In a backgrounder released on May 19, 2010 (the
"Backgrounder"), the Department of
Finance ("Finance") proposed changes to
the rules for financial institutions relating to the adoption of
the Harmonized Sales Tax (the "HST") by
British Columbia and Ontario. According to Finance, these changes
were intended to ensure that the federal rules pertaining to HST
"function properly in the context of the expanded and
modernized HST framework". On June 30, 2010, Finance released
a second Backgrounder (the "Second
Backgrounder") which includes a number of
"proposed technical clarifications and other
improvements" that follow from comments Finance received on
the Backgrounder. This update focuses on the significant impact
that these changes will have on mutual funds, many of which will
now be subject to the following requirements:
- registration for the GST/HST (for those not already
- application of the complex Special Attribution Method
("SAM") rules; and
- implementation of a system to determine and monitor the location of their investors.
WHAT ARE THE SAM RULES?
The SAM rules apply a formula to determine the net liability of a "selected listed financial institution" ("SLFI") for the provincial component of the HST (this component is referred to as the "Provincial Value Added Tax" or "PVAT"). Essentially, the SAM rules achieve this by attributing a SLFI's business among the provinces in order to determine the "correct" amount of PVAT that is payable. If the PVAT payable by the SLFI under the SAM formula differs from the PVAT actually paid, the SLFI will either be entitled to a refund (in the case of an overpayment) or will have to remit the difference to the government (in the case of an underpayment). In this way, the SAM rules attempt to ensure that SLFIs do not have an incentive to move to, or to source goods or services from, provinces that do not have the HST ("Non-participating Provinces").
WHICH MUTUAL FUNDS WILL BE SUBJECT TO THE SAM RULES?
To be a SLFI during a taxation year, a mutual fund must have a "permanent establishment" ("PE") in a province where HST applies (a "Participating Province") and a PE in a Non-participating Province in that taxation year. In the Backgrounder, Finance proposes that a mutual fund will be deemed to have a PE in any province in which it is "qualified to sell or distribute" units or shares. While not mentioned in the Backgrounder, the draft regulations proposed by Finance on June 30, 2010 also deem mutual funds (and "distributed investment plans" which includes mutual fund trusts, mutual fund corporations, unit trusts, mortgage investment corporations, investment corporations, non-resident owned investment corporations and segregated funds of insurers) to have a PE in any province where a person resident in the province holds one or more units of the mutual fund. For most mutual funds, this will include all provinces. As a result, most mutual funds will be considered to be SLFIs as of July 1, 2010 and will thereby become subject to the SAM rules.
The Backgrounder also proposes a change to the length of time before financial institutions qualify as SLFIs. Previously, financial institutions had to fulfill all requirements for two years before they became SLFIs. Under the proposed changes, financial institutions will be considered to be SLFIs during a reporting period if they fulfill the requirements at any time during the fiscal year. The Backgrounder included a carve-out for "small investment plans", which applies to certain investment funds (such as registered pension plans or employee benefit plans) which paid less than $10,000 in net GST in the previous year and did not elect to be treated as an SLFI. Thus most mutual funds will be SLFIs as soon as the rules proposed by the Backgrounder become effective.
It should be noted that the Backgrounder proposes that the SAM rules will apply to mutual funds at the series level (or class level), not at the fund level. Therefore, subject to certain elections that are discussed below, mutual funds will generally have to determine their PVAT liability in respect of each series issued by the fund.
ATTRIBUTION PERCENTAGE AND THE LOOK-THROUGH RULES
In addition to making most mutual funds SLFIs, the Backgrounder also proposes changes to how the percentage attributed to each province (the "Attribution Percentage") for the purposes of determining the applicable PVAT, will be calculated. Based on the Backgrounder, the attribution percentage for a mutual fund series will soon depend on the location of the individual beneficial investors in each series. As a result, funds will need to determine and monitor the location and holdings of their unitholders. Further, to the extent that a series is held by other institutional investors, or intermediaries such as brokers or dealers, the series will generally be required to look through these entities to determine the location of the ultimate individual investors.
