Allocating Input Tax Credits

 

These days, with all the complexities of the GST/HST rules regarding what is taxable and what isn’t, many businesses and professionals may find themselves providing a mix of supplies; that is, sales are taxable or exempt, depending on the rules (for example, a pharmacist who sells taxable items as well as exempt prescription drugs). This begs the question: to what extent can a business or professional claim input tax credits (“ITC’s”) with respect to the GST/HST paid on its expenses?

With the notable exception of financial institutions, which have their own set of specific rules, in general, a business may claim ITC’s based on the amount of its expenditures consumed in pursuit of its commercial activities.

 

General Rule for Claiming ITC’s:

The starting point is the general rule which requires ITC’s to be calculated based on the following formula:

A x B

Where

A is the GST/HST paid or payable on the purchase of a property or service, and

B is a percentage, which represents the extent to which the person acquired the property or service in the course of the commercial activities of the person.

Based on the above, it is therefore necessary to determine what is meant by the term “commercial activity”. The law defines a commercial activity as a business carried on by a person, except to the extent to which the business involves the making of exempt supplies by the person.

Therefore, to the extent that the business activities do not involve the making of exempt supplies, they constitute commercial activities.

 

 

Allocation of Expenditures for ITC Purposes:

There is no requirement to apportion expenditures based on revenues or any other measurement. The only criterion set out in the law is that the apportionment must be reasonable and consistent.

The CRA provides guidance as to how to allocate ITC’s between commercial and non-commercial activities. In its GST Memorandum 8.3, it states that the methods used should link the property or service on which the input tax was paid to commercial and other activities. It suggests that directly allocating expenses to a commercial activity is most desirable. For example, where an expenditure relates exclusively to a taxable (or zero-rated) sale, then a full ITC should be claimed on this amount. The CRA suggests that expenditures be categorized between two groups, as follows:

1. single-use property and services used wholly in a particular activity; and
2. multiple-use property and services used in more than one kind of activity;

In the case of single-use property and services, it is clear that either a full ITC will be claimed (commercial activity) or no ITC will be claimed (exempt activity).

Note that a property or service consumed substantially all (i.e.90%) for a single purpose (either commercial or non-commercial) it will be deemed to be used 100% for that purpose and so will be considered a single-use property.

For multiple-use property or services, the recommended method is an “input” based method. This means that the allocation should be made based on usage. For example, if a self-employed contractor is providing services to both the taxable and exempt activities, then an allocation based on time spent may be reasonable. Rent may be allocated base on square footage used in either activity.

The CRA goes on to state that allocation based on “output”, i.e. revenues, should be made with caution to ensure such a method fairly represents the ratio of inputs used in each activity.

The issue of “reasonable allocation” was addressed by the Federal Court of Appeal in the case of Ville de Magog v. the Queen. The point made in this case was that the law requires only that the allocation method be reasonable and consistent. If the government performs an audit, and, as they did in this case, disagrees with the method for allocating expenses, they cannot change the allocation used by the taxpayer, as long as the taxpayer’s method was reasonable. In other words, the government was not allowed to change the method used on the basis that their method was “more reasonable” than the taxpayer’s method.

Harmonized Sales Tax

Confession: I’ve never really paid much attention to the HST. Here in Quebec, we have the GST and our very own QST, and that’s been enough for us to handle so far.

Simon, Garfunkel, Ontario and B.C. - All harmonizing these days.

But things are about to change drastically, and unless you’ve just come over on the boat from PEI, you must be aware that most of us now have to pay closer attention to the HST.

First of all, Ontario and B.C. are about to implement the HST. The provincial retail sales tax systems, therefore, will be eliminated, and one tax rate will apply to their goods and services. Ontario’s rate will be 13% and B.C.’s is 12%.

There will be new “place of supply” rules that will determine whether, and at what rate, suppliers located outside a particular province must charge the HST to their customers.

For example, if you are a lawyer residing in Quebec, and you provide a service to a person who is resident in Ontario, you may now have to charge 13% HST as opposed to just the 5% GST on your services. This does not mean that you will have to register in for the HST in Ontario. Anyone who is registered for the GST will have the obligation and the ability to charge the full HST where it applies, in lieu of the GST. No new HST registration number is required.

Place of Supply Rules for Tangible Goods

In the case of a sale of tangible goods, the place where the goods are delivered, or made available to the recipient will determine the tax rate. If you make arrangements to deliver goods, for example from your warehouse in Ontario to a customer in Nova Scotia, then their 15% rate of HST will apply, even if title passes in Ontario. These rules have been in place since the beginning of the HST.

New Place of Supply Rules for Services and Intangible Personal Property (“IPP”)

The biggest change will be seen by registrants who supply services or IPP  to customers in HST provinces. Generally, under the new rules, HST on services will be charged based on the address of the customer. If the customer has more than one address, then the charge is based on the address that is most closely related to the service. If no address is obtained, then the we must look to where the service is performed.

