In what turned out to be at best a poorly kept

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1 January February 2010 Together in Imperfect Harmony: Ontario and British Columbia Embrace Value-Added Tax * By Jim Day Jim Day analyzes the potential impact and transitional rules that will apply when Ontario and British Columbia harmonize their existing sales tax systems with the federal goods and services tax, which will take effect July 1, In what turned out to be at best a poorly kept secret, the Province of Ontario announced on March 26, 2009 that it plans to harmonize its existing provincial sales tax system with the federal Goods and Services Tax (GST), effective July 1, The announcement, which was a key component in a comprehensive tax reform package introduced in Ontario s 2009 provincial budget, certainly strikes a familiar chord with the Canadian federal government, which has, on several occasions, suggested that harmonization is the single most important action that the five provinces in Canada, which currently impose their own retail sales taxes, could take to improve competitiveness. British Columbia was quick to join in the chorus, announcing on July 23, 2009 that it also plans to adopt the Harmonized Sales Tax (HST), using the same implementation date as Ontario. Jim Day is the Director of Tax Advisory Services for Ryan, where he advises a broad range of clients on all aspects of federal and provincial sales taxes in Canada. In his role as Director, Jim is responsible for overseeing the delivery of professional services to clients throughout North America and monitoring the evolution of commodity tax legislation and administrative policy. Based in Ryan s Toronto office, Jim is also the current editor of Ryan s Canadian publications, including Value-Added Taxation in Canada: GST, HST, and QST, and is a frequent contributor to various commodity tax publications. He may be contacted at jim.day@ryanco.com or Ryan, Inc. What Is the HST? The HST is a value-added tax (VAT) that applies at each stage of the production and distribution cycle, rather than at a single point, which is what occurs under the sales and use and retail sales tax systems. Various forms of VAT are currently in use in more than 130 countries worldwide. In Canada, the GST is a national, value-added sales tax that has been in place since The GST is a broad-based tax that applies to most goods and services supplied in Canada, with the exception of certain items that have been exempted or zero-rated (i.e., given a tax rate of 0%) for reasons attributable to public policy. While the GST is designed to be borne by the ultimate consumer, it impacts almost every organization doing business in Canada. Under the Excise Tax Act (ETA), most persons doing business and making taxable supplies in Canada are required to register for and collect the GST. Registration is not limited to organizations normally considered to be engaged in commercial activities. This requirement extends to all types of organizations, including governments, hospitals, charities, and nonprofit entities. A key advantage to a VAT system is the elimination of embedded tax in the price of finished goods and services, which might otherwise be passed on to consumers, thus allowing for more competitive pricing (particularly in the export market). This is ac- 17

2 Ontario and British Columbia Embrace Value-Added Tax complished by permitting organizations involved in commercial activities (i.e., those making taxable sales) to recover the tax paid on inputs. These input tax credits are deducted from any tax collected on taxable supplies to be remitted by an organization to the Canada Revenue Agency (CRA). The HST was first implemented in Canada on April 1, The term harmonized refers to specific provisions in the ETA, which govern the HST (specifically, Section and Schedule IX), and reflects the fact that, for the most part, the same tax base and administrative rules are used for both GST and HST purposes. HST is essentially GST at a different rate, which results from the addition of a provincial component to the VAT. The first provinces to adopt the HST referred to as participating provinces included Nova Scotia, New Brunswick, Newfoundland, and Labrador. The current HST rate for these provinces is 13%. Participating provinces receive federal transfer payments in exchange for partaking in harmonization. Note that the HST is not collected directly by the provinces; it is administered federally by the CRA and the Canada Border Services Agency. Persons registered to collect GST/HST are not required to separately track the tax paid or collected at different rates. GST and HST are remitted to the CRA on a single GST/HST return. In addition, since both taxes are administered under the same legislation, GST registrants are automatically registered for HST. Why Harmonize? 