Exploring credit notes and Canadian indirect tax implications
Taking “credit” when “credit” is due
INSIGHT ARTICLE |
In view of the economic downturn over the last year, businesses may have experienced various price adjustments, contract modifications or cancellations and may have issued credit notes to their purchasers. In addition, we have seen decisions by the courts relating to the meaning of “credit an amount” and “credit note”, as well as evolving approaches taken by the tax authorities at audit. Consequently, it may be an appropriate time to review the indirect tax implications of your organization’s practices relating to the issuance and/or receipt of credit notes.
Credit note procedures can have significant compliance implications for suppliers and purchasers for purposes of various Canadian indirect taxes including the goods and services tax and harmonized sales tax (GST/HST), Quebec sales tax (QST), as well as provincial retail sales taxes (collectively PST).
Section 232 of the Excise Tax Act (ETA) outlines the treatment of GST/HST that has been collected or charged by a supplier and it is later determined that GST/HST was overcharged or there was a reduction in the purchase price or consideration for a taxable supply resulting in a credit to the purchaser. The provision is intended to allow a supplier to refund or credit the applicable tax to the purchaser and then adjust the supplier’s net tax accordingly. The supplier is entitled to deduct from the supplier’s net tax the GST/HST refunded or credited to the purchaser. On the other hand, the purchaser is required to add the amount of GST/HST refunded or credited to the purchaser’s net tax calculation to the extent that the purchaser had claimed an input tax credit (ITC) for the GST/HST in a previous return.
It is important to note that the provision contains a permissive crediting or refunding of the tax and is not prescriptive. In most business-to-business scenarios where both parties are registered for GST/HST, the purchaser is not generally “out of pocket” if the supplier chooses not to credit or refund the tax, where the purchaser was able to claim a full ITC for the original tax charged. Interactions between a business and an individual consumer however, are very different given the consumer was not able to claim an ITC for the original tax charged, so they expect a credit or refund of the tax and the whole or part of the purchase price.
In the 2018 Federal Court of Appeal (the Court) case of North Shore Power Group Inc. v. R. (hereinafter “NorthShore”) the terms “credit” and “credit note” as used in the ETA was addressed in detail. The Court examined amongst other matters, the terms “credit note” and “credit memorandum” and concluded the term “credit” means the acknowledgement of a sum owed or placed at the disposal by one party to another party. We’ll discuss these aspects of the NorthShore case, as they will likely drive the direction of businesses and their purchasers or counter-parties, in handling credits and credit notes. This article also discusses the Canada Revenue Agency’s (CRA’s) and the Quebec Revenue Agency’s (QRA’s) audit policies relating to the issuance of credit notes.
This tax insight article primarily covers the implications for GST/HST registrants, but also addresses the comparable and essentially parallel impacts under the QST. Unless otherwise noted, the same principles discussed for GST/HST purposes, are synonymous with QST. We also outline briefly, the main PST implications.
When is a credit, really a credit?
The term “credit” is generally understood in a commercial context to encompass an acknowledgment of a sum owed by one party to another. The term credit is well understood in a retail transaction where this is usually an immediate refund of cash or cash equivalent, plus applicable sales taxes. However, when dealing with business-to-business transactions the definition of credit can become more difficult to interpret and apply in practice.
When receiving a credit note from a supplier it is important to consider if a credit has actually been “issued” or a sum has been placed at the disposal of, or to the credit of, the purchaser. If so, and the purchaser has claimed an ITC for the original tax amount, the credit note from the supplier is a signal to the purchaser to increase the purchaser’s net tax (effectively reducing the previously claimed ITC) in the reporting period in which the credit note is received, and the applicable tax is credited or refunded by the supplier.
The converse is also true when a supplier issues a credit note to a purchaser and refunds all or part of the original consideration and the applicable GST/HST (or QST, PST). NorthShore exemplifies this need to demonstrate that the credit has been placed at the disposal of the purchaser, along with the applicable tax. This question is the actual “rub”, where the issuer of the credit and credit note documentation, must demonstrate the issuer “credits an amount” to the purchaser, in addition to issuing the appropriate documentation, in order to be eligible to reduce the issuer’s net tax for the amount of tax credited to the purchaser.
NorthShore elaborates on this notion in considerable detail and makes it clear the issuer must be able to demonstrate (agreeably difficult to do) the credit was placed at the disposal of the counter-party and that the credit note was issued (within the specified timeframes) by the issuer. It is not sufficient to simply create a credit and a credit note, but rather the issuer must inform the counter-party by issuing the credit note.
When is a credit actually issued and factors to consider when accounting for a credit note?