There are many exceptions to the above rules. Services that relate to real property or tangible personal property must bear tax based on the location of the property or goods at the time the services are performed.

Personal services (other than consulting, advisory or professional services) that are performed in the presence of the recipient are taxed where the services are performed.

The new HST rules will come into effect for services provided and goods delivered on or after July 1, 2010, but there are a number of complex transitional rules to be navigated.

The CRA’s website has plenty of information on the transition for Ontario and B.C., and the Department of Finance is where you will find the regulations concerning the new place of supply rules. I would strongly suggest that anyone who does any business with customers in an HST province take the time to prepare for the changes.

What’s Your Tax Issue? Invoices Required

The Tax Issue:

I am going through an audit by Revenu Quebec. I have given the auditor my credit card statements as backup for certain expense claims, and he insists that he will disallow any deduction unless I can produce the actual invoice. Am I legally required to provide an invoice to support a tax deduction?

The Answer:

This is a question I get on a regular basis. The answer is no, but…..

First, let’s clarify the ground rules . We are talking here about general business expenses, and not items such as child care or tuition fees which specifically require tax receipts.

Also, we are discussing income tax deductions, not claims for GST/QST/HST inputs tax credits, which do legally require documentation showing the taxes charged and the supplier’s registration numbers.

OK, now let’s talk about tax deductions. There is nothing in the law that obliges you to produce an invoice to back up an expense claimed for income tax purposes. However, the law does place the burden of proof on you to show , on a balance of probabilities, that you have spent the amount and that it qualifies for a tax deduction.

The Quebec auditor has given you his position that he will not allow a deduction unless it is supported with an invoice. That is his right to do, and it is probably the policy of his department. The Minister can assess you based on any assumption he wishes. Here, he is assuming that no expense is deductible without an invoice.

Now, the burden falls on you to provide some other form of proof to support your claim. This is a difficult task without an invoice (which is why the auditor wants one).

Can the proof consist of verbal testimony? Yes, but it rarely works with auditors because they don’t generally have the discretion to go against their audit procedures.

You have a number of chances to state your case. There is usually some form of representation you can make to the auditor and/or the supervisor prior to an assessment. After that, you can object to the assessment at the appeals level. Finally, there are the courts, where you might wind up if the government sticks to its guns on the issue.

So, you can go ahead and let the auditor know that an invoice is not technically required, but then you must provide him (or ultimately, the judge) with sufficient proof to destroy his assumptions.

GST and Real Estate

Transactions involving real estate seem to attract hectares of GST questions. Surprisingly, the basic rules are fairly straightforward. Unfortunately, there are many “out of the ordinary” situations that complicate matters. Happily, those will not be covered here. The rules discussed below deal with most transactions practitioners will ever encounter.

Before purchasing real estate, make sure to check the GST rules

What is Taxable?

Real estate transactions fall into two main categories: Supply by way of “lease or licence” (i.e., “rentals”), and supply by way of sale.

Generally, as is the case with all GST questions, the first rule is that every supply is taxable unless it qualifies for an exception. Thus, most commercial real estate transactions involving businesses will be taxable. The major GST exemptions will involve supplies of residential property.

The long-term rental of residential property is generally exempt.

A sale of property is exempt if it qualifies under the definition of “used residential” property. Generally, a residential property is considered used if it was previously occupied or intended for use by an individual as a personal residence.

New Residential Property

A sale of a new residential property is taxable. Generally, it is a “builder” who will make such a sale. Since the builder is himself carrying on a commercial activity, he will be claiming input

tax credits (“ITC”) on his construction costs, and then charging the GST when he sells the property.

The purchaser of a new home will be eligible for a “new housing rebate”. This rebate is equal to 36% of the GST paid up to purchases of $350,000. Between this amount and $450,000, the rebate is reduced, and is eliminated thereafter (for the QST, the dollar limits are $200,000 to $225,000).

Self Supply of Residential Property

If a builder, rather than selling a completed residential complex, decides to retain it as a rental property, the “self supply rules” will apply. He will be deemed to have sold himself the property. He will self-assess and remit GST based on the fair market value of the property, including the land. This tax is not eligible for an ITC, since it is an acquisition of a residential property. It will, however, qualify for the residential rebate. If the complex is an apartment building with many units, its value will likely exceed the $450,000 limit. However, these limits will apply to each unit based on its square footage. Accordingly, if a builder completes a 5 unit apartment whose value is $1 million, each unit might be valued at $200,000 and will qualify for the full rebate.

These self-supply rules will apply equally to a “substantial renovation” of a residential property.

Input Tax Credits

Generally, any GST registrant carrying on a commercial activity is entitled to an ITC for expenses. If the activity of the purchaser is part commercial and part exempt or personal, then the ITC must be apportioned in a reasonable manner.

For capital property other than real estate, if the property is used more than 50% in commercial activities, it will be eligible for a full ITC.

