- News Release 98-103 -

Backgrounder
Election under Section 156 for Closely Related Persons

Section 156 of the Excise Tax Act allows specified members of a closely related group of corporations to elect not to account for otherwise fully recoverable tax on certain intra-group transactions. It is proposed that this election be extended to groups that include partnerships, referred to as "Canadian partnerships". To qualify as a "Canadian partnership", no member of the partnership can be a person other than a corporation or partnership and all members must be resident in Canada (within the meaning of Part IX of the Act).

Specified members of a "qualifying group" would be entitled to make the election under section 156. In addition to the closely related groups that currently qualify to make the election, a "qualifying group" includes a group consisting of Canadian partnerships, or of Canadian partnerships and corporations resident in Canada, that are closely related according to the rules set out in proposed new subsection 156(1.1). Members of groups that consist solely of corporations will continue to use the rules set out in section 128 to determine if they are closely related. For a member of either type of qualifying group to qualify as a "specified member" of the group, the member must meet the same conditions as are currently set out in the definition of that term in subsection 156(1).

Proposed subsection 156(1.1) contains rules for determining whether two Canadian partnerships, or a Canadian partnership and a corporation resident in Canada, are closely related for the purposes of section 156. A number of scenarios are covered by these rules. In all cases, however, both persons must be registrants. Under the most direct relationship, two Canadian partnerships are considered closely related to each other if one of the partnerships holds all or substantially all of the interest in the other partnership. A Canadian partnership and a corporation resident in Canada are considered closely related if the partnership owns 90% or more of the value and number of the issued and outstanding shares of the corporation having full voting rights under all circumstances or if the corporation holds all or substantially all of the interest in the partnership.

Proposed subsection 156(1.3) provides that a person, or a group of persons, holds "all or substantially all of the interest" in a partnership if:

• the person, or every member of the group, is a current member of the partnership;

• the person, or the group members collectively, as the case may be, is or are entitled to receive at least 90% of both the partnership's income for the relevant fiscal period of the partnership and the total amount that would be paid (otherwise than as a share of income) to members of the partnership if it were wound up; and

• the person or the group, as the case may be, is able to direct the business and affairs of the partnership.

Subsection 156(1.3) provides a special rule in circumstances where the partnership did have income in its last fiscal period (or did not have income in its current fiscal period if that is its first fiscal period). The income entitlement test in these circumstances is based on the share of income to which the person or group, as the case may be, would be entitled if the income of the partnership from each of its sources were one dollar. This test recognizes the fact that a partnership can have a different income sharing arrangement for each source of income of the partnership.

Another situation that is contemplated in subsection 156(1.3) is where a secured creditor (e.g., a bank) holds a security interest in either the property of the partnership or an interest in the partnership. In that case, the secured creditor may be able to direct to some extent the business and affairs of the partnership. Subsection 156(1.3) applies the control test assuming no secured creditor of the partnership has such a security interest. For this purpose, the terms "secured creditor" and "security interest" have the meanings assigned by subsection 317(4).

Proposed paragraph 156(1.1)(a) provides the rules for determining whether two Canadian partnerships are closely related and proposed paragraph 156(1.1)(b) provides the rules for determining whether a Canadian partnership is closely related to a corporation resident in Canada. The following example presents a scenario in which the two paragraphs apply.

Assume AB partnership consists of two members A and B, both corporations resident in Canada. Corporation B is a wholly-owned subsidiary of corporation A. Corporations A and B and the AB partnership decide to form a new partnership. The two corporations and the two partnerships are registrants engaged exclusively in commercial activities.

In this case, A and B are closely related corporations under the existing closely related group rules in section 128. Therefore, the two corporations constitute a "qualifying group" under the new definition of "qualifying group" in subsection 156(1).

Corporation A is closely related to AB partnership because of subparagraph 156(1.1)(b)(iii) given that all or substantially all of the interest in AB partnership is held by corporation A and corporation B collectively. The same rule makes corporation B closely related to AB partnership as well. Therefore, corporation A, corporation B and AB partnership are members of one qualifying group.

