31 January 1997 GST/HST Interpretation 11590-5[1] - GST Treatment of Performance Bonds and Labour and Materials Payment Bonds

This is in reply to a memorandum dated November 10, 1995 from XXXXX of your office concerning the GST treatment of performance bonds and labour and materials payment bonds. The above-noted registrant is inquiring whether the settlement of surety bonds should include GST or not.

Our Comments

Under the terms of the performance bond, the surety is generally required to mitigate the obligee's loss through either of two described methods which follow.

The first method of performance bond claim settlement is to "remedy the default". The surety will advance sufficient funds to the principal so that the construction project is completed. The advance of funds provided by the surety to the principal is an exempt supply of a financial service. This advance is made pursuant to the terms of the performance bond which is considered a financial instrument under subsection 123(1) of the Excise Tax Act.

The second method will be used where it is not possible to remedy the default, by settling the claim in the performance bond under one of two options, as follows:

(1) the surety shall complete the construction contract; or

(2) the surety shall re-tender the construction contract so that a new contractor enters into a contract with the obligee.

Under option (1), the surety takes over the construction work and fulfills its obligation under the performance bond to complete the construction contract.

It is our view that the issuing of a bond and the action taken to fulfill the bond's obligation are part of the same activity related to the supply of a financial service. The premium paid for the bond is the consideration for the supply of an exempt financial service which includes the fulfilment of the obligation under the bond by the bonding company. This interpretation is further supported in the Notice of Ways and Means Motion to amend the Excise Tax Act, tabled on April 23, 1996 which, by amending the definition of insurance policy, clarified that a performance bond issued in respect of a construction contract is treated as an insurance policy.

Any consideration received by the surety from the obligee with respect to the completion contract under the performance bond is not subject to GST.

In summary, there is no commercial activity when the surety undertakes to fulfill its obligations under the performance bond to complete the construction contract. As the subcontractors have been hired by the surety to supply work and materials, the surety is a recipient of taxable supplies. GST is applicable to the consideration for the taxable supplies made by the subcontractors to the surety. However, the surety is not entitled to claim ITCs on these supplies as it is not acquiring them for consumption, use or supply in the course of a commercial activity.

If on the other hand, the surety proceeds under option (2), the new contractor will complete the construction work and invoice either the obligee or the surety as follows:

•   the surety agrees to pay the new contractor for the supplies of construction provided to the obligee. The new contractor invoices the surety for the construction work. The surety is the recipient of taxable supplies and it is required to pay GST to the new contractor; or

•   the surety agrees to pay, on behalf of the obligee, the new contractor for the supplies of construction work. The new contractor invoices the obligee for the construction work. The obligee is the recipient of taxable supplies and is required to pay GST to the new contractor. In some cases, the obligee may be entitled to claim an input tax credit or a tax rebate. The surety may apply the Net-of-GST approach described in GST Memorandum 700-5-10 GST Treatment of Insurance Claims.

In the case of default within the context of a labour and material payment bond claim, the surety will have to pay, according to the specifications under the bond, subcontractors and other suppliers of labour and material who have not been paid for their supplies. These payments do not represent consideration for a supply made by the subcontractors and suppliers to the surety. Since the surety does not receive a supply of construction services, the payment which the surety pays to the subcontractors and suppliers is not subject to GST.

Should you have any further questions, please do not hesitate to contact Roy Osudar at (613) 952-9220 or Pierre Bertrand at (613)952-9219.

R. Osudar
Policy Unit
Financial Institutions and
Real Property Division
GST Rulings and Interpretations