Previously published in April 2012 edition of the Canadian GST Monitor, published by CCH Canadian Limited.
How can it be that Canadian insurers discover in spring of 2012 that they might now owe GST/HST plus penalty interest on a portion of (or, according to the Canada Revenue Agency, possibly all) reinsurance premiums paid to non-resident affiliates back to November 2005? This article looks at the events that were the genesis of the new imported supply rules, the appalling fiveyear delay between their effective date and passage into law, and the subsequently emerging CRA view that many cross-border reinsurance transactions in a seven-year window are now caught. The objective is to assist Canadian insurers in a brief self-examination for this new and (given the enormous amounts of tax involved) devastating plague. Sadly, infection is widespread, and has now begun to manifest itself in the outbreak of multi-million dollar GST assessments on the hapless victims.
GST/HST and imported services " the basic rule
Any value added tax (VAT) system such as the GST aims to collect the tax on all supplies of goods and services in the territory. A business entity that makes GST-exempt supplies, such as financial services, cannot recover all the GST it pays, and so there is an incentive to source services from outside the country to avoid the GST cost. To remove that incentive, and put domestic suppliers and non-residents on the same competitive footing, VAT systems contain a Sselfassessment rule, obliging the recipient or Importer of the service to self-assess the tax if they can not normally recover all GST paid on purchases. To the extent that a supply would be exempt if supplied in the jurisdiction, there is obviously no VAT/GST advantage in sourcing outside the regime, and so no self-assessment is required. Given that reinsurance is a defined financial service, reinsurance contracts with non-residents, whether affiliates or arms length, were never previously considered for purposes of self assessment.
GST/HST and imported services " the Canadian wrinkle
The original Canadian GST design contained the standard self-assessment rule described above. Canada took the unusual step of going one stage further with the concept, imposing the selfassessment obligation when one legal entity straddled the Canadian border. In these cases, the Canadian establishment was required to self-assess GST on the value of goods or services received from the non-Canadian establishments. No VAT regime had previously attempted to impose such a rule on events occurring within a single entity.
The design flaws in the original version of this extended rule were illuminated in a September 2003 Tax Court of Canada decision in State Farm Fire & Casualty Company [2001-2226 (GST) G]. In this case the Canadian branch of a U.S. insurer had paid very significant charges to its" U.S. head office, but had not remitted any self assessed GST. The Court first expressed doubts whether the form of the legislation did successfully create a deemed supply between the establishments to tax, but went on to conclude that the deemed supply, if in fact the legislation created one, was an exempt supply of financial services, and so self-assessment was not required. The decision was not appealed.
The Tax Court decision alerted the government to two defects in the GST system. First, it had to ensure that a deemed supply was successfully created when services were performed by the part of an entity outside Canada for the benefit of the Canadian establishment (the GST is a tax on supplies; no supply, no tax). Second, that deemed supplies in the nature of head office services might in fact be a financial service by nature, and exempt from GST. The latter was a big surprise to (only) the government, and some further thought was required on what should and should not be taxed. In the State Farm case the defects were restricted to the Canadian extension of the self-assessment rule to intra-entity events, however as you will see, the eventual legislative reaction went beyond the scope of the defects " way beyond.
A brief, sixty-eight month interlude
Twenty four months after the (unappealed) State Farm decision, in November 2005, the Department of Finance issued a press release, describing a new system for taxing imported services. While the new system contained many new definitions and concepts and was effective on the day of the press release, there was no legislation. Draft legislation finally emerged in 2007. In response to a number of submissions, the Department of Finance made some changes, refining rules that were not yet law, but that taxpayers were expected to have abided by from the date of the press release.
The legislation was finally tabled in the 2010 federal budget, and was the subject of a number of criticisms at both the House of Commons and Senate Finance Committee stages concerning its retroactivity and befuddling complexity. The Canadian Bar Association submission makes the relevant points very well [http://www.cba.org/cba/submissions/ pdf/10-29-eng.pdf]. The GST clause is one of four that the Senate Finance Committee recommended be struck from the Bill. The clause survived and finally became law in July 2010. For GST registrants that amounts to between five and sixty-eight signed GST return declarations of truth accuracy and completeness, between the effective date and passage of the law. During this intervening period registrants were expected by Finance and the CRA to have been remitting tax based on a press release, and then the evolving rules.
2011 A jolly good idea (taxing reinsurance)
To this day, nothing in the Department of Finance releases, or any published releases by the CRA, specifically identifies that the rules may now apply to crossborder reinsurance contracts.
Should insurers have been concerned about this latent risk? There was nothing to alert them to it. Quite the contrary, if one read the November 17, 2005 backgrounder issued by the Department of Finance, the section on the new imported services rule stated that its purpose was to...