Also, AB partnership and the newly formed partnership are closely related according to subparagraph 156(1.1)(a)(i). This is because all or substantially all of the interest in the new partnership is held collectively by the group consisting of AB partnership and corporations A and B (which are members of a qualifying group of which AB partnership is a member) and given that AB partnership, corporation A and corporation B are all members of the new partnership.

Therefore, corporation A, corporation B, partnership AB and the new partnership are all members of one qualifying group each member of which is closely related to each other member.

Proposed subsection 156(1.2) is similar to existing subsection 128(2). Subsection 156(1.2) provides that where two persons are closely related to the same person (or would be if the residency requirements were met by that same person), the two persons are considered closely related to each other for the purposes of section 156. For example, assume XYZ, a Canadian partnership, owns all the voting shares of X, a non-resident corporation and X owns all the voting shares of Y, a corporation resident in Canada. Assume further that X and Y corporations and XYZ partnership are GST/HST registrants. Since both XYZ and Y would be closely related to X if X were a corporation resident in Canada, subsection 156(1.2) deems XYZ partnership to be closely related to corporation Y.

The amendments to section 156 are proposed to come into force on Announcement Date.

Construction Performance Bonds

A "performance bond" is a three-party agreement constituting a type of guarantee given by the issuer of the bond (surety) to an obligee who has entered into a contract with a contractor (principal). The surety agrees that, if the contractor defaults (i.e., fails to fully perform the contract), the surety will remedy that default.

There are various means by which a surety under a performance bond in respect of a construction contract can remedy a default. In some cases, the surety may step into the shoes of the defaulting contractor and carry on the construction. Proposed new section 184.1 is intended to deal with that case.

Overall Treatment

A construction performance bond, in essence, protects against the risk of the principal defaulting. In fact, the bond is included in the definition of "insurance policy" for the purposes of the GST/HST. The payment of an amount in satisfaction of a claim arising under an insurance policy is part of a financial service and therefore generally an exempt activity. However, the case dealt with under section 184.1 is complicated by the fact that performance of the original contract for the taxable supply of construction services was not completed and the surety is stepping into the shoes of the principal.

Section 184.1 is intended, firstly, to ensure that the obligee, as a recipient of construction services, is in the same position of having to pay tax on any contract payments still owing after the surety steps in as would have been the case if the principal had not defaulted. Further, it ensures that the inputs directly related to the construction carried on by the surety (normally consisting of contractors' services) are eligible for input tax credits to the extent that the obligee must pay tax on the services produced with the use of those inputs. However, the excess of input costs to complete the remaining construction over the contract payments owing to the surety that relate to that remaining construction represents, in essence, the cost or risk that the obligee has "insured" against. It is the cost that the obligee would otherwise have suffered if not for the bond. Conceptually, this could be viewed as the value of the exempt insurance claim settlement. Therefore, the total of the surety's ITCs in respect of the direct inputs (and amounts that would be ITCs if the surety were required to pay tax on the direct inputs) is capped at the amount equal to tax calculated on the contract payments that the surety becomes entitled to receive from the obligee.

Scope of Proposed Section 184.1

Proposed section 184.1 applies to all persons who act as sureties under construction performance bonds. Therefore, it is not dependent on the person being licensed as a surety.

The section applies only to construction performance bonds relating to real property situated in Canada. Further, proposed subsection 184.1(1) ensures that section 184.1 applies to sureties whether carrying on the construction themselves or acquiring the services of contractors to carry on the construction for them. If, however, a contractor's services are acquired by the obligee, the surety is not considered to be carrying on the construction work undertaken by that contractor. For example, suppose the surety agreed only to pay a cash amount as a means of remedying the principal's default. However, assume that the surety arranged for the obligee to enter into a completion contract with a contractor to whom the surety, though not the recipient of the services, would forward payments, which were part of the surety's settlement with the obligee. Section 184.1 would not apply in that case.

