Rationale of Bad Debt GST Refund
In a sale of goods of services, the supplier must remit GST/HST whether the supplier is able to collect the money up front or not. This could result in transactions where the supplier first bills a customer, then fails to collect either the principal amount or the HST from the customer, but has to remit GST/HST based on gross billings. To remedy this situation, subsection 231(1) of the Excise Tax Act allows the supplier to claim a refund against a past remittance of GST/HST that has been billed to a customer but is uncollectible because the account is written off as a bad debt.
Subsection 231(1) operates by a deduction from net tax as computed under subsection 225(1) of the Excise Tax Act rather than as an Input Tax Credit. The adjustment for bad debt is calculated on line 107 of the GST return, rather than being included in the total amount for computing Input Tax Credits.
Conditions for Bad Debt GST Refund
The following conditions must be met in order for a supplier (vendor) to claim a Bad Debt GST/HST deduction:
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- 1. The supply (sale) was taxable and not zero rated. This rule effectively excludes any supplies that are listed as Exempt Supplies under Schedule V or any supplies that are listed as Zero-rated supplies under Schedule VI of the Excise Tax Act. Both exempt and zero rated supplies exempt the supplier from charging GST/HST from the customer. However, the supplier of a zero-rated supply is entitled to claim an Input Tax Credit (ITC) on goods or services acquired in the course of making the zero-rated supply. The supplier of an exempt supply is not entitled to such ITC claim. The rationale being if no GST/HST was remitted in the first place, then the supplier is not entitled to a bad debt GST/HST refund.
- 2. The supply was made for “consideration”. Consideration is a contract law concept, it means anything of value given from one party to the other party of a contract in exchange for the fulfillment of a legal obligation by the other party. In the context of making a supply, that usually means an amount becomes payable to the supplier as result of making the supply. Therefore if the supplier gifted properties to a client as promotion, then that supply is not eligible for GST/HST bad debt refund. This will often involve close scrutiny of the contract and the circumstances in which the supply was made to determine whether a supply was made as a gift or whether it was made for consideration but the supplier simply could not collect the amount from the customer.
- 3. The taxpayer must be a reporting entity which is the person, whether a natural person or a corporation, who is registered with a GST/HST number and is responsible for collecting and remitting GST/HST on any sales made to a customer. Reporting entity is defined in subsection 231(5) as either the supplier or the agent that has made a subsection 177(1.1) election. The subsection 177(1.1) election allows the registrant to act as an agent on behalf of the person who is required to collect and remit GST/HST.
- 4. The supply was made to a recipient. Recipient is defined in subsection 123(1) as the person who is contractually liable to pay for the supply, not the person who receives the benefit of the supply.
- 5. The recipient was dealing at arm’s length with the supplier. There are three ways for two parties to be non-arm’s length parties. First if two parties are related by direct blood relationships, or are related through marriage, common law marriage, or adoption, then they deal at non-arm’s length. Second, if one person is a corporation and another person, whether that other person is a corporation or a natural person, controls the first person, then the two parties deal at non-arm’s length. Third, if a person is the beneficiary of a personal trust, then that person and the trust do not deal at arm’s length.
- 6. The bad debt is written off on the supplier’s books and not as an Input Tax Credit. The book must be physical or electronic, and the writing off of the bad debt must be in accordance with Generally Accepted Accounting Principles (GAAP). Under GAAP, when a supply is made, revenue is reported immediately even if the customer does not pay up front. A supplier is required to assess the probability of collecting from their customers from time to time, often quarterly or yearly. If the supplier estimates that a particular obligation cannot be collected, then the supplier has to report an expense to offset the revenue he reported at the time of the sale. If the bad debt was later collected, then the supplier must first reverse the write-off entry and then record the cash collection on the account.
- 7. The taxpayer supplier must claim the bad debt and it must be reported in the GST return of the supplier. The taxpayer must show in his return where he claimed and amount and then prove that it was not paid. In Paquin v. The Queen, 2004 TCC 597, the Court sets out that in order for the supplier to prove the debt was not paid, the supplier must have made a reasonable collections effort. In Paquin, the supplier was dealing with a recipient corporation in which a husband and wife were the corporation’s only directors and shareholders. After the recipient corporation failed to pay the supplier their supplies, the supplier pursued collection action against the husband as the director but not wife. Subsequently, the supplier claimed a bad debt write off when the collection effort failed. The Court ruled that the supplier had not taken reasonable collection actions against the customer. What constitutes a reasonable collection effort is a contextual determination. For more discussion on what constitutes bad debt, see below.
- 8. The supplier must claim the bad debt within four years of the writing off of the bad debt in the supplier’s books. The four-year limitation period is specifically enumerated in subsection 231(4) of the Excise Tax Act.
What constitutes a Bad Debt
The leading case on the interpretation of Bad Debt in tax law comes from the income tax side.
In Rich v R. [2003] 1. C.T.C. 308 (F.C.A.) 200, D.T.C. 5115 [argued by our Toronto tax law firm at trial and with our assistance at the appeal] Rothstein J.A. set out 7 non-exhaustive factors for determining whether an owed obligation is considered bad debt.
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- 1) History and the age of the debt:
- 2) The financial position of the debtor, its revenues and expenses, whether it is earning income or incurring losses, its cash flow and its assets, liabilities and liquidity.
- 3) Changes in total sales as compared to prior years.
- 4) The debtor’s cash, accounts receivable and other current assets at the relevant time and as prior years.
- 5) The debtor’s accounts payable and other current liabilities at the relevant time and as compared with prior years.
- 6) The general business conditions in the country, the community of the debtor, and in the debtor’s line of business.
- 7) The past experience of the taxpayer with writing off bad debts.
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Claiming GST Bad Debt Refund – Tax Tips
Our top Toronto tax lawyers can help you determine whether you are eligible to claim a GST/HST bad debt refund. If the CRA has denied your claim for a GST/HST bad debt refund, our firm can help you navigate through the complex process of filing a Notice of Objection and Appeal to Tax Court of Canada. We serve corporations, partnerships, and sole proprietors. Feel free to contact us for a free and confidential 10 minute tax law consultation with one of our tax law students.