proposal is intended to ensure that pension plan GST relief accrues to pension plan entities. Following consultations with industry stakeholders, the Government is now releasing draft legislation to implement the GST pension plan rebate proposal.
The proposed mechanism would have the effect of deeming all of the GST on pension-related expenses incurred by employers participating in a pension plan to have been paid by the relevant pension entity. The pension entity would then be entitled to claim a rebate of 33% of the GST it has paid or is deemed to have paid. The rebate would be available irrespective of the nature of the plan arrangements or whether the pension entity is registered for the GST. Certain restrictions are noted below that would apply to plans where 10% or more of pension contributions are made by FIs.
To recognize that employers may be responsible for payment of a portion of pension plan-related expenses, an election would be provided whereby the pension entity and all the participating employers could jointly elect to transfer some or all of the entity's rebate entitlement to some or all of the plan's participating employers that are GST registrants. The election would permit these participating employers to make a deduction in determining their net tax in respect of the transferred rebate amount. Where all the participating employers are exclusively engaged in commercial activities, the pension entity and the employers would be free to transfer the rebate entitlement as they choose. Where any of the participating employers are not engaged exclusively in commercial activities, the maximum proportion of the rebate entitlement transferable to an employer would be in proportion to that employer's share of the total pension contributions. In that case, the deduction would be further limited by the employer's tax recovery rate, which is generally the percentage determined by dividing the total of ITCs and public service bodies rebates that the employer is entitled to by the employer's total tax paid.
The only pension entities that would not be eligible for the rebate would be pension entities of pension plans where 10% or more of the contributions to the pension plan are made by listed FIs. This restriction applies since listed FIs cannot generally claim ITCs to recover GST paid on their expenses. However, a pension entity of such a plan and the participating employers of the plan would be permitted to make a joint election whereby the participating employers could make a deduction in determining their net tax in respect of what would otherwise have been the pension entity's rebate entitlement. As outlined above, this deduction would be limited by the employer's share of the total pension contributions and the employer's tax recovery rate.
These proposed deeming rules would apply for fiscal years of employers beginning on or after the Announcement Date. With respect to pension entities, the proposed rules would apply to a pension entity's claim periods (i.e., a reporting period if the pension entity is a registrant or the first two or last two fiscal quarters of a fiscal year if the pension entity is not a registrant) beginning on or after the Announcement Date.
GST Information Return for Financial Institutions
In a January 26, 2007 press release, the Department of Finance announced the introduction of a new GST annual information schedule for FIs. Following consultations, the Government is now releasing proposed draft legislation with respect to this proposal.
Currently, very limited information is required from businesses on their GST returns. The information schedule, now referred to as an information return, for FIs is being introduced in recognition of the need for supplementary data from the financial services sector given the complexities in the sector and the specific GST rules that apply to FIs. Additional GST data from FIs will help to improve compliance, maintain an efficient and effective tax administration system, assess policy and legislative changes in a timely manner and assist the Government in meeting its commitments to the provinces under the harmonized sales tax.
The Minister of National Revenue has the authority to require the information provided on the information return. However, in order to provide certainty and guidance, the Government is now releasing draft legislation that sets out a legislative framework for compliance and administration related to the return. Further, following extensive consultations with the FI industry, modifications are being made to the January 2007 proposal to assist FIs in complying with their reporting obligations.
The proposal would require an FI that is a registrant and that has total annual revenue (as stated in its financial statements that are filed with its income tax returns) in excess of $1 million, to file an information return that provides an analysis of the information provided on the GST return. The new information return is intended to apply to the broad range of FIs as defined in subsection 149(1) of the ETA that meet the above tests including, among others, banks, insurers, securities dealers, businesses that have a significant amount of financial services in their activities (commonly referred to as de minimis FIs), and businesses that are deemed to be FIs by virtue of the intra-group election under section 150 of the ETA.
The information return would be required to be filed annually, within six months after the end of the fiscal year of an FI, and would apply for fiscal years of FIs commencing after 2006.
Key points of this draft legislative framework, including modifications made since the January 2007 proposal, include:
- Penalties would apply for failure to report or misstatements of amounts required to be reported on the information return. An exception is proposed in the draft legislation where the taxpayer has exercised due diligence in attempting to report the required information and, as noted below, the penalty provisions would be phased in and the Minister of National Revenue would be given certain discretion in the application of penalties.
- The fields on the information return would be classified into tax amounts and non-tax amounts. Tax amounts are data that are used to provide an analysis of the more global amounts reported on the regular GST return (i.e., GST34 and/or GST494 returns); these would include the details necessary to identify the components of the GST collected/collectible and adjustments, and total ITCs and adjustment amounts on the GST return. Non-tax amounts pertain to information such as taxable sales, taxable purchases, and intra-group transactions that are not directly used in building up the tax liability. In order to provide flexibility, FIs would be permitted to provide estimates for non-tax amounts for which the actual values are not reasonably ascertainable at the time of filing the information return.
- The Minister of National Revenue would be provided the authority to allow FIs to provide estimates for tax amounts on the information return. The Minister would also have the authority to exempt any FI or class of FIs from filing the information return.
- To facilitate this new reporting obligation of FIs, a transitional period would be provided with the new rules coming into force for fiscal years commencing after 2007. Penalties in respect of tax and non-tax amounts would apply for fiscal years commencing after 2008.
Additional details on the proposed legislative framework are provided in the explanatory notes that accompany the draft legislation. The Canada Revenue Agency has already made the GST information return (GST111) form and the accompanying guide available on their website at www.cra-arc.gc.ca.
Extension of Filing Due Date of GST Returns for Financial Institutions
All GST registrants are required to file a GST return for each of their reporting periods. Generally, a registrant's reporting period (i.e., fiscal month, fiscal quarter, or fiscal year) depends on its threshold amount (i.e., annual taxable supplies made by the registrant).
However, in the case of listed FIs, other than businesses that have become listed FIs for GST purposes by virtue of a group election, the above annual taxable supplies thresholds do not apply. Unless they elect to file monthly or quarterly, these listed FIs file their GST returns annually within three months after the end of their fiscal year. Annual filing significantly reduces the compliance burden of FIs which, due to the mix of taxable and exempt activities, are required to apportion their inputs for the purpose of claiming input tax credits.
"Selected listed financial institutions", i.e., listed FIs that operate in both harmonized and non-harmonized provinces, are required to file a GST494 return in addition to (in the case of monthly and quarterly filers) or in place of (in the case of annual filers) their regular GST34 return. The GST494 is required to be filed within three months after the end of the fiscal year.
Some of the proposed changes outlined above (i.e., imported taxable supplies rules, FI information schedule), would link GST reporting obligations of FIs to their reporting obligations under the Income Tax Act,which require income tax returns to be filed generally within six months after the end of the taxation year.
To facilitate compliance, it is proposed that the filing due date of GST returns (GST34 or GST494) for FIs that are annual filers, be extended to six months after the end of the fiscal year. Further, the filing due date of GST494 returns for selected listed FIs that are monthly and quarterly filers would be extended to six months after the end of their fiscal year. The proposed changes come into effect for reporting periods of an FI commencing after 2009.