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.

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.