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Tax Expenditures and Evaluations - 2000: 5

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GST/HST Treatment of Export Distribution

I. Introduction

The 2000 budget announced changes to the goods and services tax/harmonized sales tax (GST/HST) treatment of export distribution activity. This paper provides detailed information on these changes. The proposed changes would ensure that the cash-flow implications from having to pay and finance the GST/HST do not impose unintended costs that would preclude Canada as a location for North American distribution businesses. The measures would enable participants to acquire or import most goods without the payment of GST/HST where those businesses export substantially all of their outputs or perform export distribution operations for other businesses, and add limited value added in the course of processing goods.

The legislative proposals for these changes would come into force on January 1, 2001, so as to allow for consultations in the spring of 2000.

II. Background

The GST/HST Treatment of Export Distribution Activity

A number of programs under the GST/HST provide cash-flow relief with respect to the export sector. These programs are each targeted towards a certain type of export-oriented activity. However, as a result of ongoing monitoring of the GST/HST application to the import and export sectors, it was determined that none of the programs adequately deal with the problem faced by businesses involved in distribution activities. These export-oriented firms want to perform some limited processing activity on goods either imported or purchased in Canada for export. An increasing number of firms are engaged in this type of activity, such as the installation of software or customization of products to reflect purchasers’ specific needs.

No GST/HST applies to exported goods and services, and tax paid by exporters on their inputs is fully refundable though the input tax credit mechanism. However, in cases where there is minimal processing in Canada, the cost of financing the GST/HST paid on either imported or domestically acquired goods to be processed, as well as various component parts, can be significant in relation to the level of value added to goods. In particular, these financing charges can be significant given that the profit margins of these types of businesses are low in relation to the value of goods processed. Thus, for these types of businesses, financing the GST/HST component can increase their capital requirements, ultimately affecting the viability of locating such an operation in Canada.

How the GST/HST Operates

The GST/HST is a tax on the final consumption of goods and services in Canada. A supplier is required to collect either the GST at the rate of 7 per cent or the HST at a rate of 15 per cent on any taxable supplies, other than "zero-rated" supplies [1], made in Canada. In order to eliminate the taxation of inputs, the GST/HST is designed as a multi-stage tax. While businesses throughout the production and distribution chain charge tax on their domestic sales, they are able to claim a refundable credit, called an "input tax credit", for any tax paid on purchases of goods and services used in the course of carrying on business.

Based on a determined reporting schedule, a business simply adds up all of the GST/HST it has paid to suppliers, and subtracts this from the GST/HST it collects on it sales. Only the net amount – tax collected less tax paid – is remitted to the Government.

Under the GST/HST system, businesses that supply the domestic market are generally required to collect the GST/HST on their supplies. Where the GST/HST is collected, the vendor may receive a cash-flow benefit from holding the GST/HST amounts in trust until they are required to be remitted to the Government. For most businesses, the amounts collected would be greater than the GST/HST paid on purchases.

A key objective of a value-added tax such as the GST/HST is to fully relieve exported goods and services from the tax. Thus, no GST/HST is charged on sales made outside of Canada and goods and services destined for export are zero-rated. Under the GST/HST system, where an exporter purchases or imports goods, it must pay tax on the purchases, which it subsequently recovers through the input tax credit mechanism. Where the Government has not sent the refund of GST/HST within 21 days of receiving the GST/HST return, it pays interest based on the amount owed calculated by reference to recent Treasury Bill rates.

Exporters face a cash-flow burden because they do not collect any GST/HST to offset the amount of the GST/HST they pay on their purchases, but rather claim the tax back through the input tax credit mechanism. However, it is important to recognize that alternative approaches to this mechanism to relieve this burden and to ensure that sales tax applies only at the point of final consumption in Canada, such as single-stage sales taxes (e.g., retail sales tax), involve the universal use of exemption certificates. These certificates provide point-of-sale tax relief in limited circumstances. That is, not all businesses are able to use the certificates and the certificate cannot be used for all purchases. Indeed, as a general rule, about a third of revenues from such taxes come from taxes on business inputs. As a result, tax systems that rely on exemption certificates cannot remove all of the tax from exports.

In addition, since a good may have several different uses, vendors and tax authorities find it difficult to determine whether the sale is tax-free or not. The liberal use of certificates would cause significant exceptions to the general application of the sales tax. For tax administrators, a system using exemption certificates, unlike an input tax credit system, provides few opportunities for cross-verification.

The GST/HST, on the other hand, allows purchasers to claim input tax credits and, therefore, eliminates tax cascading and administrative complexities. However, the benefits may come, in special circumstances, at the cost of a cash-flow burden for certain sectors, such as exporters.