Finally, proposed section 184.1 applies only in relation to the "particular construction" that is carried on by the surety in full or partial satisfaction of the surety's obligations under the bond. Therefore, if the surety agrees to perform additional construction work (e.g., adding an extra wing that was not contemplated in the original contract for constructing a building), section 184.1 would not apply in respect of that additional construction except insofar as the surety acquires inputs used in both the construction undertaken in satisfaction of its obligations under the bond and in the additional construction. Section 184.1 contains rules, discussed further below, that affect the input tax credit entitlements of inputs used at least in part in the construction undertaken in satisfaction of its obligations under the bond.

Taxable Supply by Surety

Proposed paragraph 184.1(2)(a) ensures that, if the surety is entitled to receive, at any time, payments (referred to as "contract payments") from the obligee by reason of the surety's agreeing to carry on the construction, the surety is deemed to be engaged in making a taxable supply at all times at which it is carrying on that construction. This is for all purposes except determining the extent to which the intended and actual consumption, use or supply of the surety's inputs is in commercial activities (which paragraphs 184.1(2)(b) and (c) expressly deal with).

In many cases, the surety will be a "selected listed financial institution", within the meaning of subsection 123(1). Such financial institutions are subject to special rules (the "special attribution method") for determining their net tax. These rules are principally set out in section 225.2 and regulations under that section. The method also entails a special rule for determining certain rebates under Part IX of the Act (proposed section 263.01 released in draft form on March 21, 1997). To ensure that the new rule in proposed paragraph 184.1(2)(a) does not give rise to any ambiguity or inconsistency with any of those provisions, it is proposed that they be modified to make explicit reference to the satisfaction of a surety's obligations under a construction performance bond wherever they refer to the investigating, settling or defending of a claim under an insurance policy. These changes are proposed to come into force on Announcement Date.

The key effect of proposed paragraph 184.1(2)(a) is to ensure that tax is payable by the obligee in respect of the contract payments to which the surety becomes entitled, which are deemed to be consideration for the taxable supply made by the surety. The amounts deemed to be consideration do not include GST/HST or any provincial or local tax or fee that would otherwise be excluded from the GST/HST base. As well, to avoid double counting, if, through a subrogation for example, the surety is in receipt of an amount in respect of construction work that was undertaken by the principal (e.g., a holdback attributed to construction performed by the principal) and the GST/HST calculated on that amount is or was required to be included in determining the principal's net tax, the amount is not treated as consideration for the supply by the surety. Of course, if the surety actually collects any amount as or on account of tax, there is nevertheless the usual obligation on the surety to remit that amount.

Section 184.1 would apply only if the principal's supply of construction services were made in Canada. The taxable supply that the surety is deemed to be making is deemed to be made in Canada also. Furthermore, the place of the principal's supply determines whether the surety's supply is deemed to be in or outside an HST participating province and therefore the rate at which tax applies to the surety's supply.

With respect to the taxable supply that the surety is considered to be making, paragraph 184.1(2)(a) overrides the application of sections 150 and 156, as well as section 166. Section 166 deals with supplies by small suppliers who are not registrants. Therefore, regardless of whether the surety is a registrant, tax would be payable in respect of all payments made by the obligee to the surety by reason of the surety carrying on the particular construction in satisfaction of its obligations under the bond and the surety would be required to collect and remit the tax that the obligee is required to pay.

General Rule for Inputs Attributable to the Carrying on of Construction by Surety

Proposed paragraph 184.1(2)(b) ensures that the carrying on of the particular construction that is undertaken in full or partial satisfaction of the surety's obligations under the bond is not considered a commercial activity of the surety for the purposes of determining the extent to which the intended or actual consumption, use or supply of inputs is in the course of commercial activities. One effect of this paragraph is that the surety would have to self-assess tax if it received an imported taxable supply of an input for use in carrying on the particular construction. Principally, proposed paragraph (2)(b) has the effect of denying the surety ITCs in respect of inputs to the extent that they relate to the construction that is undertaken in satisfaction of the surety's obligations under the bond.