18 Adopting the HST is intended to make Ontario and British Columbia more competitive by reducing the marginal effective tax rate on new business investment in both provinces. In simple terms, the theory is that the elimination of non-recoverable taxes, such as provincial retail sales taxes, on certain business inputs will make a province more attractive for investment. The administration of a single sales tax, rather than several independent taxes, should also reduce the tax compliance burden for many Canadian organizations, as well as overall government administrative costs. Indeed, the Ontario government estimates that businesses will see compliance cost savings of more than $500 million per year under a harmonized system. Furthermore, there is optimism that any cost savings realized by businesses in harmonized provinces will eventually be passed on to consumers, offsetting at least partially the price increase that will be borne by those consumers on goods and services that become subject to HST but were previously exempt from provincial sales tax. How Will It Work? Adopting the HST is intended to make Ontario and British Columbia more competitive by reducing the marginal effective tax rate on new business investment in both provinces. On July 1, 2010, Ontario and British Columbia will become participating provinces. In Ontario, the HST rate will be levied at a combined rate of 13%, consisting of a provincial component of 8% (which happens to match the existing general provincial sales tax rate in Ontario) and a federal component of 5%, which is the current GST rate in Canada. British Columbia is proposing to have a combined HST rate of 12%, comprised of a provincial component of 7% (which equals the existing general provincial sales tax rate in that province) and the same federal component of 5%. Both Ontario and British Columbia will have the ability to increase or decrease the HST rate (through the provincial component of the tax) two years after the implementation date. Unfortunately, the inconsistency in HST rates between British Columbia and other participating provinces may create issues regarding the disclosure of tax in different jurisdictions. Point-of-Sale Tax Relief One element of the HST implementation plan is the introduction of several point-of-sale rebates. These rebates will effectively provide consumers with an exemption from the provincial component of the HST on a limited number of otherwise taxable items, including: Children s clothing and footwear Children s car seats and car booster seats Diapers Feminine hygiene products Books (including audio books, subject to certain criteria)

3 January February 2010 Ontario and British Columbia will also have the flexibility to Public Service Body control which items are eligible for point-of-sale rebates, within broad parameters to be established in the ETA and related regulations. This should allow Charities and Qualifying both provinces to maintain certain Nonprofit Organizations unique aspects of their provincial sales tax regimes. For instance, British Columbia has announced that point-of-sale rebates will be provided for certain types of motor fuels, including gasoline, diesel fuel, marine diesel, and aviation fuel. While Ontario has provided no indication that it is considering a similar rebate for motor fuels, it has recently expanded its point-of-sale rebate offerings to include print newspapers and prepared food and beverages costing no more than $4 two items which are currently exempt under the province s existing retail sales tax. This targeted tax relief preserves the supplier s ability to claim input tax credits, while ensuring that consumers do not suddenly find themselves paying an extra provincial tax on items that are not taxed under their current system. An obvious issue will be the potential for inconsistencies in the tax relief offered by various participating provinces in Canada. Input Tax Credits As previously discussed, organizations making taxable (including zero-rated) supplies of goods and services are generally able to claim input tax credits for any GST/HST paid on their purchases in relation to those commercial activities. However, the expansion of the HST to two more participating provinces may not be good news for organizations making exempt supplies. These organizations are not eligible to claim input tax credits for tax paid on expenses in relation to those activities. For example, financial institutions are generally not able to claim input tax credits for GST/HST paid in relation to the exempt supply of financial services. Organizations making exempt supplies and located in Ontario or British Columbia cannot generally recover the GST paid on a portion of their expenses through input tax credits. Consequently, in the absence of other tax relief, the introduction of the HST in these jurisdictions will result in a 7 or 8% increase in the cost of certain inputs. While consumers might be accustomed to paying neither GST nor retail sales tax on financial services or other exempt supplies, they HST Rebate in Ontario (8% provincial component only) HST Rebate in British Columbia (7% provincial component only) can be confident that any cost increase experienced by their suppliers will be passed on to them in the form of higher prices or fees. Similarly, public service bodies, including municipalities, universities, school boards, hospitals, charities, and nonprofit organizations, may experience an increase in costs under a harmonized system due to the nature of their work, which typically involves exempt supplies. In an effort to address this issue, both Ontario and British Columbia plan to allow certain public service bodies to claim rebates for the provincial component of the harmonized tax. Rebates for Public Service Bodies Current GST Rebate Municipalities 78% 75% 100% Universities and Colleges 78% - 67% School Boards 93% - 68% Hospitals 87% - 83% 82% 57% 50% To date, the following rebate rates for eligible public service bodies have been proposed by Ontario and British Columbia: The rebate percentages are designed to keep the net effect of the HST fiscally neutral for each type of public service body, based on the relative amount of retail sales tax presently paid and the broader tax base anticipated under the HST. However, the