III. Proposed Changes to the GST/HST Treatment of Export Distribution Activity

To address the issues discussed above relating to export distribution activities, changes to the GST/HST treatment of these activities are proposed. The changes would ensure that the cash-flow implications from having to pay and finance the GST/HST do not impose costs that would preclude Canada as a location for North American distribution businesses. The measures would be designed in a targeted manner to ensure that the effectiveness of the multi-stage GST/HST tax is not impaired.

Overview

The changes are aimed at export distribution businesses that perform limited processing on goods before they are exported. These proposals do not require the establishment of specific geographic "tax-free zones" or "foreign trade zones." Nonetheless, the changes, when coupled with other existing programs (e.g., the Duty Deferral Program that provides duty relief), would provide the benefits of such zones. But unlike tax-free zones or foreign-trade zones, which restrict the benefits only to those businesses situated within a particular geographical area, the changes would apply to eligible businesses regardless of where they are located. As such, this approach would not promote the dislocation of existing industry from one locale to another, which could be the case if designated geographical zones were created.

The proposed changes are aimed only at those export-oriented businesses that carry on limited processing where the cash-flow costs associated with the GST/HST are significant relative to the value added. The new measures would not apply to businesses that manufacture or produce goods, thereby adding significant value in the process. In such circumstances, the cash-flow costs resulting from the GST/HST on the goods either acquired domestically or imported are much less significant in relative terms. [2]

Example 1: A good costs $100 to produce and bring to market. The cost (excluding soft costs) to produce the good up to the point of distribution is $50 worth of material and $35 labour. The distribution of the product (e.g., packing and shipping) costs $15. A manufacturer would be required to pay and finance $3.50 GST on material costs in the course of producing the good up to the point of distribution. In contrast, a distribution business that acquires the good or imports it on the manufacturer’s behalf would be required to pay and finance $5.95 based on the value of the material and labour costs up to the point of distribution (i.e., $85).

Through the use of a certificate, a business will be able to import, tax-free, its own goods or those belonging to another person. It will also be able to purchase domestic goods tax-free by using a certificate. Tax relief would be available for the purchase of goods that are to be processed as well as goods (e.g., component parts) that are to be added or utilized in the course of the processing activity.

Tax relief would not be available in respect of imports or purchases of capital property. Also, the certificate would not be available for domestic transactions valued at less than $1,000. Limiting the use of the certificate to transactions of at least $1,000 would reduce administrative complexities for domestic vendors and would normally only involve vendors having a significant business relationship with the certificate holder. [3] Also, export distribution businesses would continue to pay GST/HST on any soft costs (e.g., rent, utilities, domestic transportation or professional services) acquired and consumed in Canada. However, as these businesses would be required to be registered for the purposes of the GST/HST in order to benefit from the proposed changes, they would be able to claim input tax credits for these GST/HST amounts in the normal fashion.

Eligibility Requirements

For the purposes of the proposed changes, eligible businesses would be those:

The export revenue threshold is intended to target the proposed changes at export-oriented businesses. For this reason, an export revenue test would apply such that at least 90 per cent of the total revenue generated in Canada by a business must be generated from exports. The test would only apply with respect to revenue generated in Canada, since the inclusion of revenue generated outside Canada in determining whether or not the threshold has been exceeded would inappropriately exclude some businesses.

The export revenue threshold would ensure that, to use the proposed changes, a business would only have limited sales in the domestic market and, therefore, would not enjoy a cash-flow advantage over other domestic suppliers by virtue of using their certificate to acquire or import goods tax-free. For the purposes of this test, "export revenue" would include revenue from the sale of goods to be exported as well as revenue from the provision of services in respect of other persons’ goods that are to be exported.

It is also important to recognize with respect to the export revenue threshold that the cost to an export-oriented business of financing the GST/HST diminishes as domestic sales rise. This is due to the fact that the business is collecting GST/HST on their domestic sales and those amounts, which are held in trust by the business, are used to offset the GST/HST paid on either imported or domestically acquired goods.

As the proposed changes are intended to address situations where only limited value-added processing takes place in relation to turnover, eligible businesses would not be able to undertake the manufacturing or producing of goods. There would also be defined limits on value added. For those businesses that process their own goods before export, the limit would require that the direct labour content of the cost of the goods supplied by the business not exceed a prescribed percentage. [4] With respect to customers’ goods, a test would apply to ensure that the value of the services provided in respect of those goods does not exceed a prescribed percentage of the total value of those services plus the value of the goods when imported or transferred to the business. In both instances, these prescribed percentages would be determined after consultations with stakeholders on the proposal.

