The Canada Revenue Agency (CRA) has begun significant audit activity of financial institutions in connection with payments for cross-border financial services between non-arm's length parties. In this article, we review and analyze the basis for these audits and discuss certain difficulties associated with the theory and practice of assessing GST/HST in respect of financial services.
On November 17, 2005, the Department of Finance issued a press release describing a new system for taxing imported supplies for most financial institutions (the defined term is "qualifying taxpayer"). Draft legislation was published in 2007 and a revised version became law in July 2010. Now, in 2013, financial institutions remain concerned about the possible retroactive assessment of GST/HST under the new legislation. The law is deemed to have come into force on the Announcement Date in 2005, and there is an anomalous seven-year assessment period (the usual period is limited to four years) for tax under the new system for qualifying taxpayers.
Loading: An Overview
The key concept in the analysis is a new definition in the Excise Tax Act (ETA) of "loading". For qualifying taxpayers, "qualifying consideration" is taxable on a self-assessment basis, which includes all outlays and expenses that are allowed as a deduction, an allowance or allocation for a reserve under the Income Tax Act (ITA) (or would be so allowed if that act applied). "Permitted deductions" are carved out of this broad category and excluded from the self-assessment requirement. "Specified non-arm's length supplies" (i.e., a financial service that includes the issuance, renewal, variation or transfer of ownership of a financial instrument, credit/charge card voucher or money) are permitted deductions and therefore not subject to tax, but an exception is made for "loading". As a result, "loading" is taxable on a self-assessment basis.
What is loading? Loading means any part of the value of the consideration for a supply of a financial service that is attributable to the following:
- Administrative expenses
- An error or profit margin
- Business handling costs
- Commissions, other than commissions for a "specified financial service"
- 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,
- Any other costs or expenses of a person who makes the supply.
The following items are excluded from the definition of "loading":
- In the case of an insurance policy, the estimate of the net premium of the insurance policy; and
- In the case of money, credit/charge card voucher or financial instrument (other than an insurance policy), the estimate of the default risk premium that is directly associated with the qualifying instrument.
According to Finance's Technical Notes, the idea is as follows:
"Inputs for a supply of a financial service, which are largely administrative in nature, fall within the definition 'loading'…However, the part of the consideration for a supply of a financial service that is clearly and fundamentally financial in nature…generally do not fall within the definition of 'loading'".
Taxing "Loading": An Anti-Avoidance Measure?
For unexplained reasons, "loading" is only taxable in connection with non-arm's length cross-border transactions. In the case of arm's length cross-border transactions, the entire consideration payable for a financial service would be a "permitted deduction". It would appear that Finance thought that consideration for non-arm's length cross-border financial services were being "loaded" with other, administrative costs, and thereby avoiding tax on legitimately taxable cross-border services. Why Finance decided to single out cross-border non-arm's length supplies of financial services, while retaining the status quo with respect to domestic non-arm's length supplies of financial services, is only one unanswered piece of this strange puzzle.
Section 155 of the ETA is similarly aimed at ensuring that tax is paid properly on supplies between non-arm's length parties, but it relies on the concept of "fair market value". Where consideration charged between non-arm's length parties is less than fair market value, and where the recipient does not fully recover the GST/HST that it pays (i.e., where there is a loss to the government) section 155 deems the supply to have been made at fair market value, and the ETA demands tax on that higher amount. Whereas fair market value implies an external comparison of consideration with other similar arm's length transactions, "loading" looks to the internal cost components of the financial service itself (i.e., the "inputs for a supply of a financial service"), which is a concept that is otherwise foreign to the GST/HST legislation. Generally speaking, GST/HST applies to the consideration charged by the supplier to the recipient of a supply, not to the input cost components of a supply.
Also, since the concept of "loading" is internal-looking, rather than external-looking, there is no comparison of treatment between arm's length and non-arm's length transactions. The arm's length market may include "loading" cost components in their financial services on a regular basis, and they would not be taxable. In fact, it is almost certain that the arm's length market does include at least some components of "loading" in their fees for financial services, given that "loading" includes "an error or profit margin". This is perhaps the oddest inclusion in the definition of "loading". Not only is profit generally ubiquitous in both arm's length and non-arm's length supplies, it does not at all fit Finance's description of "loading" as "largely administrative in nature". Most curiously, by defining the new term "qualifying consideration", it appears that Finance has excluded cross-border financial services from the scope of section 155, because section 155 applies to "consideration", not "qualifying consideration", which is the basis for the self-assessment of tax under the new system. In other words, there appears to be no mechanism in the ETA to deem supplies of cross-border financial services to be made at fair market value, except perhaps indirectly through the application of the ITA.
One issue that remains to be seen is how this concept of "loading" can be audited. Generally speaking, financial services have been exempted in most countries with a value-added tax because of technical difficulties in applying the tax to these services. The conventional rationale for exempting financial services under a value-added tax is the perceived inability to identify and measure on a transactional basis those intermediation charges that are not explicit. As noted in the European Commission's Study of Methods of Taxing Financial and Insurance Services (1996), page 22:
"[F]or each of the major categories of financial services, the financial flows that arise will consist of [i] transfers of funds from savers to investors and consumers, [ii] pure interest charges which reflect a return related to timing of consumption, [iii] a risk premium to adjust for losses and [iv] the intermediation services of the financial institution. It is only the final element of the four which is value added and which should be in a VAT base. However, the charges for this intermediation service will be mingled in the other financial flows among saver, intermediary and investor or consumer. In many cases, it will not be possible to identify the actual margin associated with financial intermediation in a particular transaction, particularly as cross-subsidization of transactions is not uncommon."
Perhaps at a conceptual level, "loading" is aimed at capturing the value of the "intermediation service" by the financial institution. Effectively, this would mean that Finance is attempting to tax the "value added" component of financial services, if only in the case of cross-border non-arm's length financial services. But the difficulty of identifying these costs, however, does not disappear merely by defining the term. "Loading" is supposed to catch every value component of a financial instrument other than the financial instrument itself and some value attributable to risk. In theory, it may be possible for a supplier to isolate the taxable components of the consideration and provide the information to the related-party recipient. However, it may be exceedingly difficult, in practice, to isolate the value-added component of a financial service as it relates to Canada in the context of ongoing cross-border related party transactions. It will remain to be seen whether "loading" can be audited and accurately assessed by the CRA.