lack of consistency in rebate percentages for the provincial component of the HST among participating provinces, as well as differences between those percentages and the existing rebate percentages for GST purposes, will undoubtedly create further complexity for public sector bodies in preparing for HST implementation. Input Tax Credit Restrictions for Large Businesses The implementation of the HST will not necessarily be straightforward for organizations involved in commercial activities either. One reason is the introduction of temporary input tax credit restrictions for large businesses. Businesses in Ontario or British Columbia with annual taxable sales in excess of $10 million, as well as financial institutions, will not be permitted to recover the provincial component of the HST paid on certain types of expenses, including: Journal of State Taxation 19

4 Ontario and British Columbia Embrace Value-Added Tax Telecommunications (excluding Internet access and certain toll-free services) Meals and entertainment Licensed road vehicles under 3,000 kilograms (and associated parts and certain services) Fuel for licensed road vehicles (in Ontario only) Energy not used to manufacture goods for sale or in farming operations These restrictions will be eliminated equally over a three-year period after they have been in place for five years. Note that the input tax credit restrictions on the provincial component of the HST will not apply to goods or services acquired solely for re-supply by large businesses. For example, a utility acquiring natural gas or electricity for redistribution to its customers will be eligible to claim an input tax credit on the full amount of HST paid. Both provinces have also agreed that purchases subject to these restrictions will not extend beyond the types of expenses previously described. The change in the proportion of tax to be recovered on most purchases (i.e., at the HST rate vs. the GST rate) and the need to restrict input tax credit claims on certain types of expenses (and later phase-out those restrictions) will necessitate further adjustments to accounting systems and compliance procedures used by organizations involved in commercial activities. Again, questions about consistency among the participating provinces with respect to the treatment of the provincial component of the HST may also arise. New Housing Rebates Under the current provincial sales tax systems in Ontario and British Columbia, tax becomes embedded in the cost of a new home, through tax paid on materials used during construction, but the supply of the completed home is not subject to provincial sales tax. However, once the HST comes into effect, the purchase of a new home will be fully subject to the provincial component of the tax. This would result 20 However, the lack of consistency in rebate percentages for the provincial component of the HST among participating provinces, as well as differences between those percentages and the existing rebate percentages for GST purposes, will undoubtedly create further complexity for public sector bodies in preparing for HST implementation. in new home buyers paying significantly more tax on the purchase of a new home upon HST implementation. In order to address the potentially negative impact that the introduction of the HST might have on the residential construction industry, both provinces will introduce rebates for qualifying new houses and new residential rental housing. Ontario will offer a rebate for 75% of the provincial component of the HST on eligible properties, to a maximum of $24,000. In British Columbia, a similar rebate of five-sevenths of the provincial component of the HST, to a maximum of $26,250, will be made available for qualifying properties. These rebates will be administered federally in a manner similar to existing GST rebates for new housing and new residential rental properties, using the same eligibility criteria. Transitional Relief for Low- Income Persons The burden of a VAT, such as the proposed HST, falls mainly on individuals and families. To ensure that low-income residents of Ontario or British Columbia are not adversely affected by harmonization, both provinces have announced measures to provide transitional relief. Ontario will provide a transition benefit, paid out in three installments, to Ontario tax filers age 18 and over. The maximum total payment available to single persons is $300, compared to $1,000 for single parents and couples. These amounts will be reduced by 5% of a recipient s prior year s adjusted family net income over $80,000 for individuals, and $160,000 for families. In British Columbia, an HST low-income tax credit will be made available. An individual will be entitled to a credit of $230 each year, provided his/her income does not exceed $20,000. A family will be entitled to a credit of $230 for each family member each year, provided the family s income does not exceed $25,000. A credit will also be available to individuals and families with incomes in excess of these limits; however, it will be reduced by 4% of

