June 5, 2017
All Tax Articles

If you own or manage a business, you occasionally end up in disputes with customers or suppliers over the terms of a contract or payment. Sometimes these disputes have to be referred to lawyers, and sometimes they end up in court.

A settlement or award for breach of contract will normally be considered tax-included if the following conditions are met:

The payment is made by the “recipient” to the “supplier” rather than the other way round. That is, it is the purchaser, lessee or customer who is making the payment, and the vendor, lessor or supplier who is receiving it. (In other words, money is flowing in the same direction as it would have flowed under the contract.)

The payment is for breach, termination or modification of a contract or agreement. (It need not be a written contract; an oral agreement is still a contract.)

GST or HST was payable, or would have been payable, under the contract, if it had been fulfilled as planned.

In these circumstances, any settlement amount is normally deemed by the Excise Tax Act to be a total that already includes GST or HST.

The supplier (vendor, lessor) must carve out a fraction of the total and remit it to the Canada Revenue Agency as GST or HST. The fraction depends on the province. If your customer is in Ontario, for example, where the HST rate is 13%, the fraction is 13/113ths, or just over 11.5%. In Alberta, where the GST rate is 5%, the fraction is 5/105ths.

The recipient (purchaser, lessee) can claim an input tax credit and recover the same amount from the CRA, provided the recipient would have been able to claim the credit if the money had been paid under the contract.

Example 1

Landlord leases office space in Ontario to Tenant for $5,000 per month plus 13% HST, under a one-year lease. Six months into the lease, Tenant wishes to cancel. After some discussions, Landlord agrees to accept a one-time payment of $10,000 to release Tenant from the lease.

Landlord must treat the amount received as HST-included. If Landlord accepts $10,000, it must calculate 13/113ths of this amount or $1,150 and remit this amount to the government as HST collected. In other words, Landlord has really settled for $8,850 plus 13% HST of $1,150.  (The $8,850 will also be income for income tax purposes, but this article is not about income tax.)

Similarly, Tenant is paying $8,850 plus HST of $1,150. If Tenant is a normal business that can claim input tax credits for HST that it pays, Tenant can recover the $1,150 as a refund when filing its next HST return — which may be something of a windfall if Tenant made the deal without expecting this. This is so even if the settlement agreement does not mention the HST.

If Landlord really wants to settle for $10,000, Landlord should add 13% for HST and settle for $11,300. Then Landlord keeps $10,000 and sends $1,300 (13/113ths of the $11,300) to the government as HST, and Tenant (if a business) can claim the same $1,300 as an input tax credit.

Note that in Quebec, the Quebec Sales Tax (QST) is treated the same way, in addition to the GST.

The same rule applies to an amount that is kept as a forfeited deposit.

Example 2

B (a builder) builds a new home for sale in Calgary. P (the purchaser) offers $300,000 for the home, putting down a $10,000 deposit. P then changes his mind and walks away from the deal, forfeiting the deposit. B decides not to sue and just keeps the $10,000.

B does not really get to keep $10,000. The $10,000 is considered to be GST-included. The GST is calculated as 5/105 of this amount, or $476. Thus, B really gets $9,524 plus 5% GST of $476, and must remit the GST to the government. (Again, the $9,524 is also income for income tax purposes.)

This may come as a shock to B. B should not have accepted the $10,000 deposit unless B was aware that it was really only a deposit of $9,524 plus GST.

(Note that in this case the deposit includes the full 5% GST even though, if the home sale had been completed, 1.8 percentage points of that GST would have been refunded to P via the new housing rebate.)

Note that these rules do not apply to payments by a supplier — e.g. payment by a landlord to cancel a tenant’s lease early. They also do not apply to payments that are not related to a contract — for example, payments for damage caused by negligence, such as where someone with whom you have no contractual relationship damages your business’s property.

This letter summarizes recent tax developments and tax planning opportunities from a third-party affiliate; however, we recommend that you consult with an expert before embarking on any of the suggestions contained in this blog post, which are appropriate to your own specific requirements. Please feel free to get in touch with Lee & Sharpe to discuss anything detailed above, we would be pleased to help.
Sandy J. Lee

Hello my name is Sandy Lee, I am a partner at Lee & Sharpe.

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