As discussed below, paragraph 184.1(2)(c) overrides paragraph (2)(b) with respect to certain direct inputs when the surety is considered under paragraph (2)(a) to be making a taxable supply. For the purposes of these rules and determining input tax credits that may be claimed, where a direct input is used both in construction undertaken in satisfaction of the surety's obligations under the bond and in additional construction, that part that is for use in the construction relating to the terms of the bond and the remaining part are each deemed, under proposed subsection 184.1(3), to be a separate input acquired by the surety.

Exception for Certain Direct Inputs

Where the surety is deemed to be making a taxable supply, proposed paragraph 184.1 (2)(c) generally overrides paragraph (2)(b) with respect to inputs (other than capital property and improvements to capital property) acquired, imported or brought into a participating province by the surety for consumption, use or supply exclusively and directly in the course of carrying on the particular construction that is in satisfaction of the surety's obligations under the bond. These inputs (referred to as "direct inputs") are deemed to have been acquired, imported or brought in exclusively in the course of commercial activities of the surety, except for the purposes of sections 155 and 156 and Divisions IV and IV.1. Since paragraph (2)(b) is not overridden for the purposes of sections 155 and 156, the surety would be required to pay tax on supplies of direct inputs from related parties and members of a closely related group. Because of the exception for Divisions IV and IV.1, the surety would be subject to self-assessed tax on any imported taxable supplies of direct inputs or on direct inputs brought into an HST participating province.

The effect of proposed paragraph (2)(c) is that the surety's input tax credits in respect of the direct inputs (including those to which tax under Division IV or IV.1 applied) would equal the tax payable on those inputs. However, the amount of those input tax credits that the surety would be entitled to actually claim in determining its net tax would depend on the rule set out in proposed paragraph (2)(d).

Cap on ITCs for Direct Inputs

Under proposed paragraph 184.1(2)(d), the total amount that the surety is entitled to claim as ITCs in respect of direct inputs that are determined on the basis of the deeming rule in paragraph (2)(c) is capped at the amount equal to tax calculated on the total contract payments to which it becomes entitled from the obligee in respect of the construction carried on by the surety in satisfaction of its obligations under the bond. The calculation of the cap also takes into account imputed input tax that the surety would have incurred but for an election under section 150 or 167 or the fact that the surety was considered to have acquired the input for use exclusively in commercial activities (e.g., the tax that would have been payable but for the operation of section 155 or 156). In these circumstances, it is the total of the actual and imputed input tax credits that cannot exceed the amount equal to tax calculated on the total contract payments to which the surety becomes entitled.

It should be noted that the cap would normally be determinable on the basis of the actual tax collectible by the surety on contract payments to which it becomes entitled. However, tax may not actually be collectible if the obligee is, under an Act of Parliament for example, not required to pay tax. Therefore, the cap is based on the amount that is equal to tax calculated on the total contract payments to which the surety becomes entitled, at either the rate of 7% or 15%, depending on whether the surety's supply is made in an HST participating province.

Further, in determining the cap, the surety must not include any amount that is not in respect of the particular construction that is carried on by the surety in satisfaction of the surety's obligations under the bond. For example, under paragraph 184.1(2)(a), consideration for the taxable supply made by the surety might include an unadvanced amount collected by the surety in respect of construction carried on by the principal. The surety must not include such amounts in the total contract payments for the purposes of paragraph 184.1(2)(d).

Coming Into Force

The general application rule for proposed section 184.1 is that it applies where, after Announcement Date, the surety begins to carry on, or first engages another person to carry on for the surety, construction that is in full or partial satisfaction of the surety's obligations under the performance bond. However, the section would not apply at all if, on or before Announcement Date, an advance contract payment by the obligee were paid or became due to the surety in respect of that construction and the surety treated it as non-taxable (i.e., did not charge or collect any amount as or on account of GST/HST).