5 January February 2010 the income that exceeds the limit until the credit is fully eliminated. Transitional Rules In October 2009, both Ontario and British Columbia announced a series of proposed transitional rules for the HST implementation on July 1, These rules will determine which tax the current provincial sales tax or HST will apply to supplies of goods and services straddling the implementation date. Note that the transitional rules utilize an announcement date and pre-implementation date to clarify which transactions will be subject to HST. The announcement date of October 14, 2009 effectively grandfathers certain transactions by preventing HST from applying to existing contracts that were formalized prior to the formal notice of the intended change in the sales tax system. HST will generally not apply to consideration that becomes due, or is paid without having become due, on or before the announcement date. On the other hand, consideration that is paid or becomes due on or after the pre-implementation date of May 1, 2010 will generally be subject to HST, where the actual supply is made on or after the implementation date. The transitional rules announced to date are summarized as follows. above), HST will apply to the consideration for the sale of taxable real property where both possession and ownership of the property is transferred on or after July 1, Leases, Licenses, and Similar Arrangements For leases of real property, HST will apply to the part of a lease interval in respect of a lease, license, or similar arrangement that occurs on or after July 1, A concession will be made where the lease interval starts before July 1, 2010 and ends prior to July 31, 2010, whereby HST will not apply to the consideration for that lease interval. Similar rules will apply to the lease or license of tangible personal property. Services HST will generally apply to services performed on or after July 1, 2010, including situations in which the consideration is paid or becomes due on or after May 1, 2010, but prior to the implementation date. However, HST will not apply if all or substantially all (i.e., 90% or more) of the service is completed prior to the implementation date. Apportionment may be required for services that straddle the implementation date but are less than 90% completed by July 1, Tangible personal property HST will not apply to tangible personal property supplied by way of sale, where the consideration is paid or has become payable prior to July 1, 2010, and the property is delivered and ownership has transferred prior to that date. Where the transfer of ownership and the delivery of the tangible personal property take place on or after July 1, 2010, HST will generally apply to the transaction. For continuous supplies, such as utility and telecommunications services, HST will not apply where the supply is delivered before the implementation date, even where the consideration is paid or becomes payable after July 1, Where a supplier is unable to determine the actual delivery date of a continuous supply, the consideration for that supply should be prorated based on the number of days in the billing period before and on or after the implementation date. Real property Other than for supplies of residential housing (to which special rules apply, including the rebates noted Intangibles For supplies of intangible personal property by way of sale, HST will apply to consideration that becomes due, or is paid without having become due, on or after July 1, Payments for memberships and admissions will effectively be treated as consideration for services under the transitional rules. However, special rules will apply to the consideration for lifetime memberships in clubs, organizations, or associations. Prepayments and Special Rules Special rules apply to prepaid goods acquired by non-consumers. Where the consideration for a taxable supply of goods by way of sale becomes due, or is paid without having become due, after the announcement date, but before the specified pre-implementation date, and the goods are to be delivered and ownership will transfer on or after the implementation date, a non-consumer may be required to self-assess the provincial component of the HST on the transaction. The term non-consumer generally refers to persons other than individuals. Journal of State Taxation 21

6 Ontario and British Columbia Embrace Value-Added Tax However, it is important to note that this requirement to self-assess tax will only apply in limited situations where: A non-consumer acquires supplies otherwise than for use exclusively in commercial activities (i.e., for use in making exempt supplies) A non-consumer acquires supplies for use exclusively in commercial activities, where the items in question would be subject to an input tax credit restriction (see previous discussion) Similar rules will also apply to the lease or license of property, as well as the acquisition of services and intangibles. Special transitional rules will also apply to other types of transactions, including transportation services, subscriptions, progress payments, and imports. It will be critical for organizations to carefully analyze the impact of the transitional rules on their operations, including any significant transactions that might be contemplated near the implementation date, to minimize any sales tax liabilities. Key Concerns The move to a harmonized sales tax system will pose several challenges for organizations both within and outside Ontario and British Columbia, ranging from the need for accounting system changes to determining the tax status of specific transactions to managing potential operating cost increases and cash flow issues. A brief summary of several important considerations heading into the HST implementation follows. Registration and Place of Supply As previously noted, GST registrants are also HST registrants under the ETA. Consequently, when the HST is implemented on July 1, 2010, registrants must be prepared for the reality that a much larger number of transactions will be subject to HST and the requirement to collect this tax. The ETA provides place of supply rules to determine whether or not GST or HST applies to a transaction, subject to other legislative provisions. 