24 April 1996 GST/HST Interpretation 11643-2 - Non-Compliance Fees (Ruling Requests from )

                                                                        File:: 11643-2; 11755-1(lhk)

                                                                        Leg. Ref: s. 182, s. 123(1) - supply, consideration

I refer to your memo of November 27, 1995, concerning the application of the GST to non-compliance fees paid to XXXXX and XXXXX by their suppliers. The memo summarizes the facts you have presented to Mitch Bloom of my staff during several phone discussions you had with him on the subject of the application of the GST to non-compliance fees. I also understand that you have previously forwarded us copies of correspondence between your office and XXXXX XXXXX in XXXXX on the same subject .

Please accept our apologies for the delay in responding to you in writing. As you are probably aware, the issue of the application of the GST to non-compliance fees and similar payments has been under policy review for some time. Although the policies encompassing these issues have already been drafted, they are still under consideration by our Directorate's Policy Review Committee. Therefore, until such time as these policies are finalized the opinions expressed in this letter must be regarded as reflecting the interim policy position of the Department.

Background

XXXXX

Based on your memo to us and the documents provided by XXXXX, our understanding of the facts of the situation is as follows:

1. XXXXX mails a Vendor Manual to XXXXX suppliers who represent the majority of the purchases made by XXXXX[.] The manual contains a verification form that is to be completed and returned by the vendor who thereby agrees to comply with the contents of the manual.

2. The covering letter to the Manual indicates that XXXXX is prepared to impose expense offset charges on non-compliant vendors. The expense offset charges are intended to recover the costs incurred by XXXXX due to vendor non-compliance.

3. A complete list of non-compliance conditions, including the effective date and the expense offset charge for each condition, is provided in The Expense Offset Policies included in the Manual. Examples of the non-compliance conditions include:

•   not using UPC catalogue or using incorrect UPC catalogue

•   invoices not transmitted via EDI

•   incorrect FOB terms

•   incorrect routing, i.e. use of incorrect carrier

•   incomplete information on bill of lading

•   failure to provide CSA approval standard identification, fabric content, or country of origin on the product

•   incorrect hanger type

•   etc.

XXXXX

Based on the information provided in your memo of November 27, 1995, the facts pertaining to XXXXX are similar to XXXXXXXXX except that:

1. XXXXX had not charged but was only contemplating imposing non-compliance fees (also referred to as "non-compliance penalties") on its suppliers.

2. By charging non-compliance fees, XXXXX intend to penalize its suppliers when they do not comply with the terms and conditions of purchase agreements entered into by XXXXX[.] Examples of these non-compliance situations include:

•   incorrect packaging

•   failure to meet indicated date of shipment

•   errors in item quality or quantity

•   errors in invoicing

•   inability to conform to acceptable distribution methods, etc.

3. XXXXX intends to collect the non-compliance penalties by reducing the amount owing to the supplier (i.e. offset against the consideration for the supplies made by the supplier). Where no amount is owing to the supplier, XXXXX intends to issue an invoice to cover the non-compliance penalty.

Interpretation Requested

There are three questions arising from the non-compliance fees (penalties) imposed by XXXXX and XXXXX in the above described circumstances:

1. Would the non-compliance fees fall within the scope of subsection 182(1) of the Act?

2. Can one view such non-compliance fees as adjustments (reduction) of consideration that could fall within subsection 232(2) of the Act?

3. Would the non-compliance fees fall within the general provisions of the Act and, if so, are they consideration for a supply?

Interpretation Given

1. Would the non-compliance fees fall within the scope of subsection 182(1) of the Act?

We agree with the views expressed in your letter to XXXXX confirming the statement made by XXXXX in their letter that the non-compliance fees do not fall within the scope of subsection 182(1) of the Act. The reason is that the fees are paid by suppliers to the recipient (i.e. XXXXX or XXXXX) which are not captured by subsection 182(1) of the Act.

2. Can one view such non-compliance fees (penalties) as adjustments (reduction) of consideration that could fall within subsection 232(2) of the Act?

The possible application of subsection 232(2) to non-compliance situations appears to be more of a concern for XXXXX than XXXXX. Based on the information you received from XXXXX in non-compliance situations XXXXX intend to collect the penalties by reducing the amount owing to the supplier (i.e. reduce the consideration due for the initial supply made by the supplier). Where no amount is owing to the supplier, XXXXX intends to issue an invoice to cover the penalty. The question in this case is whether the amount reduced (or invoiced) can be regarded as an adjustment or reduction of consideration that falls within the scope of subsection 232(2) of the Act?

One could compare this situation to a performance warranty given in respect of a supply of property. The warranty may or may not be a separate supply. Regardless, a settlement of a claim under the warranty would not be an adjustment (reduction) of consideration for the making of the particular property. Instead, the settlement would be regarded as consideration for a claim or right to a claim. Rather than a claim, the situation might be such that the supplier reduces or refunds the consideration (e.g. premiums) paid by the warranty holder if the latter is not satisfied with the warranty. In such circumstances, the reduction or refund of premiums may fall within the scope of subsection 232(2) of the Act. The reason is that, each amount that is reduced or refunded represents an amount previously charged as consideration (i.e. premiums) for the supply of performance warranty.

