What is an Input Tax Credit?
Canada’s federal and combined federal and provincial value added taxes – Harmonized Sales Tax (HST) and Goods and Services Tax (GST) – are meant to be paid solely by the end consumer of a product or service. Nonetheless, GST is charged on each taxable supply in Canada regardless of whether the supply is made to an intermediary or end user to ensure collection of these taxes. A taxable supply is the sale of goods or providing of services to which GST/HST apply, a supply made in the course of commercial activities. In order to have only the end consumer pay the GST/ HST, a system of input tax credits or ITCs was introduced.
An ITC is the GST/HST payable or paid on the purchases and expenses incurred for use in a business’ commercial activities. When a business reports its GST/HST payable for the reporting period, it decreases the amount of GST/HST owing by claiming ITCs. As such, the business recovers GST/HST it paid on products or services which it utilizes in creating goods or services for sale. Since the end consumers are generally unable to claim ITCs, this system of credits ensures only the end consumer pays GST/HST.
As an example, Samantha employs an accountant to prepare her personal income taxes. The accountant charges Samantha GST/HST on his services. To attract customers like Samantha, the accountant ran an advertising campaign and paid GST/HST for those advertising services. When the accountant reports his GST/HST for the year to the Canada Revenue Agency (CRA), he reports the GST/HST paid to him by Samantha but offsets that amount by claiming an ITC for the GST/HST paid to the advertising company. Because Samantha is the end consumer, she cannot claim any ITCs to offset the GST/HST she paid for the accounting services.
ITCs cannot be claimed to offset Provincial Sales Tax (PST). In Quebec, Quebec Sales Tax (QST) is reported and input tax refunds are claimed in place of ITCs.
Zero-rated vs. Exempt Supplies
Zero-rated supplies are those which have a 0% GST/HST tax rate applied and include products such as medical assistive devices, feminine hygiene products and basic groceries. Exempt supplies have no GST/HST applied to them and include services such as legal aid and music lessons. Zero-rated and exempt supplies are functionally identical effect for the purchaser – no GST/HST is paid on these products or services. However, there is an important distinction between zero-rated and exempt supplies for the purposes of claiming input tax credits.
A taxpayer can only claim ITCs where the taxpayer charged GST/HST on goods sold or services provided. No ITCs can be claimed where a taxpayer provides only exempt supplies as no GST/HST was charged on these supplies. However, ITCs can be claimed where a taxpayer provides zero-rated supplies because GST/HST was technically charged though at a zero percent rate.
Limits on Claiming ITCs
Businesses cannot claim ITCs on every purchase or expense they incur. Whether ITCs can be claimed in respect of a particular product or services depends on the product or service and the business attempting to claim the ITC. Some products, services and businesses have unique rules applied to them. Therefore, only general rules can be discussed here.
The ITCs claimed must be in respect of purchases or expenses for use in commercial activities, not personal activities. ITCs in respect of operating expenses, for example, can only be claimed where substantially all – 90% or more – of the operating expense is related to commercial activities. If a taxpayer has commercial and non-commercial activities, the operating expense can be apportioned. Different rules for operating expenses apply to financial institutions. No operating expenses can be claimed if the taxpayer uses the quick method of accounting. The ITCs claimed must also be, according to the CRA, reasonable in quality, nature, and cost in relation to the nature of the business. ITCs can only be claimed where the person who supplied the services or goods the ITCs relate to is a GST/HST registrant. The person claiming the ITCs is responsible for verifying the supplier is a registrant. The taxpayer must be a GST/HST registrant to claim ITCs.
How to claim an Input Tax Credit & Record Keeping
ITCs are claimed by entering the amount the taxpayer wishes to claim into the appropriate field in the taxpayer’s GST/HST return for the reporting period. ITCs should be claimed in the period the related expense was incurred but it is not a requirement. ITCs can be claimed in reporting periods after the reporting period in which the expense was incurred but no later than the GST/HST return filing deadline for the GST/HST reporting period that ends four years after the reporting period in which the expense was incurred. ITCs cannot be claimed for periods prior to when the expense was incurred.
Claiming ITCs requires keeping appropriate records in case those ITCs claimed are challenged by the CRA. Most notably, invoices or other supporting documentation related to ITCs claimed must meet prescribed requirements. The Input Tax Credit Information (GST/HST) Regulations states the supporting documentation must show the supplier’s business names per the records of the CRA, the ITC claimants’ business name or the name of authorized agent or representative and the supplier’s business number. There is some variation to these rules for taxable supplies for consideration under $150.
The CRA operates a registry search which allows taxpayers to enter a business’ business number, business name and the date of a transaction to verify those match the CRA’s records. The CRA does warn the registry search can produce incorrect results. Further due diligence is advised where a taxpayer expects to claim a large value of ITCs from a single source.
Retroactive Registration for GST/HST
ITCs can only be claimed where the taxpayer claiming the ITCs is a GST/HST registrant. A taxpayer does not need to register for the current period but can instead choose to register retroactively for previous periods. The taxpayer will be liable to report and pay GST/HST for each period the taxpayer is registered. Taxpayers looking to retroactively register to claim ITCs should keep the time limit for claiming ITCs discussed above in mind. If a taxpayer discovers ITCs were claimed from a supplier who was not a GST/HST registrant at the time the related expenses were incurred, retroactive registration can assist. The supplier can register retroactively and reissue supporting documentation to the taxpayer’s business with the necessary information. A full discussion on retroactive registration can be found in our article Retroactive GST/HST Registration.
Pro Tax Tips: Input Tax Credits Tax Audits and Gross Negligence Penalties
When a business is audited in respect of GST/HST, the CRA tax auditors will often attempt to verify whether all ITCs were properly claimed. The CRA tax auditors will request supporting documentation for all ITCs and deny those improperly claimed, such as invoices without proper information or duplicate claims of the same ITCs. The CRA auditor may also recommend imposing gross negligence penalties pursuant to section 285 of the Excise Tax Act on the denied ITCs where he or she believes the taxpayer “knowingly, or under circumstances amounting to gross negligence” made a false statement with regards to the ITCs. Preventing denied ITCs and gross negligence penalties usually requires good record keeping. Our experienced Canadian tax lawyers can also assist taxpayers facing a GST/HST audit in preparing a response to the tax auditor’s inquiries and mitigate the chance of an adverse tax assessment from the GST/HST audit.