May 2009

The recently announced sales tax measures by the Ontario government will have a significant impact on the energy and resource sector.

In its March 26, 2009 budget, the province of Ontario announced that it had entered into a memorandum of agreement with the federal government to create a framework for the federal collection of a single value added sales tax in Ontario. Starting July 1, 2010, the Ontario retail sales tax (ORST) will be converted to a value added tax that will be combined with the federal goods and services tax (GST). The new Ontario harmonized sales tax (OHST) will have a combined rate of 13% consisting of an 8% provincial component and a 5% federal component. Although there were limited details released with the provincial budget both the federal and provincial governments are currently working on developing important transitional and place of supply rules. Details are expected to be released later in 2009.

For a summary of the proposed harmonized tax regime, please read Deloitte’s March 27, 2009 edition of   Canadian Indirect Tax News.

Impact on purchases
Under the ORST, many exemptions existed for manufacturing or processing equipment. These exemptions will cease under the OHST regime; however, while OHST must be paid, it will be recoverable by the purchaser in the form of an input tax credit (ITC). The OHST eliminates the challenges that exist in determining the type of machinery and equipment that qualify for the current ORST exemption.

Supply and install projects relating to real property have a significant ORST cost embedded in the project price. The contractor pays ORST on the materials, supplies and equipment used in performing the contracts, which becomes embedded in the price. Non-resident contractors had to pay ORST on the temporary use of equipment and tools brought into Ontario to perform the contract plus post a 4% bond to ensure tax was remitted. This should be eliminated, resulting in lower costs and less administration or risk in contracting with non-resident contractors.

Most businesses incur a significant ORST expense on goods for own use, promotional materials, as well as furniture, fixtures and equipment including non-custom software and hardware, etc. Given that the provincial component of the OHST will generally be recoverable on such input costs by businesses in the energy and resources sector, the tax savings could be significant. These savings could also apply to many suppliers to businesses in the energy and resource sector. These businesses should discuss with their major suppliers the impact, if any, that such savings will have on the pricing of the suppliers’ goods and services.

The OHST may lead to some cash flow challenges that will need to be considered, including strategizing on ways to deal with suppliers to minimize the impact. This potential cash flow impact will further depend on whether raw materials and other inputs, including machinery and equipment, are sourced within Canada or are imported. To the extent that commercial imports are treated the same under the proposed OHST as they are for the current harmonized sales tax (HST) rules applicable to supplies made in New Brunswick, Nova Scotia and Newfoundland, commercial imports will be relieved from the provincial component of the OHST upon import. It is not clear though whether imports will be treated in this manner. If not, the cash flow implications could be significant for importers and their brokers.

As noted above, the OHST generally will be recoverable as an ITC. However, for the first eight years post-harmonization, large businesses (i.e., with annual taxable sales in excess of $10 million) and financial institutions will be restricted from recovering the provincial component of the OHST in respect of costs incurred for energy, except where purchased by farms or used to produce goods for sale; telecommunication services other than internet access or toll-free numbers; road vehicles weighing less than 3,000 kilograms (and parts and certain services) and fuel to power those vehicles; and food, beverages and entertainment. It is anticipated that ITC restrictions for energy costs incurred for use other than in the production of goods for sale will apply to purchases of electricity, natural gas, oil, combustibles and steam. Such purchases after June 30, 2010 will impact these large businesses and financial institutions for the 8% provincial component that cannot be recovered.

There are a couple of points to consider with respect to the above ITC restrictions. First from a tax cost perspective, with the exception of energy costs, the expenses subject to the restrictions are currently taxable for RST purposes and therefore this restriction will not, for the most part, result in an increased tax cost.  

Second, the restriction regarding purchases of electricity, natural gas, oil, combustibles and steam will add certain complexity because Ontario manufacturers/processors will be required to track their energy costs related to manufacturing and non-manufacturing use in order to be able to recover the full provincial component of the OHST on the portion used for manufacturing. There will be more incentive to carefully track the usage of energy in order to maximize the recovery of OHST.