Activities that can presently be undertaken in a customs bonded warehouse (CBW) would be specifically excluded from the value-added calculation. The rules with respect to the CBW Program allow a wide range of activities to be carried on, but these activities are subject to limitations. The exclusion of these activities that are presently allowed in a CBW reflect the fact that in certain situations, these activities, in and of themselves, could cause the defined limits on valued added to be exceeded easily.

Example 2: Company A, a distribution business, purchases screws in bulk. The service it provides to the manufacturer is to break down the bulk screws and package them in plastic containers, five per package. At present, such activity can be undertaken in a CBW. Where such activity takes place under the proposed changes for export distribution activity, the value added by virtue of the packaging of the material would likely exceed the defined limits of value added to goods. However, activities, such as breaking bulk packages, that are presently allowed under the CBW Program are excluded from the value-added calculation.
Adjustments

The export revenue test and the value-added test would be applied on an annual basis at the end of a business’s fiscal year. Where these tests are not satisfied, or there has been improper use of the certificate, the export distribution business would be required to make adjustments to its net tax for the first reporting period of the business following that fiscal year. This would ensure that no cash-flow benefits are realized by the business from having used the certificate when comparing its situation to other domestic vendors.

Example 3: Company B meets the eligibility criteria for using the proposed changes and is authorized by the Minister of National Revenue to use a certificate in order to obtain tax relief on domestic acquisitions and imports. However, at the end of its fiscal year, upon calculating its export revenue percentage for the year, it is determined that only 85 per cent of its total revenue was from exports. This was due to a large, one-time order from a domestic purchaser. As a result, Company B is required to make an adjustment to its net tax.

In certain circumstances, a business’s authorization to use the proposed changes would be automatically revoked. This would occur immediately after their fiscal year where:

Administration

An application for the authority to use a certificate under the proposed changes would be required in a prescribed form and manner. An application would have to be filed with the Minister of National Revenue, who would be required to verify the applicant’s eligibility to participate in the program prior to authorization.

The authorization to use a certificate would be valid up to three years after the day on which the authorization became effective unless the authorization is revoked prior to that time.

Where the three-year time period draws to an end, a qualifying business would be required to formally renew its authorization by submitting a request in writing to the Minister of National Revenue.

In addition to the circumstances where automatic revocation occurs (see above), the Minister could revoke an authorization at any time throughout a fiscal year where:

Where the authorization for a business to use a certificate is revoked, effective on a particular day, the business would not be entitled to reacquire a certificate before:

Coming Into Force Date

Budget 2000 proposed that the measures described above come into force on January 1, 2001. Consultations on specific aspects of the proposal, for example, to specified percentages for the value-added test, took place in the spring of 2000.

IV. Conclusion

The proposed changes in the GST/HST treatment of export distribution activity would alleviate the cash-flow burden faced by operators of qualifying distribution businesses as a result of their having to finance the GST/HST. As a result, the targeted changes are designed in such a manner as to remove any unintended costs that would preclude Canada as a location for North American distribution without threatening the effectiveness of the multi-stage GST/HST.

The proposed changes, in conjunction with the other programs currently available for imports and exports, support an overall objective of the GST/HST in relieving tax from exported goods and services. Moreover, unlike tax-free zones and foreign trade zones, which restrict the benefits only to those companies situated within a particular geographical area, the benefits of the proposed changes and existing programs apply to eligible businesses regardless of where they are located in Canada.


Appendix 1: Relevant Current GST/HST Rules for Exporters

The federal government recognizes the cash-flow burden often faced by export-oriented businesses and in the past has introduced programs to alleviate these associated financing costs. However, these programs are targeted towards certain types of activities. In particular, they do not allow for even limited processing of one’s own goods prior to export – activities that typically take place in distribution businesses.

The programs that currently exist to provide GST/HST relief to exporters are briefly discussed below.

Exporters of Processing Services Program

The Exporters of Processing Services (EOPS) Program allows the tax-free importation of goods that continue to be owned by an unrelated non-resident, for the purpose of processing the goods in Canada and then re-exporting them. The EOPS Program has been designed to ensure that Canadian service providers can compete with non-Canadian service providers in world markets.

The EOPS Program has limited application in the context of distribution-business type activity. First, the program is targeted to service providers. Consequently, it does not apply when the service provider owns the goods. Second, all of the goods on which services are performed must be exported, which precludes any supplies to the Canadian market whatsoever. Finally, the resident service provider who is authorized to participate in the EOPS Program receives tax relief only on imports, as the program is export-service oriented. This precludes Canadian goods purchased by the non-resident from being serviced on a tax-free basis.