Institutional investors and intermediaries will generally be
required to provide their Attribution Percentages or face
penalties. Specifically, under the Second Backgrounder, if the
information is not provided on or before the later of November 15
and 45 days after the fund requests it, the penalty would be the
lesser of $10,000 and 0.01% of the total value of units for which
information was not provided. However, there is an exemption from
the look-through requirements for institutional investors that are
"specified investors", including: (a) certain
institutional investors that have less than $10 million invested;
and (b) investment plans other than mutual fund trusts, mutual fund
corporations, segregated funds, unit trusts and mortgage investment
corporations, regardless of whether they are "small investment
plans" or not. In general, funds will be able to use the
principal business address of these investors for the purposes of
determining the attribution percentage.
In the Backgrounder, the above exemption was limited to "small investment plans", but this rule was extended under the Second Backgrounder. The Second Backgrounder also proposes a related party restriction, such that amounts invested by related parties are generally aggregated together in determining whether the $10 million invested test is met. Under the rules proposed in the Backgrounder, funds needed to determine the location of individual investors that hold all or substantially all (generally considered by Finance to be 90% or more) of the value of a given series. If this was met, the information for the 90% could then be considered to be representative for the entire series. If funds were unable to determine investor information in respect of 90% or more of the value of the series, the value of units in Canada for which information was unavailable were to be considered to be subject to the highest provincial tax rate. As of July 1, the highest rate will be Nova Scotia's combined rate of 15%.
Finance proposes to change the above test in the Second Backgrounder, such that if the trustee or fund manager obtains residency information for over 50% of the value of investments in a particular series of a fund, only the portion for which investor residency information is needed to reach the 90% threshold will be deemed to be subject to the highest rate of PVAT (rather than all amounts over the known amount). For example, if a fund can determine the residency information for 80% of the value of investments, previously the remaining 20% would have been subject to the highest rate of PVAT. Under the Second Backgrounder, only 10% would be considered to be subject to the highest rate of PVAT, and the remaining 10% would be allocated based on the same distribution as the 80% for which the fund has the investor information. Please note that if a fund cannot determine the residency for over 50% of the value of its investments, the entire value for which the fund cannot determine residency will be subject to PVAT at the highest rate.
HOW WILL THESE RULES WORK IN PRACTICE?
Mutual funds will need to determine their Attribution Percentage at least once in a fiscal year. A single date, Sept. 30, will be the attribution date in most cases, but funds can generally elect to use a daily, weekly or monthly average. It should be noted that the calculation of the Attribution Percentage, as laid out in the Backgrounder, originally ignored non-residents (the test was residents in a province/residents in Canada). This could have resulted in increases in the amount of PVAT liability for a fund to the extent that a series was held by non-residents. For example, if 50% of a series was held by Ontario residents and 50% was held by non-residents, the formula would have attributed 100% of the series to Ontario.
In the Second Backgrounder, Finance proposes to include non-residents in the calculation of the provincial attribution percentages of a fund so long as the non-residents are treated as residents for GST/HST purposes (i.e. the fund did not claim any input tax credits with respect to services provided to these non-residents). The Second Backgrounder also proposes that funds will be allowed to elect out of the above rule (so non-residents are excluded from the calculation, but the fund can claim input tax credits to the extent applicable). If this election is made, it cannot be revoked for 5 years unless early approval is given by the Minister of National Revenue. Funds which are currently registered for GST purposes and are claiming input tax credits with respect to certain services provided by non-residents should review their operations to determine whether they should be making the election, or whether they should be including non-residents in the provincial attribution calculations.
The Backgrounder and the Second Backgrounder propose allowing funds to elect between three methods to determine their tax payable or refundable in a given fiscal period. These elections are not required to be filed with the CRA, but must be in place for at least three years.
- General Rule: The fund will use the Attribution Percentage of the previous year to estimate the PVAT due in the current year. There is no reconciliation at the end of the year;
- Preceding Year Method with Reconciliation: This method is essentially the same as the General Rule (the Attribution Percentage of the preceding year is used), but the fund must reconcile this amount with the actual PVAT due at the end of the year; and
- Real Time Method: This method involves the real time evaluation of the attribution percentage on a daily basis, or on the first day of each month. This method is only available in certain circumstances.
Please note that under the Backgrounder the general rule previously was that the fund would use the preceding year method with reconciliation, and a fund had to elect to use the preceding year method with no reconciliation. The Second Backgrounder changed the general rule to the preceding year method without reconciliation.