In the case where the surety began to carry on, or first engaged another person to carry on for the surety, the relevant construction on or before Announcement Date, paragraph 184.1(2)(a) alone would apply, provided that, if the surety was in receipt of any contract payments from the obligee on or before Announcement Date, the surety consistently treated all such payments as taxable (i.e., charged or collected GST/HST on every payment and did not, on or before Announcement Date, adjust the tax under section 232). Where paragraph 184.1(2)(a) alone applies, the surety would, for all purposes of Part IX of the Act, be treated as being engaged in making a taxable supply in carrying on that construction and there would not be any limits imposed under section 184.1 on the claiming of related ITCs.

Meal and Entertainment Expenses

Input Tax Credit Recapture

Section 236 of the Excise Tax Act is intended to parallel section 67.1 of the Income Tax Act. These provisions result in a limitation on amounts in respect of food, beverages or entertainment that may be deducted in determining income for income tax purposes and that determine the net recovery of GST/HST as input tax credits (ITCs). Specifically, the intended treatment for GST/HST purposes is to recapture ITCs attributable to these expenses in the same proportion as the expenses are disallowed as a deduction for income tax purposes by reason of section 67.1. It should be noted that, in addition to section 67.1, there could be other provisions of the Income Tax Act that apply to a particular expense and affect its deductibility for income tax purposes. Section 236 parallels only the effect of section 67.1 of that Act (as an example, see the discussion below on conventions).

While section 67.1 of the Income Tax Act refers only to amounts paid or payable in respect of food, beverages or entertainment, existing section 236 of the Excise Tax Act refers to "supplies" of these items. This difference in wording can result in some ambiguity where a payment is attributable to a number of items of which food, beverages or entertainment is one but not necessarily the principal item.

For example, a fee for a supply of a professional's services to a client may include an amount attributable to the professional's disbursements on meals. While the client therefore pays an amount in respect of food or beverages, that amount is not for a supply of food or beverages made to the client.

The formula in proposed subsection 236(1) determines the amount of the ITC recapture by reference to the amount considered for purposes of section 67.1 of the Income Tax Act to be the amount paid or payable in respect of food, beverages or entertainment. It should be noted that, for this purpose, an amount in respect of entertainment includes an amount in respect of amusement or recreation given the definition of "entertainment" in that section. Further, an amount paid or payable in respect of food, beverages or entertainment includes, in addition to consideration, related gratuities, GST/HST and provincial or local taxes.

The following is an example of the calculation of the ITC recapture in the case of a meal expense incurred by a registrant exclusively in the course of commercial activities, assuming the registrant claims an ITC for the full GST on the meal and the expense is reasonable in the circumstances. The example also shows the net effect for income tax purposes of the income tax and ITC limitation.

In the case of a conference, convention, seminar or similar event that entitles the participant to more than incidental food, beverages or entertainment, if the portion of the event fee that is attributable to those items is not identified, the amount considered to be actually paid or payable in respect of those items is the amount deemed under subsection 67.1(3) of the Income Tax Act. That amount is $50 (or such other amount as may be prescribed under that subsection) times the number of days of the event that food, beverages or entertainment is provided.

The deductibility for income tax purposes of certain convention expenses is also affected by subsection 20(10) of the Income Tax Act, which generally provides that taxpayers can deduct expenses incurred in attending not more than two conventions per year. Section 67.1 of that Act nevertheless applies to all of the convention expenses incurred by the taxpayer that are in part attributable to food, beverages or entertainment. It is important to note that subsection 20(10) is not mirrored in the GST/HST legislation. Therefore, the taxpayer is entitled to claim an ITC in respect of convention expenses that are disallowed for income tax purposes as long as all requirements under Part IX of the Excise Tax Act for claiming the ITC are met. The amount that section 67.1 deems to be paid or payable in respect of food, beverages or entertainment would serve as the basis for determining the portion of that ITC that is subsequently recaptured. This would be the case for every convention at which food, beverages or entertainment were provided, notwithstanding that the taxpayer may be limited to choosing only two of the conventions in respect of which to claim an income tax deduction.

