Fear factor

By Christina Zurowski
Illustrations : Mike Constable

The GST was meant to be simple and straightforward, but when tax is included, it gets more complicated

It’s hard to believe today, but back in 1990 the goods and services tax (GST) was introduced as a simple tax and a somewhat acceptable, if not entirely welcome, replacement to the federal sales tax. Oddly enough, part of the criticism levied against the federal sales tax was that as a tax on manufacturers rather than consumers, it was hidden in the cost of manufactured goods — so it was replaced with the very visible GST, and the rest as they say is history. Ironically, the GST’s visibility is one reason why an election promise to reduce it could generate so much popular support.

The promised simplicity of the GST could probably be strongly debated — just ask any organization how simple it was to implement the 1% rate change effective July 1, 2006.

That being said, from a business perspective, one of the real benefits of a value-added tax is that even though most organizations are required to pay the tax, most are eligible to recover tax paid as an input tax credit (ITC) — at least to the extent the GST was incurred for use in the organization’s commercial (i.e., taxable) activities. In theory at least, ensuring that the tax does not form part of the cost of the goods or services leaves the ultimate burden of the tax to consumers (who are not generally eligible to recover the tax).

While the GST can for the most part be tracked relatively easily on most purchases and sales, there are situations where the record keeping related to the GST can become burdensome, especially where transactions are numerous and contain small amounts of GST. As a result, to assist organizations in meeting their GST obligations, various tax factors have been provided either legislatively or administratively. Many of the factors are geared specifically to an organization’s ability to recover tax (e.g., employee reimbursement and allowances and the recovery of tax on bad debts), while others are aimed at an organization’s requirement to remit tax (e.g., streamlined accounting methods). And these are just the factors provided by the government, most organizations using enterprise resource planning systems or accounting software that incorporates sales tax rates or tables into their accounts receivable or payables systems will generally have many other factors imbedded into their systems.

For the most part, many of the GST factors do not vary based on where in Canada the supply or expenditure was incurred (other than for HST provinces), thus limiting at least the number of factors that must be maintained by an organization. For example, the same factor applies whether an allowance was paid by an employer for the use of an employee’s automobile in Alberta (which does not have provincial sales tax) or in Ontario, even though the underlying expenses for the Ontario employee will generally include Ontario sales tax of 8%.

Managing and keeping these factors current can be a challenge, particularly when the software application is centralized outside Canada. Understanding which factor applies in which situation is another obstacle because many of the factors are similar, contributing to potential confusion. However, by far the sheer number of factors to be maintained and updated can be the real problem (highlighted of course by a rate change). But there are some factors organizations should consider on a regular basis.

Employers may claim a notional input tax credit for GST/HST deemed to be included in certain allowances paid to employees (e.g., qualifying mileage allowances). The factor after July 1, 2006 is 6/106 of the allowance amount (or 14/114 if the allowance is paid in respect of qualifying expenditures made in the HST provinces). Prior to the GST reduction in July, the rates were 7/107 and 15/115, respectively.

Employers may claim the actual amount of tax paid by an employee in respect of expenses incurred in the course of an employer’s commercial activities, but where the employer chooses to claim the actual tax paid, it must make sure that the general documentary requirements permitting an ITC have been met — GST registration number, clear indication of tax charged, information that is often not readily available on an employee reimbursement. As an alternative, administratively, Canada Revenue Agency permits employers to use a prescribed factor to recover the tax on employee reimbursements. The prescribed rate takes into account the fact that the reimbursement may very well include non-GSTable amounts, such as gratuities and provincial sales tax.

Organizations that choose to use the prescribed factor method to recover GST/HST incurred by an employee must do so consistently by category of expense for an entire fiscal period. The current rate is 5/105 (6/106 prior to July 1, 2006) or 13/113 (14/114 prior to July 1, 2006) for expense reimbursements incurred in the HST provinces. Note that the rate is determined by when the underlying expenditure is incurred and not by when the reimbursement is made; so that if an employee is submitting a reimbursement for expenses incurred prior to July 1, 2006, i.e., that were subject to GST at 7%, in September 2006, the organization is still entitled to use the 6/106 rate to calculate its potential ITC recovery.

Certain taxable benefits create a GST remittance obligation for an employer. The remittance rates were generally 6/106 of the tax-included amount of the taxable benefit (14/114 in HST provinces) but with the reduction in the GST rate to 6% as of July 1, 2006, the rate for 2006 is 5.5/105.5 (13.3/113.5 in HST provinces) and 5/105 and 13/113 respectively for 2007, assuming no further rate changes in the interim.