Adapting the EOPS Program to apply to distribution-business type activity would be problematic due to the broad range of services that it covers. In particular, removing the criterion that the service provider not own the goods being processed, and providing for tax-free acquisition of domestic products, would significantly erode the general application of the multi-stage tax, leading to added complexity for many domestic suppliers, and creating administrative difficulties in controlling tax-free purchases in the domestic economy.

Customs Bonded Warehouse

The CBW Program defers payment of taxes and duties until goods enter into the Canadian economy or are exported. Where the goods are exported, never having entered into the Canadian economy, no taxes or duties are payable. The CBW Program is effective in providing tax and duty relief where goods are transiting Canada, and no processing is required.

The program rules allow a wide range of activities to be carried on in a CBW. There are, however, limitations, namely that the goods in the warehouse should not be manipulated, altered or combined with other goods except in limited circumstances such as inspecting, labelling, storing, packaging or testing. [5]

The CBW Program could be used for certain distribution-centre type activities. However a number of issues arise. First, a business operating in a CBW can carry on only clearly defined limited processing activities with respect to goods. This does not reflect the nature of modern distribution centre activities, where goods are often customized to reflect particular markets or to meet a purchaser’s specific requirements. Second, the CBW Program allows goods to leave the CBW either for export or to enter the domestic economy. Finally, a warehouse authorized under the CBW Program cannot acquire goods domestically free of tax; relief applies only to imports.

Expanding this program to distribution-business type activity would have negative implications. As this program provides tax relief only in respect of imported goods, it would create a bias towards importation versus domestically acquired goods. Further, the CBW Program is very broad in its application and can be used not only by export-oriented businesses, but also businesses supplying to the domestic market. Also, if minor processing were allowed under the CBW Program, an unfair distortion would be created against purely domestic suppliers such that they may face cash-flow costs on domestic and imported inputs that a CBW would not. In addition, domestic suppliers of inputs to businesses operating in a CBW would be disadvantaged compared to non-resident competitors, who would not be required to charge and collect the GST/HST when shipping into a CBW situated in Canada.

Export Trading House

The Export Trading House (ETH) Program relieves GST/HST on domestic goods purchased for resale by businesses that are exporters. This program is the domestic counterpart of the CBW Program with respect to GST/HST relief. However, the goods cannot be further processed in any manner, except to the extent reasonably necessary or incidental to their transportation.

Two issues arise when applying the ETH Program to distribution-business type activity. First, in order to limit the effects of the program on the general application of the tax, no processing is permitted. As a distribution business must have the ability to customize goods in response to a particular market or to meet a purchaser’s specific requirements, the ETH Program is not suitable. Second, GST/HST relief is provided only with respect to domestically-acquired goods and does not apply to taxes payable on imports.

This program is of little assistance to distribution businesses that frequently import goods on behalf of non-resident businesses, warehouse them and ultimately deliver them to the final purchaser.

Other GST/HST Mechanisms

A number of other legislative mechanisms exist to provide GST/HST relief in the import and export areas. However, these provisions are limited in application and are designed to apply to particular types of common business practices.

The Drop Shipment Rulesallow sales to non-residents of goods bound for export and of services performed on those goods to be made on a tax-free basis, provided that the goods remain in the possession of Canadian service providers before export. The Drop Shipment Rules essentially facilitate the transfer of goods owned by non-residents between Canadian processors. It does not provide the type of relief suitable for the distribution business sector.

The Non-Taxable ImportationsProgram permits tax-free importation of goods for the purpose of repair, maintenance or overhaul. This program is not open to Canadian suppliers who also supply property (e.g., components) with the service. Additionally, the Non-Taxable Importations Program is restricted to certain types of services (e.g., it clearly excludes distribution type activity).


Notes

  1. Zero-rated goods and services are those to which a "zero" rate of tax applies – in other words, they are totally tax-free.
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  2. For businesses that are engaged in manufacturing and/or producing, programs such as the Duty Deferral Program and the Exporters of Processing Services Program may provide relief from any applicable duty and the GST/HST on imported goods provided the particular program conditions are satisfied.
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  3. It is important to reiterate that there are significant potential risks associated with the widespread utilization of exemption certificates. As previously stated, this system typically results in tax being built into the cost of exports, and both vendors and tax authorities find it difficult to determine whether a sale should be tax-free or not.
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  4. The cost of the goods should be ascertained in keeping with acceptable methods of cost determination used in inventory valuation.
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  5. A complete list of acceptable activities can be found in section 3 of Part I of the Customs Bonded Warehouses Regulations.
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