Generally, it is the form and substance of the agreement(s) that would determine whether the non-compliance payment is a reduction in consideration for the initial supply or an amount attributed to a supply made by the recipient of the initial supply. However, in the case of XXXXX suppliers never charge XXXXX an additional amount for performance guarantees. The performance guarantee may or may not be a constituent element of the supply made by a supplier. Regardless, consideration due from XXXXX would generally be attributed to a single supply of the particular property.

Although non-compliance penalties are not adjustments to the consideration in respect of the initial supplies, XXXXX could still offset such penalties against amounts owing to the suppliers. The point is that XXXXX might have debt arrangements with the suppliers and therefore, transfer amounts previously regarded as consideration for initial supplies into "debt" accounts (e.g. accounts payable). Subsequently, the penalties are used to reduce or extinguish such debts. In such circumstances, the penalties would fall within the provisions of subsection 182(2) of the Act (assuming initial supplies were taxable at 7%). Where subsection 182(2) applies, XXXXX would be deemed to have made to the supplier a taxable supply for consideration equal to the consideration fraction (i.e. 100/107ths) of the amount of debt extinguished. Unless the transitional rules provided in subsection 182(2) apply, there would also be a 7% tax (calculated on that consideration) deemed to have been collected by XXXXX from the suppliers.

3. Would the non-compliance fees fall within the general provisions of the Act and, if so, are they consideration for a supply?

Before answering the above question it is important to understand the usual circumstances surrounding non-compliance payments.

Usually, it is a situation where a supplier is required to pay the recipient of the supply compensation for not fulfilling the supplier's obligations in an agreement. The supplier had previously guaranteed that the property or services supplied (referred to here as the "core supply") would meet the performance requirements set out in the agreement. In some cases, the guarantee would be a constituent element of the "core supply". Alternatively, it might be viewed as a separate supply. Regardless, where those performance requirements are not met, the supplier would be required to pay damages (in the form of fees, charges, penalties, etc.) to the recipient in respect of expenses or losses incurred. Such payments are commonly referred to as "non-compliance fees".

The specific circumstances leading to the payment of "non-compliance fees" can vary from one situation to another. While in some cases the payments are made without a dispute, in other cases, the payments may have arisen after a dispute and as part of a negotiated settlement. In some cases, a formal release is issued by the payee while in other cases neither a release is issued nor one is required by the payer. In any case, generally, the payments are in respect of a fulfillment of an obligation that had been previously made by the payer to the payee. Since the payment is made to absolve the payer from the obligation to the payee, it can also be regarded as a payment for a "release" explicitly or implicitly made by the payee to the payer. The question is whether such a "release" constitutes a supply.

The issue of non-compliance fees paid by a supplier to the recipient is discussed in the draft policy "Meaning of the words 'provision of' in the definition of 'supply'" and the conclusion reached there is that, from an overall perspective, a supply exists in the case of non-compliance fees as the performance commitment made by the supplier is a right granted to the purchaser at the time the agreement was entered into and the right can be bought back (liquidated or extinguished) by paying compensation (i.e. a non-compliance fee). Consequently, non-compliance fees are consideration for the supply by way of reduction, liquidation or extinguishment of those rights previously granted by the supplier. Since the rights referred to here fall within the definition of "property" in subsection 123(1) of the Act, as "incorporeal rights" or perhaps more specifically "choses in action", non-compliance fees would be consideration for a supply of property.

In the case of XXXXX and XXXXX there are performance obligations given and thus rights granted by their suppliers in respect of the property supplied. The performance obligations are set out in the purchase agreements and/or separate agreements (e.g. in the case of XXXXX suppliers are required to complete and return the verification form included in the "Vendor Manual" thereby agreeing to comply with the contents of the manual). In the case of XXXXX the agreement (through the Vendor Manual) clearly stipulate the non-compliance fee that would be charged by XXXXX to the supplier for each infraction of performance obligations.

Can one put a label to the supply made by XXXXX or XXXXX for which non-compliance fees are paid by the suppliers? One can argue that non-compliance fees (penalties) are consideration for the supply of a "right to supply" granted by XXXXX. A better characterization would be that non-compliance fees are consideration for the supply of an act of "forbearance", i.e. the act of refraining or abstaining from the enforcement of a right. It is important to note that "forbearance" would in turn be regarded as "consideration" by virtue of the common meaning of that term. However, in this case it is attributable to a monetary payment (i.e. non-compliance fees are expressed in money) meaning that the act of forbearance by XXXXX or XXXXX is not consideration for a supply.

I hope the above rationale for our position on the issue will be of assistance to you. If you have any questions or require additional information, please contact Lalith Kottachchi at (613) 952-9588 or one of the other members of the Imposition Team in the Taxing Provisions Unit. They are: Serge Bernier (613) 952-9580, Gerry O'Reilley (613) 952-9589 and Anny Roy (613) 954-2560.

Yours truly,

H.L. Jones
Director
General Applications Division
GST Rulings and Interpretations        1690(REG)