When a supplier issues a credit note to its purchaser and adjusts the tax, it is important to ensure the accounting and documenting evidence, and demonstrate a credit has been issued. When a supplier issues a credit note to a purchaser, this provides a mandatory accounting and signal to both parties that a credit exists and specifies the amount of the credit to be paid or placed at the disposal of the counter-party, plus any applicable indirect taxes such as GST/HST.
In NorthShore, the Court focused on whether a credit was placed at the disposal of the counter-party. The Court spent considerable effort in examining this meaning, and concluding the supplier and issuer of the credit note, must not only issue the credit and related documentation (i.e. the credit note), but also be in a position to satisfy the credit note.
In addition, if your business is the recipient of a credit note from a supplier and it is understood the amount is not in fact recoverable due to insolvency of the supplier or a relationship issue, it is worth questioning if a credit actually exists. A credit exists when there is evidence the amount will be collectible. If your business does not recognize an amount is receivable from the supplier, based on the decision in the NorthShore case, a credit may not exist.
How does this affect your business?
NorthShore highlights how the term credit is interpreted by the Court in this fact pattern and how this interpretation can affect your business. This applies whether your business issues or receives the credit, the related credit note and any related indirect taxes. We see these issues in practice throughout a variety of situations, from large dollar value changes in pricing or volumes involved in energy contracts (e.g. electricity, natural gas, oil, etc.), to situations involving basic revisions of invoices and later adjustments of the applicable tax, to scenarios involving bankruptcy, as well as partly or wholly cancelled and unfulfilled contracts.
Based on current administrative audit practices, the CRA audit division offers to confirm (where the credit note issuer is under audit) that the counter-party indeed received the credit note, provided the documentation meets the regulatory standard. This is a welcome approach.
As a practical manner, the question is whether the amount of the credit is in fact placed at the disposal of the purchaser can be more problematic for the purchaser. From the supplier’s standpoint, if due to insolvency or some other business relationship matter, the supplier has no intention to pay the amount of the credit and related tax adjustment, the supplier not should not reduce its net tax.
The purchaser is in a more difficult situation, whereby the purchaser is required to increase the purchaser’s net tax for the amount of the GST/HST being adjusted in the reporting period in which the credit note is received, but may not have received the related cash or be able to take advantage of the credit placed at its disposal. For example, the purchaser could, in light of NorthShore, wait until the cash is actually received. However, this could result in the adjustment being late since the purchaser is required to increase its net tax in the period the credit note is received, which may not be the same period in which the cash involving the credit and the tax is obtained.
Nevertheless, if the purchaser has a concern that the credit will in fact be realized, a possible approach may be to document the circumstances in which the purchaser is concerned that the credit amount will actually be paid and delay increasing net tax until the amount is received. Alternatively, in view of the permissive nature of the provision allowing the supplier to credit the tax to the purchaser, in a business-to-business case involving a purchaser engaged exclusively in taxable activities, the purchaser could advise the supplier not to adjust the GST/HST.
Application in the QST context
As noted above, the GST/HST credit note rules apply similarly under the QST regime from a legislative perspective. However, in our experience, the QRA takes a different evidentiary view regarding the word issued concerning the credit note, by requiring the issuer (i.e. the person under audit) to prove that the counter-party indeed received the credit note where the QST was reduced by the supplier and credit note issuer.
This is not an entirely novel concept given the supplier has advised the purchaser or counter-party, by way of a credit being placed at the disposal of the counter-party. Similar to GST/HST, the credit note issued to the purchaser is a signal to increase its net tax to reduce the previously claimed input tax refunds (ITR) for the QST on the original invoice.
In practice, QST auditors routinely require suppliers who issue credit notes with a QST credit where they’ve claimed an ITR in that reporting period and to have reduced their net tax, to prove they have issued the credit note to the purchaser or counter-party. This is particularly prevalent in the energy sector where volumes and/or pricing are routinely adjusted in subsequent periods to when the original purchase and delivery of these continuous transmission commodities are transacted.
QRA’s auditors (including QRA appeals) are arguably following the words of the law insofar as the supplier had to have advised and issued to the counter-party, evidence the supplier is reducing its QST previously collectible in the prescribed period. By extension, the counter-party being in receipt of the credit note, must also reduce its previously claimed ITRs and thus increase its net tax.
From the CRA and QRA’s perspective, this is an equitable result given all parties are correctly debiting or crediting their respective QST obligations in a theoretical zero-sum game, such that no parties engaged exclusively in commercial activities are financially dis-enfranchised.
Credit notes in a provincial sales tax (PST) context
The impact of the NorthShore interpretation of a credit does not have a significant PST impact. If a supplier reverses a taxable transaction related to PST, the whole or part of the consideration and the PST are routinely credited together. This is customary since PST is not generally a refundable tax, which contrasts with GST/HST or QST.