EXCHANGE TRADED FUNDS
The Backgrounder proposes a number of special rules to govern Exchange Traded Funds ("ETFs"). ETFs will generally not be required to look through their institutional investors, and will have different rules with respect to the attribution date such that they will generally be required to use two points in time in the preceding fiscal year. If an ETF cannot determine the location of individual investors that hold 90% or more of its value, the ETF can seek preapproval from the CRA on what rate it should use to calculate its Attribution Percentage. Otherwise the ETF will be required to calculate its PVAT liability as if the investors were located in the province with the highest rate of HST (currently Nova Scotia's 15% rate, as noted above).
The Backgrounder outlines several transitional rules that are intended to apply from July 1 to December 31, 2010 (the "Transition Period"), including:
Attribution Calculation Method - Transitional Year
As many mutual funds will not be able to obtain information on their unit holders on a province-by-province basis during the Transition Period, mutual funds may elect to use a transition year method whereby if at least 90% of the value of units in a series are held by individuals, the fund will not be required to look through the institutional investors. In addition, if more than 10% of the value of units of a series is held by institutional investors, and the fund can look through at least 90% of these institutional investors, the fund can apply the provincial attribution of the institutional investors it looks through to the remaining institutional investors.
Other Transition Rules
There are a number of additional transitional rules which are designed so that SLFIs are not subject to double taxation as a result of provincial transitional rules, and others which are designed as anti-avoidance rules (for instance there is a rule which restricts companies from stockpiling input tax credits by not claiming input tax credits in periods prior to July 1 where only GST applied, and claiming them after July 1 when the HST would apply). The Backgrounder and Second Backgrounder also propose special rules to determine the Attribution Percentages of new funds or series (including those created by amalgamation of existing funds or series).
ELECTIONS TO EASE ADMINISTRATIVE COMPLIANCE
Mutual funds will be able to make several elections that will make compliance easier in certain circumstances. These elections include:
- Reporting Entity Election: Under this
election, mutual fund managers will be able elect to file GST/HST
returns on behalf of the mutual fund;
- Consolidated Filing Election: A mutual fund manager will be able to elect to file one consolidated return for all mutual fund series that it manages for which a reporting entity election has been made. If this election is made, the manager would determine the PVAT liability for each series but would only file a single return. If this election is made, the manager will generally have to file a consolidated return for all series where the manager has this election available. However, the CRA may allow the manager to file more than one consolidated return in certain circumstances (e.g. if the manager is acting for separate groups of mutual funds, etc.); and
- Tax Transfer Election: Where the first two elections have been made, this election can be made to avoid cash flow issues to the mutual fund which could apply based on the place of supply rules (i.e. paying HST and having to later claim a rebate, or paying only GST and having to pay additional tax at the end of the year). Under this election, the fund manager would aggregate all of the positive or negative net tax adjustments determined under the SAM formula for each series of the fund. If, on an aggregated basis, an amount is owing, this would be remitted by the manager. If the fund would be entitled to a rebate, the manager would be allowed to credit/refund that PVAT amount to the fund. As this calculation can be made on an ongoing basis, if made, the fund manager can essentially charge each series of the fund the net PVAT it will be required to pay without having to wait for the fund to claim a refund.
Originally these elections had to be filed before the beginning
of the fiscal year, but the Second Backgrounder proposes that the
Minister of National Revenue have discretion with respect to the
deadlines for filing these elections. In addition, under the
Second Backgrounder, SLFI investment plans and segregated funds
which have jointly made the consolidated filing election will be
permitted to use a single GST/HST registration number.
WHAT SHOULD MUTUAL FUNDS BE DOING IN PREPARATION?
- Mutual funds that are not already registered for GST/HST should
determine whether they will be required to do so (under the rules
proposed by the Backgrounder, most mutual funds will
effectively be required to register).
- Mutual funds should implement a system to determine and monitor
the locations of their investors.
- Mutual funds should consider the various elections to determine
which are appropriate for them in their particular circumstances,
and make filings as appropriate.
- Mutual funds should consider whether issuing separate series for each province makes sense from an economic perspective (while this would generally ease HST compliance costs, it may be more costly and difficult to manage overall).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.