September 11th, 2023
Allow Consultaxe’s sales tax specialists to explain the application of GST/HST/QST to damage payments in Canada.
In general, an amount in damages is not considered consideration for a GST/HST/QST taxable supply. However, certain payments for breach of contract or payments are deemed to include GST/HST/QST, where the contract was for the production of a taxable supply.
What is a compensation payment in this context?
A damage payment is the payment of an amount of money by one person to another as compensation or indemnification for damages (e.g., damaged property, loss of income, inconvenience) that the first person has caused, or is claimed to have caused, to the second person. This also applies to compensation payments made following an out-of-court settlement.
Which damage payments are taxable under GST/HST/QST?
Any payment made as compensation or as consideration other than for a supply made under an agreement may be subject to the deeming provision of section 182 of the Excise Tax Act (ETA), if it meets the conditions for its application, which results in a GST/HST liability.
Section 182 of the ETA may apply where, as a result of the non-performance, amendment, or termination of an agreement for the production of a GST/HST-taxable supply (other than a zero-rated supply) in Canada by a registrant, an amount is paid or waived to the registrant otherwise than as consideration for that supply. Section 182 of the ETA may also apply under the same conditions where a debt or other obligation of the registered supplier is reduced or forgiven without repayment on account of the debt or obligation.
Example of a taxable damage payment covered by Section 182 of the ETA
CompBuy and CompSell entered into a contract under which CompSell, a GST/HST/QST registrant, was to make a taxable supply of equipment to CompBuy.
Due to unfortunate circumstances, CompBuy cancelled the order before the planned delivery date, but agreed to pay CompSell a sum in compensation. CompBuy received absolutely nothing in return for the payment.
Do you know how to calculate the GST/QST deemed to be included in the amount of a compensation payment?
5/105 of the amount paid for GST (a ratio based on the relevant GST/HST rate, e.g. 13/113 for Ontario where an HST of 13% is currently in effect).
Careful, though: in Quebec, the QST is not calculated at 14.975/114.975!
Here is an example for a total payment of $1,000:
Deemed consideration under federal law = $1,000 x 100/105 = $952.38
GST deemed paid = $952.38 x 5% = $47.62
Deemed consideration under provincial law = $1,000 x 100/109.975 = $909.29
QST deemed paid = $909.29 x 9.975% = $90.70
Total taxes deemed collected = $47.62 + $90.70 = $138.32
Thus, if the original supplier wishes to get a net amount of $1,000 in damages, he will have to negotiate an amount to be paid by the purchaser of $1,160.52 (1 000$ +GST = $55.26 + QST = $105.26).
Here are some examples of situations in which compensation payments are not subject to GST/HST/QST under section 182 of the ETA.
- When no prior agreement existed between the parties concerning the production of a supply (the contract may be written or verbal);
- When there is a contract, but it does not concern a taxable (non-zero-rated) supply;
- When the supplier is (or was) not a GST/HST/QST registrant (e.g. a small supplier and persons whose activities are 100% GST/QST exempt);
- When the amount is not paid as a result of the non-performance, modification, or termination of the agreement for the production of a taxable supply (e.g. in tort);
- When payment (or waiver) is made by the original supplier and not the original buyer (see note);
- The payment is additional consideration for the initial supply (e.g. past rent) (see note).
Note: Section 182 of the ETA does not apply to the payment in these situations, but it is important to confirm whether it could be subject to the general rules and be subject to GST/HST/QST!
Example of a non-taxable damage payment
In an unfortunate turn of events, Mr. Speedy lost control of his vehicle and damaged the fence of a company, B Ltd., a GST/HST/QST registrant. B Ltd. made the necessary repairs and demanded compensation from Mr. Speedy for the costs incurred to repair the damaged fence, but Mr. Speedy refused to reimburse B Ltd.
B Ltd. sued Mr. Speedy for reimbursement. The lawsuit was settled out of court, after which Mr. Speedy made a payment to B Ltd. for the amount the latter had incurred to repair the fence. B Ltd. accepted the payment in full settlement of the claim and released Mr. Speedy from any further liability.
The payment is essentially compensatory in nature. It represents compensation for damage to B Ltd.’s fence and is intended to restore B Ltd. ― to some extent ― to its pre-damage situation. The payment is therefore not taxable.
What to do when in doubt about the application of GST/HST/QST on a damage payment?
If in doubt about the application of GST/HST/QST to a compensation payment, whether you are the payer or the payee, we strongly recommend that you consult a commodity tax specialist.
Example of a situation in which it would have been preferable to consult a tax specialist before negotiating the amount of the compensation payment
Following a lengthy dispute with a builder over the renovation of a building used in the buyer’s commercial activities, the purchaser’s legal counsel negotiates a settlement worth $5 million, which the buyer must pay to the builder as compensation. This compensation is paid because the buyer did not comply with certain provisions of the contract stipulating that he should not use the building before a certain degree of progress had been made. This breach of contract resulted in significant additional costs for the builder. Since the settlement agreement does not mention the matter of GST/QST, the builder does not consider paying GST/QST on the amount of compensation received from the buyer in settlement of the dispute. For his part, the buyer, having been well advised by a commodity tax specialist, claims the GST/QST deemed included in the amount of compensation paid as an input tax credit and input tax refund.
A year later, following an audit by tax authorities, the builder realized the mistake. Indeed, he must now pay the GST/QST deemed included in the amount collected, plus potential penalties and interest for taxes deemed collected and not remitted.
The auditor shows him the taxes deemed collected under Section 182 of the ETA as follows:
Deemed consideration under federal law = $5,000,000 x 100/105 = $4,761,905
GST deemed paid = $4,761,905 x 5% = $238,095
Deemed consideration under provincial law = $5,000,000 x 100/109.975 = $4,546,488
QST deemed paid = $4,546,488 x 9.975% = $435,512
Total taxes deemed collected = $238,095 + $435,512 = $691,607
Since GST/QST is deemed to be included in the amount paid to the builder, and he was unaware of this at the time payment was negotiated, this error in the application of GST/QST has cost him $691,607 and reduced the amount of compensation received by the same amount ― and this before calculating any additional penalties and interest that may apply.
As the above example shows, the application of GST/HST/QST is not always obvious for this type of payment, and an error in the interpretation of the ETA could be very costly, or advantageous, for your organization. We can help.
The information presented in this article is intended to provide information to Consultaxe clients and others whom the topic interests. The information presented herein is general. Before making a decision, readers should consult a professional advisor.