Contracts
While ORST rules will become a thing of the past, businesses will need to consider whether OHST will apply to purchases or be charged on sales. In some cases, because of the increased tax base, additional unrecoverable sales tax costs will result (e.g., with respect to restricted ITCs). 

Existing contracts for supplies that are expected to straddle the proposed implementation date will need to be reviewed to determine the impact of harmonization and clarify wording therein where necessary. Tax clauses for new contracts to be entered into that will survive the proposed implementation date must be carefully considered to ensure the desired results are achieved, including minimizing the tax cost where applicable.

Impact on sales
For goods sold in Ontario, the provincial component of the OHST is to be collected in the same manner as the GST, with some exceptions that only apply on sales to end consumers. Therefore, a significant factor will be ensuring that the current tax codes used for GST purposes are correct along with the challenge of building into the system when supplies are made in Ontario to determine when the additional 8% is required to be collected.

There may be challenges with many customers having to incur the 8% provincial component on certain energy costs including natural gas and electricity, and purchases where ORST currently is not a cost to them. For example, natural gas used for lighting and heating and all electricity currently is exempt for ORST purposes. These will be fully taxable under OHST. More specifically, where it is not recoverable as a result of the ITC restrictions for the provincial component of the OHST as noted above or where the customers are not involved in commercial activities for OHST purposes (e.g., individual end consumers), there will be an 8% tax cost increase on the charges to them for that energy. 

It will be important for businesses in the energy and resources sector to understand the impact OHST will have on their customers. They will need to be prepared for dealing with customers’ requests to understand how pricing to them will be affected and to what extent will the benefits, if any, from reduced costs to the suppliers due to the removal of non-recoverable ORST on their input costs be reflected in that pricing.

Place of supply rules
These rules have yet to be published. Although there are rules currently in existence in the GST legislation that deal with HST in New Brunswick, Nova Scotia and Newfoundland, it is unclear whether these will be applicable in their current form with respect to supplies made in Ontario.

Of particular note, it is expected OHST will not apply to imports where physical cross-border flows of continuous transmission commodities (CTC) are solely as a result of the pipeline or power-line's route. In addition, it is likely OHST would apply to ensure that flows out of Canada to reach another point in Ontario are not exports for zero-rating purposes. The place of supply rules would be considered, as opposed to the CTC routing, to determine if OHST were to apply. Extra care will be required to ensure that the place of supply rules are well understood as it applies to CTCs since there may be a requirement to collect 13% OHST versus only 5% GST.

Impact on systems
A significant implication for entities in the energy and resource sector with the introduction of the OHST is the required systems changes. Such changes will impact the accounts receivable and billing systems as well as the accounts payable systems in numerous ways. It will be necessary to identify the priorities for IT departments related to the specific system requirements for the OHST and ensure the requisite testing and implementation procedures are executed

Now is the time to prepare and plan
Some opportunities to plan ahead begin to emerge. Examine the potential benefits of prepaying certain expenses that are not currently subject to ORST and may not be fully recoverable under the OHST. Review the benefits of certain elections not to tax inter-company transactions.

For large businesses, consider how to deal with the restricted ITCs on the provincial component of the OHST, including giving thought to the percentage of energy used in the production process (as the restriction does not apply here); and ensuring telecom expenses are broken out accordingly to be able to identify restricted expenses.

Deloitte can assist in preparing and planning for harmonization. We can guide businesses in the energy and resource sector in understanding and prioritizing the issues that will require attention. We can perform a diagnostic impact analysis to assist with budgeting and forecasting the impact of harmonization, establishing priorities for necessary systems and process changes and planning for minimizing the cost and cash flow impacts. Although many details are still to be released, such as the transitional rules that will apply and the rules relating to place of supply, the time to begin preparing for these changes is now.

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