22 It will be critical for organizations to carefully analyze the impact of the transitional rules on their operations, including any significant transactions that might be contemplated near the implementation date, to minimize any sales tax liabilities. Schedule IX to the ETA provides the specific rules for determining when a supply has been made in a particular province. It seems likely that most of the existing rules in the ETA will be used to determine if a supply has been made in Ontario or British Columbia and, therefore, may be subject to HST when the new tax is introduced in July. These rules are rather straightforward for supplies of tangible personal property by way of sale. Generally, a supply of tangible personal property is considered to be made in a participating province if the goods are delivered or made available in such a province. However, different and more complicated rules exist for tangible personal property supplied otherwise than by way of sale (i.e., rentals and leases), supplies involving real property, services, and intangibles. For instance, the general place of supply rule for services is that the service is deemed to be made in a province if all or substantially all (90% or more) of the Canadian element of the service is performed in a participating province. If the application of this test does not determine the place of supply, the service will be considered to have been supplied in a particular province if the place of negotiation of the supply is located in the province, unless all or substantially all of the service is performed outside that province. For the purposes of this rule, the place of negotiation is the province in which the person who negotiated the contract on behalf of the supplier normally reports to work. Consequently, under the existing rules, all services provided on a Canada-wide basis will become subject to HST if the contracts are negotiated through an office in Ontario or British Columbia and at least 10% of the work is performed in that province. To further complicate matters, the ETA contains a specialized place of supply rules for certain types of services, such as telecommunications and transportation services. It is also possible that the federal government may use the latest harmonization as an opportunity to revisit the place of supply rules in the ETA and, where considered necessary, update them.

7 January February 2010 In planning for HST implementation, organizations should review the existing and/or proposed place of supply rules to determine how having Ontario and British Columbia as participating provinces will affect their sales tax obligations. Impact on Cash Flow For the most part, manufacturers, retailers, and many service providers will benefit from avoiding the imposition of unrecoverable tax on certain inputs into their activities. However, organizations involved in exempt activities, including many service organizations in the public sector, may see their costs rise as a result of the broader tax base coupled with an inability to fully recover the provincial component of the HST through input tax credits or rebates. Several factors must be considered in evaluating the overall cash flow impact of the HST on an individual organization, including: The nature of its activities and the tax status of its supplies The relative mix of taxable versus non-taxable inputs acquired and how this mix will change once the HST is implemented The availability of exemptions, zero-rating provisions and rebates for specific types of supplies, transactions, and organizations The willingness of suppliers to pass on any potential cost savings The ability of an organization to adjust its pricing for any potential cost increases All of these factors should be taken into account in determining how the HST will influence an organization s financial forecasting models and cash flow projections. Decisions will have to be made on how to deal with incremental cost increases or savings, and whether or not to pass on the impact of any changes to customers. Accounting Systems and Procedures Most organizations with operations in Ontario or British Columbia will be required to make substantial changes to their accounting systems and procedures to ensure proper compliance under a harmonized system. The following key areas require the attention of all registrants prior to implementation. Billing systems A top priority for organizations should be the adjustment of billing or invoicing systems, including point-of-sale terminals, to ensure that tax is properly collected as of July 1, This change will involve more than simply adjusting the GST rate from 5% to 12 or 13% because only supplies made in participating provinces will be subject to HST. Tax tables may need to be adjusted to reflect any changes in the tax status of particular products and services or customers. For example, many previously exempt services will be subject to HST. However, these same services will remain subject to GST only when supplied outside of the participating provinces. Similarly, customers who were previously exempt for provincial sales tax purposes may be required to pay the provincial component of the HST. In addition, billing systems may have to be modified to effectively handle point-of-sale rebates (previously discussed) and credit notes or refunds that were subject to different taxes (and the associated rates) prior to