A purchase of real property is subject to unique rules. Generally, the ITC must be apportioned based on commercial use. If the purchaser is an individual, no ITC is available at all if the property is used primarily (>50%) as a residence. Thus, an accountant who uses 20% of her home as an office cannot claim any ITC on the real estate purchase.

Who Collects

Generally, a vendor of real property is responsible for collection and remittance of the GST. However, this is not the case where the purchaser is a GST registrant. In this case, the purchaser will self-assess the GST and simultaneously claim any eligible ITC. The vendor should verify the purchaser’s registration number with the government.

If the sale of real property is exempt, it will be because of the vendor’s history with the property. The purchaser should insist on a written confirmation of exempt status from the vendor. Otherwise he will be liable for the tax if such status is subsequently denied for any reason.

GST Rebates for Non-Profit Organizations

One of the most asked questions in the area of GST concerns the rebate available to non-profit organizations (“NPO”). In general, where a GST registrant makes taxable supplies, it is entitled to a full input tax credit on purchases that relate to its commercial activities.

All of an NPO’s activities that are not commercial are in the realm of “non-profit”. All supplies of goods or services that are not for profit are considered exempt supplies under the Excise Tax Act (“the Act”). Exempt supplies are supplies on which the NPO may not charge GST and is not entitled to any ITC on expenses that relate thereto.

In the case of expenses that may relate to both the commercial and exempt operations of the NPO, these expenses must be apportioned on a reasonable basis to determine what percentage of the total is used in commercial activities in order to determine their ITC entitlement. For example, if 40% of the NPO’s activities involves the supply of taxable goods and services, then 40% of its office supplies may be allocated to the commercial activity and an ITC may be claimed for that portion.

The tax on the portion of the NPO’s expenses used in exempt activities may qualify for a special rebate under section 259 of the Act, which provides for a rebate of GST for certain NPO’s.

The rebate is available to the following organizations:

  • Charities
  • Qualifying NPO’s; and
  • Selected public Service Bodies

Each of the above has its own definition:

Charity: is a registered charity or registered Canadian amateur athletic association as defined in the Income Tax Act;

Qualifying NPO: is an NPO that receives at least 40% government funding;

Selected public service body: is:

(a)    a hospital;
(b)   a non-profit school authority;
(c)    a non-profit university;
(d)   a non-profit public college or
(e)    a municipality.

The current GST (QST) rebate rates available to these organizations are as follows:

(a)          Charities and qualifying NPO’s: 50%
(b)         Hospital: 83% (55%)
(c)          School authority: 68% (47%)
(d)         University or public college: 67% (47%)
(e)          Municipality: 100% (0%)

To make the claim in Quebec, separate forms for the federal and Quebec governments must be filed as follows:

  • Federal: form FP-66-V
    (Guide: form FP-66.G-V)
  • Quebec: form VD-387-V

The above forms may be found over at Revenue Quebec.

If an NPO is not registered for GST purposes, there is no requirement to do so to claim a rebate. For current registrants, the claim must be made within four years from the deadline date for the GST/QST return for the period in question. For non-registrants, the claim must be made within four years from the end of the year in question.

Non-Resident Vendors and the GST

The Goods and Services Tax (“GST”) is a Canadian sales tax of 5% levied on all goods and services (“supplies”) made in Canada. Anyone making a supply in Canada must register for the GST, collect the tax from its customers, and remit the tax to the government.

Now, I hear what you’re saying: What about me? I’m a non-resident of Canada. Surely, I don’t have to comply with this nonsense.

If you cross the border to sell that snake oil, you may have to charge the GST.

Well, perhaps you do. Any non-resident who carries on a business in Canada must register.

Are you carrying on a business in Canada? The law here is not simple. The answer is, it depends on your level of activity. You must have a substantial presence in Canada, and your income-earning activities must be located here.

What do the courts and the CRA look for to make the determination? The CRA has outlined 12 factors:

1. The place where agents and employees of the non-resident are located;
2. The place of delivery;
3. The place of payment;
4. The place where purchases are made or assets acquired;
5. The place from which transactions are solicited;
6. The location of assets or an inventory of goods;
7. The place where business contracts are made;
8. The location of a bank account;
9. The place where a non-resident’s name and business are listed in a directory;
10. The location of a branch or office;
11. The place where the service is performed; and
12. The place of manufacture or production

The weight given to any one factor depends on the type of activity. For example, in the case of a leasing business, the location where the contract is signed and the location of the goods to be leased are two of the more important factors.

Carrying on business in Canada has income tax consequences as well, as we discussed in an earlier post.

Also, depending on the province, you may have to collect the HST (Harmonized Sales Tax), which combines the 5% GST with the province’s rates.

If your activities in Canada are on the rise, and you want to remain in good standing with the Canadian tax authorities, contact a Canadian tax advisor to ensure you don’t run in to any problems down the road.