GST/HST burden, insolvent suppliers, and the pros & cons of credit notes

On January 12, 2018, the Canadian Federal Court of Appeal (the “FCA”) released its decision in North Shore Power Group Inc. v. Canada, 2018 FCA 9 (“North Shore Decision”), which addressed the tax implications to a purchaser of receiving credit notes from an insolvent supplier.  The FCA’s unanimous decision also sheds light on the scope of a purchaser’s obligation for unremitted goods and services tax/harmonized sales tax (“HST”) and illustrates how the textual, contextual and purposive approach to statutory interpretation is applied by Canadian courts.  The decision also serves as a useful reminder of the practical considerations for purchasers, as well as suppliers, in using credit notes when dealing with refunds.

HST overpayments generally

By way of background, HST overpayments made by a purchaser to a supplier are generally addressed in one of two ways: (1) the purchaser files a rebate with the Canada Revenue Agency (the “CRA”) for the tax (an option that many suppliers favour), or (2) the supplier can refund the tax to the purchaser and claim the refunded tax back in its HST return (an option that many purchasers favour).  The rules relating to option (2) are set out in section 232 of Part IX of the Excise Tax Act (Canada) (the “HST legislation”), and were the subject of the North Shore Decision.

Section 232 of the HST legislation

Subsection 232(3) is triggered when a supplier “adjusts, refunds or credits” HST under section 232 (e.g. because the HST was incorrectly charged or the price was later reduced) to a purchaser and generally requires, among other things, that the supplier “within a reasonable time, issue to the other person a credit note, containing prescribed information…” If the purchaser has already claimed back the HST paid to the supplier as an input tax credit (“ITC”), section 232 requires the purchaser to repay the credited HST to the CRA when it files its HST return, so that it is prevented from recovering the single HST payment twice (i.e. once as an input tax credit and once as a credit from the supplier).

FCA decision

In this case, North Shore had contracted with Menova Energy Inc. (“Menova”) for the purchase of solar panels.  The purchase of the solar panels included installation, and was to be paid in two payments including HST: one-half up-front, and the balance on delivery.  Menova subsequently cancelled the bulk of its contracts with North Shore, and issued documentation  which it called credit memos (“Credit Memos”) that confirmed the cancellations and documented Menova’s obligation to refund the up-front payments received from North Shore, including HST. Menova then failed to remit the HST that it had collected from North Shore, became bankrupt, and North Shore was unable to recover the amounts owing under the Credit Memos, including the HST. North Shore ultimately recovered only a small portion of what it was owed.
These transactions were reported in North Shore’s HST returns as follows: (1) North Shore claimed an ITC on the up-front payments; (2) when Menova cancelled the contracts (and issued the Credit Memos), North Shore initially added the HST to be refunded by Menova to its net tax (i.e. the amount payable by North Shore to the CRA);  (3) North Shore subsequently reversed this position in its HST returns, and was reassessed by the CRA as a result.  The CRA took the position that the HST to be refunded by Menova under the Credit Memos was required to be added to North Shore’s net tax and paid over to the CRA, even though the amounts were never actually refunded to North Shore.

The Tax Court of Canada sided with the CRA by broadly interpreting the term “credit” in section 232 as meaning “acknowledgement of a sum of money owed” and concluded that the HST was credited to North Shore (and North Shore’s requirement to pay related amounts over to CRA as part of its net tax triggered) when Menova issued the Credit Memos.  The Tax Court also focused on the fact that North Shore had treated the Credit Memos as valid, and also dismissed North Shore’s arguments on related policy considerations.

The FCA applied the standard of “correctness” in its review of the Tax Court’s decision on the basis that the issue at hand (the meaning of the term “credit” for purposes of section 232) was a question of law.  The FCA considered the ordinary meaning of “credit”, and the context and purpose of section 232, and found that a narrower meaning of the term “credit” was intended: namely, “putting a sum of money at the disposal of the recipient of the credit” and not the broader meaning as alleged by the Minister: “acknowledgement of an amount owed.”

The FCA also looked to the “scheme of the [HST] legislation as a whole” and found that “[t]he Act generally imposes an obligation on all suppliers to collect tax on behalf of the government” and that “[t]he financial position of the supplier does not change this.”  The FCA concluded that North Shore was never “credited” the tax within the meaning of section 232 and that North Shore’s net tax should be reduced accordingly.

Thoughts and Takeaways

 Although the CRA normally pursues the supplier in cases of unremitted HST, this option was unavailable here due to Menova’s bankruptcy. The North Shore Decision does not address whether the CRA had tried to pursue Menova’s directors for the taxes.  While it would have been easier for the CRA to pursue North Shore instead for the taxes in this case (the Minister had argued for a finding that promotes certainty and ease of audit, and had also argued the tax burden ought to be shifted to purchasers in circumstances where the purchaser is in a better position than the government to assess the financial position of the supplier), the FCA pointed out that this would “open the door for tax consequences to taxpayers like North Shore that are contrary to the general scheme of the Act.”  Indeed, it is not clear what North Shore could have done to mitigate its risks in this case, without knowing the details of Menova’s financial position, and little or no control over the issuance of the Credit Memos by the supplier.

The North Shore Decision demonstrates the FCA’s focus on the general scheme of the legislation and the importance of the contextual and purposive analysis where, as in this case, the ordinary meaning of a term could have alternate meanings – one broad and one narrow.  Indeed, the FCA rejected the Minister’s arguments for the broad interpretation on the basis that it “promotes tax consequences that are not in harmony with the scheme of the Act as a whole.”  The FCA also noted that “[i]t would have been useful for the parties to provide more detailed submissions on [the general scheme of the legislation]”.  Parties preparing for HST litigation in particular may wish to make note of these comments by the FCA.

Finally, the North Shore Decision illustrates the potential complications that may arise with credit notes.  Suppliers typically will avoid issuing them except in situations that are clear-cut, and involve little risk of the CRA taking a different view of the tax treatment.  Credit notes also create compliance requirements for both parties, as they must contain prescribed information and be retained as supporting documentation, in the same way as invoices or other ITC documentation.

Credit notes may well be the best option if a purchaser that does not have a 100% ITC recovery rate and the purchaser does not want to go through the work and delay inherent in filing a rebate claim with the CRA to recover overpaid taxes.  However, if a purchaser has already claimed full ITCs, a credit note will generally only add compliance work and tax risks for both sides.  If North Shore had claimed the initial ITC at 100%, it may have been advisable to ask Menova to refund the purchase price only, and not the related HST. Of course, the best approach for any taxpayer will need to be determined in each case with regard to the tax considerations as discussed above, as well as the underlying commercial and other non-tax considerations.