implementation. A/R and A/P Systems Customer and vendor tax codes used in accounts receivable and accounts payable systems must also be adjusted to reflect the application of HST. In many systems, the tax codes used to create purchase orders drive the tax status of transactions throughout the system. These codes must be adjusted for the change to HST. Journal Entries and Programmed Payments It is common for many organizations to use standard or recurring journal entries and automatic payments. Where these items include a GST component, an adjustment to the journal entry or payment calculation may be required for HST purposes. Payroll and Taxable Benefit Calculations The HST implementation will also result in changes to rates and factors used to calculate certain taxable benefits, which must be incorporated into payroll and taxable benefit systems. Employee expense reports and allowances are often handled in a completely separate accounting system, which increases the possibility that required changes to rates and factors used in these systems might be overlooked. New factors may be required to properly calculate the percentage of recoverable tax on certain expenses. Recovery of tax Organizations will want to ensure that the full HST, including the correct provincial component, is re- Journal of State Taxation 23

8 Ontario and British Columbia Embrace Value-Added Tax covered as an input tax credit on eligible purchases. During the transition, care must also be taken to ensure that input tax credits are not over-claimed by assuming that HST was paid when only GST was collected. Organizations with a mix of commercial (i.e., taxable) and exempt activities should review their input tax credit allocation methods to ensure that any calculations reflect the potential application of HST to purchases. The pending implementation is also a good opportunity to review any allocation methods used for reasonability and compliance with the legislation. Public service bodies should consider whether or not it is necessary to track the provincial component of the HST separately. This will likely be required where an organization s rebate percentage differs for purposes of the GST and the provincial component of HST. As with all significant modifications to accounting systems and procedures, a post-implementation review and testing are recommended to ensure that everything is working as intended and any commodity tax exposure is minimized. In addition, the positive impact of properly educating and training all accounting and finance staff about harmonization cannot be overstated. By providing employees with sufficient knowledge about the impact of the change, an organization can empower its staff to prevent and resolve potential issues. Time for Action Despite a few off-key notes, Ontario and British Columbia seem poised to join the chorus of harmonization in less than six months. Both provinces completed Comprehensive Integrated Tax Coordination Agreements with the Government of Canada in November And by mid- December, Ontario s Bill 218, the Ontario Tax Plan for More Jobs and Growth Act, 2009 (which contains the enacting legislation for HST in that province), and the Canadian government s Bill C-62, the Provincial Choice Tax Framework Act (which amends the ETA to implement the HST in Ontario and British Columbia), had both been passed into law. To their credit, the federal and provincial governments have done an excellent job in communicating how this substantial change will impact taxpayers. Several information notices and bulletins have been released to provide further information on various technical aspects of the harmonization plan, including specific transitional rules and details on how each province intends to wind down its current provincial sales tax. It is interesting to note that the Memoranda of Agreement signed by the Government of Canada with the Governments of Ontario and British Columbia require all parties to make every effort to finalize the necessary policy, legislative, and administrative details to enact the HST prior to March 31, In this regard, everything would appear to be on schedule. Unfortunately, organizations impacted by the HST implementation cannot afford to wait until the final note has been sung. Potential issues resulting from harmonization must be identified, analyzed, and prioritized as quickly as possible. In many organizations, significant changes will be required to accounting systems and procedures, and important decisions must be made regarding the financial consequences of this fundamental shift in tax policy. The time to plan and prepare for harmonization is now. Otherwise, those who find themselves unprepared to face the music in July may be left singing a different tune. En d n o t e s * Because facts and circumstances vary from case to case, you should conduct an independent analysis and consult with qualified tax professionals before taking any action in your particular situation. Ryan and its affiliates are not responsible for, and expressly disclaim, any liability for damages or losses arising out of use of or reliance on these materials or on any of the information contained in these materials. 24 This article is reprinted with the publisher s permission from the Jo u r n a l o f Stat e Ta x at i o n, a bimonthly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher s permission is prohibited. To subscribe to the Jo u r n a l o f Stat e Ta x at i o n or other CCH Journals please call or visit wwwcchgroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of CCH or any other person.