Most businesses will, at some point, have to deal with a situation where they have made advance payments for goods and services that never end up being provided. The cause for this non-supply is often due to the fact that the supplier has become impecunious. This results in obvious commercial headaches for the recipient, which can be exacerbated by corresponding GST implications.
Typically in such situations, the recipient will pay GST to the supplier in respect of the advance payment and take a corresponding Input Tax Credit (“ITC”) in its next GST Return. The supplier is required to remit that GST collected to the fisc. Pursuant to subsections 232(1) and (3) of the ETA, where the supplier will not be making the supply (or, for other reasons, reduces the consideration owed for the supply), it can adjust, refund or credit the amount collected (including the GST collected), and issue a “credit note” to the recipient. In turn, pursuant to paragraph 232(3)(b), the supplier can apply an adjustment in its next GST return to reduce its net tax by the GST amount in the credit note. Correspondingly, pursuant to paragraph 232(3)(c) the recipient is required to apply an adjustment to increase its net tax by the same amount (to account for the portion of the ITC previously taken, but now credited).
To the extent that the supplier is impecunious, the recipient will be left with a situation where it has had to increase its net tax, pursuant to a credit note received that will never actually be honoured. This was exactly the situation in the TCC decision in North Shore Power Group Inc. (2017 TCC 1).
North Shore, a subsidiary of an Ontario municipality, entered into 18 contracts with Menova Energy Inc. (“Menova”) for the supply and installation of solar panels. North Shore made an advance payment to Menova of half of the contracts’ total amount (including half of the GST/HST due under the contracts). North Shore claimed ITCs for the GST/HST paid as part of the advance payment. However, Menova only supplied approximately 9% of the total value of the contracts and issued North Shore documents labelled as “credit memos” in the amount of the difference between the advance payment made by North Shore and the value of the supplies actually made. Menova had become impecunious and failed to remit any GST/HST collected on the advance payments to CRA. It also did not honour the “credit memo” issued to North Shore. North Shore eventually recovered about 10% of the amount identified in the credit memos through the Menova bankruptcy proceedings.
North Shore initially treated the credit memos as “credit notes” for the purposes of section 232 of the ETA, by increasing its net tax in subsequent returns by the amount of the credit note. North Shore reversed its position in subsequent returns by re-claiming the ITCs, taking the position at the Tax Court that the credit memos did not constitute “credit notes” under section 232 of the ETA, thus relieving it from the requirement to increase its net tax by the amount in the credit memo under section 232 of the ETA.
At the Tax Court, North Shore argued that section 232 was not engaged because: (1) the credit memos did not constitute “credit notes” within the meaning of that section because they were not explicitly labelled as such and because there was no effective guarantee or security underlying them; (2) there was no actual refund or credit issued – just a recording of a credit; and (3) a result to the contrary would result in an easy abuse of the ITC system by a supplier on the brink of insolvency, insofar as the supplier could pocket GST collected on advance payments, not make any supplies and issue credit notes on the eve of bankruptcy.
The TCC rejected all of these arguments. It concluded that the credit memos constituted “credit notes” under the ETA, noting that they are acknowledged as being the identical instruments in commercial practice and that notions of securitization and guarantee should not be read into the definition of “credit note” for ETA purposes. It also noted that North Shore treated the credit memos as having legitimately establishing a credit in its favour by reversing its initially claimed ITCs and using the credit memos to take security and establish a claim in Menova’s bankruptcy. In terms of North Shore’s public policy argument, the TCC noted that had North Shore rejected or repudiated the credit memos and not originally reversed its ITCs, the public policy argument “would have some sway”.
From a policy perspective, the case boiled down to who was going to be ‘left holding the bag’ in respect of amounts collected as tax but not remitted by the impecunious Menova – the recipient or CRA. The decision is in line with the general “super-priority” granted to the fisc under the GST scheme.
In our view the decision was the correct one, as the documents issued by Menova appeared to have all of the characteristics of a “credit note”, from a commercial perspective. To the extent that they were rejected as such by the TCC, the door would have been opened for CRA to reject suppliers’ reductions in net tax under paragraph 232(3)(b) where they have issued such credits to recipients. This would have been an unfortunate result in our view, as it would have given rise to unnecessary scrutiny of such documents by CRA, which is out of line with general commercial practice. CRA’s scrutiny of ITC documents often does not take into account standard commercial practices, in our view – credit notes avoiding a similar fate is certainly welcome.
* A version of this article appears in the June 2017 edition of Canadian Tax Highlights.