The following is an example of the ITC recapture in respect of a two-day seminar at which food is provided both days and no part of the total fee of $1070 (GST included) is identified as being attributable to the food. The example assumes that the purchaser is a GST registrant that incurs the expense exclusively in the course of commercial activities and claims an ITC for the entire $70 GST. It also assumes that the deemed food expense of $50 per day is reasonable in the circumstances and that the registrant is not restricted under any provision other than section 67.1 of the Income Tax Act from deducting the seminar expense in determining income.

Proposed new subsection 236(1.2) of the Excise Tax Act ensures the correct ITC recapture in respect of an expense partly attributable to food, beverages or entertainment when all or part of the expense is found to be unreasonable in the circumstances under subsection 170(2) of the Act. In that case, the tax calculated on the unreasonable amount is excluded from the calculation of the related input tax credit. Therefore, subsection 236(1.2) ensures that, in subsection 236(1), the "amount that becomes due from a person or that is a payment made by a person without having become due" is taken to be that amount as otherwise determined minus the unreasonable consideration and any gratuity or tax in respect thereof.

Coming Into Force

With respect to amounts that are in fact paid or payable for supplies of food, beverages or entertainment or as reimbursements or allowances in respect of such supplies, the proposed wording changes in subsection 236(1), and proposed subsection 236(1.2), apply to the determination of net tax for reporting periods ending after Announcement Date, and to the determination of any rebate under section 261 filed on or after Announcement Date, given that these amounts are already covered by existing subsection 236(1). In all other cases, the proposed amendments apply only to amounts that become due, or are paid without having become due, after Announcement Date.

Timing of ITC Recapture

The rules identifying the return in which the ITC recapture in respect of meals or entertainment must be reported are set out separately in proposed new subsection 236(1.1). These timing rules are the same as in existing subsection 236(1), with one exception relating to persons who cease to be registered in a fiscal year.

In that case, existing paragraph 236(1)(a) provides that the person must account for the recapture of the ITCs claimed in that year in determining the person's net tax for the person's last reporting period in the year. While the person would still have reporting periods in that year (i.e., calendar months), by the end of the fiscal year, the person likely would no longer otherwise be filing GST/HST returns. To avoid the situation where the person would have to file a return only to account for the ITC recapture for meals and entertainment, the proposed amendment provides that the accounting for the final ITC recapture must be made in the person's return for the last reporting period in which the person is registered. This change is proposed to apply to persons who cease to be registered for GST/HST purposes on or after Announcement Date.

Financial Services

The Financial Services (GST) Regulations prescribe services that are included in the definition of "financial service" in subsection 123(1) of the Excise Tax Act and services that are excluded from that definition.

Under the Regulations, services that are essentially administrative in nature are generally excluded from the definition "financial service" and are therefore taxable, except where they are provided by a person at risk in respect of the financial instrument to which the services relate. A specific exemption from this treatment is provided for services supplied by members of the Canadian Payments Association under the national payments system.

In accordance with the Department of Finance Press Release of November 5, 1991, the proposed amendments will clarify, as of January 1, 1991, the concept of "person at risk" in relation to a financial instrument. Proposed subsection 4(1) of the Regulations stipulates that a "person at risk" does not include a person who becomes at risk solely through the provision of a clearing, settlement or authorization service. The effect of this change will be to ensure that otherwise taxable administrative services, such as those provided in respect of credit card transactions, do not fall within the definition of "financial service" only because the service provider agrees to assume the remote risk of honouring the payment authorized under the credit transaction in the event of a failure by the relevant financial institution.

Subsection 4(3) of the Regulations currently provides that administrative services supplied in respect of a financial instrument by an agent, salesperson or broker who transfers ownership of the instrument for a person at risk, or a person closely related to a person at risk, are not excluded from the definition of "financial service" and therefore are exempt. It is proposed that, consistent with existing administrative practice, this provision be amended, effective January 1, 1991, to ensure that the issuance, renewal or variation of a financial instrument by an agent, salesperson or broker for such a person is likewise exempt.

- News Release 98-103 -