"Respond to a Tax Court of Canada decision regarding self-assessment provisions for intangible property and services imported into Canada by re-establishing the intended application and policy objectives of these provisions in a way that ensures more consistent treatment between importations and comparable domestic transactions." [emphasis added]
An attempt to apply the new imported services rules to cross-border reinsurance contracts offends against two of the stated objectives here. Reinsurance contracts supplied by a Canadian entity remain exempt financial services even when supplied between affiliates, so the latest CRA initiative is discriminatory, taxing salary, finance and profit components of cross-border supplies of financial services, rather than restoring cross-border and domestic comparability. Reinsurance contracts between non-residents and their Canadian affiliates were audited many times between the inception of the tax in 1991 and 2005, and always accepted as wholly exempt from GST: consequently, if the new rules are to be Sre-establishing the intended application and policy objectives then they cannot apply to cross-border reinsurance contracts. For the CRA to apply the new rules in this way is a clear expansion of the tax base to something that was never within the scope of any stated policy, and factually and conceptually light-years from the State Farm situation, the Tax Court decision to which the new rules are a response. Some Canadian insurers may yet be blissfully unaware of the legislative blight that now afflicts them. The ailment will burst forth once, on audit, the CRA explains its new fangled incremental revenue source from the words Finance has crafted, and Parliament has voted in over the detailed protests of many tax experts. Insurers now carry the consequence of trustingly breathing the air of the Canadian corporate taxation climate, once crisp and clean, but now, depending on how events unfold, possibly quite unwholesome.
The new imported services rules for financial institutions
We will not bore you with a recital of all the new legislation, but will focus on the fulcrum of the dispute. The daisy chain of new definitions (in italics) leading the CRA to a taxable result is as follows. The Canadian insurer is a qualifying taxpayer and the reinsurance premium paid to the non-arms length party is qualifying consideration, subject to selfassessment. A permitted deduction from the consideration subject to taxation, however, is that part of the specified nonarm"s supply that which is not loading. In essence, the structure of the legislation is that any part of a reinsurance contract between a Canadian insurer, and a non-resident reinsurer that is not at arm"s length from the insurer, that is attributable to loading, as defined, is subject to self assessed tax.
So, if tax is payable on the loading portion of the value, what is that?
S Loading means any part of the consideration for a supply of a financial service that is attributable to administrative expenses, an error or profit margin, business handling costs, commissions, communications expenses, claims handling costs, employee compensation or benefits, execution or clearing costs, management fees, marketing or advertising costs, occupancy or equipment expenses, operating expenses, acquisition costs, premium collection costs, processing costs or any other costs or expenses of a person that makes the supply, other than commissions for a specified financial service or the part of the consideration that is equal to:
(a) If the value of the financial service includes the issuance, renewal, variation or transfer of ownership of an insurance policy but not of any other qualifying instrument, the estimate of the net premium of the insurance policy;
This brings us to the nub of the problem. How much of the value of any particular reinsurance contract is attributable to the sixteen offending components of Sloading and therefore subject to tax? Defined by displacement, in subparagraph (a) of the definition, it is all the value that is not net premium. The Department of Finance technical notes to the legislation explain that the net premium Sgenerally corresponds to the average cost of a claim, multiplied by the probability that the event being covered will occur. One might take the view that the nature of most reinsurance is that the consideration paid is all net premium as described in the technical notes, with the possible exception of an allowance for profit, and indeed that is a possible outcome if this matter proceeds to the Tax Court. That view would certainly fit with the design intent, which was to tax any back office functions of a primary insurer that were conducted outside of Canada. The CRA does not accept that view when it is offered, however a reinsurance policy is certainly a policy of insurance, and so the CRA was left to try to apply the wording to reinsurance, and it has been very active in those attempts in a spate of recent audits of insurers.
A concern expressed with the definition of Sloading across the entire financial sector is that it is artificial, impractical and an unrealistic approach to the myriad financial services that flow into Canada. A financial service is not like a car, which can have all its components identified in an exploded diagram, and individually valued by category such as drive train, electronics, or country of origin. Consequently, when the CRA invites the GST registrant to embark on the moonbeam count of identifying and valuing the sixteen Sloading components of an imported supply, what should the registrant do? The registrant can suspend disbelief, clap three times, say SI believe in loading and make a best effort and provide a number to the CRA, who will then issue an assessment. The problem with this approach is that to challenge the assessment, the registrant is effectively denying its own calculation. Perhaps a better approach is to explain to the CRA that the concept in the legislation is problematic, provide the CRA with any data it requests, and invite it to count the moonbeams. At least then the registrant is pursuing a consistent line when it challenges the assessment at the Tax Court, as someone will undoubtedly do. Early experience has been that the CRA will examine reinsurance on a contract by contract basis, and identify the loading content as anywhere between a third of the premium, and its entire value. The magnitude and extensive retroactivity of the resulting assessments will certainly put Canada on the global taxation map in a notorious way, and send a discouraging message to global investors.
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.