However, automobile operating cost benefits were subject to a different set of prescribed remittance rates: 5% (GST) and 11% (HST) of the benefit amount in previous years, 4.5% and 10.5%, respectively, for 2006, falling to 4% and 10% in 2007.

If only paying GST was enough to enable an organization to claim an ITC. However, as those who have been through a GST audit know, legislatively, paying the tax is not sufficient to permit an organization to claim an ITC. Very specific documentary requirements must be met before an organization may claim an ITC. Unfortunately, many times the required documentation is not generally included on a procurement card, or P-card, statement. The organization choosing to use the P-card statement to support its ITCs has the option of obtaining all the required documentary support (effectively reducing some of the benefits of P-card, such as simplifying the tracking of related purchases and reducing the administrative costs of accounting for individual purchases) or of using an estimate of the tax paid. The concern with the second alternative is the potential risk that the factor used to estimate the tax paid does not accurately reflect the tax charged by the supplier. Not because the estimate did not reflect that correct amount of tax that should have been charged but rather because the supplier did not charge the correct amount of tax.

In July 2005, CRA introduced a policy allowing certain registrants to apply to the CRA to use calculated ratios established through a statistical analysis of their P-card purchases to determine their ITCs on subsequent P-card purchases for up to five years. However, the policy has some important limitations, including the fact that it cannot be used for purchases of more than $1,000, that it cannot be used by organizations not involved all or substantially all in commercial activities (e.g., municipalities, universities, schools and hospitals as well as financial institutions), as well as the somewhat arduous application and testing procedures that must be undertaken before CRA will authorize the use of the factors.

For GST purposes, purchases made via a company credit card are treated no differently than purchases made directly by the organization for which the general documentary requirements must be met prior to the claiming of any ITCs.

In limited situations, where the employee and the employer are jointly and severally liable with the financial institution for expenditures incurred on the credit card, CRA has administratively permitted the use of the employee reimbursement factor (currently 5/105 and 13/113) to recover the tax (see rates above).

In an effort to simplify the accounts payable and invoicing functions, many organizations have invested in sophisticated software applications that use a tax matrix to arrive at the appropriate tax factor to extract the amount of tax included on an invoice. Using these factors to estimate the tax amount charged can be challenging for several reasons but, primarily because CRA does not provide a prescribed factor to estimate the tax, organizations must ensure that the estimates used reflect the actual tax amount charged. The use of factors in this situation does not waive an organization’s requirement to meet the general documentary requirements for claiming an ITC.

The problem is that, whereas the GST/HST rules may be somewhat simple to incorporate into a tax matrix (most goods and services are subject to tax), the PST rules are likely to be more problematic. The estimate must take into account the fact that for PST purposes, the supply may be not be subject to tax because of the purchaser’s use of the supply or because the supplier is not registered for PST. Furthermore, even if we manage to account for every possible correct application of tax, there is always the problem of the supplier not charging tax appropriately, resulting in an incorrect estimate of tax paid.

Organizations writing off amounts as bad debts on which GST/HST were collected are entitled to claim a credit for the GST/HST deemed to be included in the bad debt. The factors were 7/107 or 15/115 of the total amount written off as a bad debt. The rate will decrease to 6/106 and 14/114 for bad debts written off for which tax was collected at 6% or 14%, respectively.

Small businesses may also be eligible to use the simplified method of accounting for ITCs — a method aimed primarily at organizations with less than $500,000 of taxable sales. The method basically waives much of the documentary requirements for claiming ITCs and permits a recovery of tax based on 6/106 (7/107 prior to July 1, 2006) or 14/114 (15/115 prior to July 1, 2006) of the organization’s taxable purchases with no requirement to exclude nontaxable amounts such as PST or gratuities. Many supplies are deemed to be tax-included for GST purposes, e.g. qualifying damage payments. In most instances of deemed tax, the tax is deemed to be included at a rate of 6/106 or 7/107 prior to July 1, 2006.

Certain qualifying organizations may choose or be required to use streamlined accounting methods to determine the amount of tax to remit. Tax must generally be collected at the appropriate rate but to simplify the tracking of GST paid on expenditures relating to taxable (generally recoverable) or exempt supplies (generally not recoverable), the streamlined methods permit tax to be remitted at a reduced rate. There are approximately 40 different remittance rates to capture the varying remittance requirements for different companies. Companies using these methods must generally agree to forgo ITCs relating to their taxable activities, but then they are only required to remit a portion of the tax collected.

So as is apparent, what at first blush is supposed to be a simple straightforward tax can become much more complicated when you factor in the tax factors.

Christina Zurowski, CA, is a senior manager in Ernst & Young LLP’s Toronto office
Technical editor: Trent Henry, partner, Ernst & Young in Toronto