Tax on Demand

One of the most significant tax issues to affect Canadian insurers in many years is the position recently taken by Canadian Revenue Agency (CRA) that HST (or GST depending upon the province) is applicable to a portion of reinsurance premiums paid to related unlicensed reinsurers. The tax exposure of Canadian insurers for HST/GST is retroactive to 2005, and has been estimated to be as high as $800 million.

HST/GST is a tax on a supply of goods or services. Under the current HST/GST regime, financial services (including insurance) are considered to be exempt from HST/GST. One important aspect of the current regime is that it requires a Canadian resident to self-assess the amount of HST/GST for the value of goods or services that have been provided to it by most non-residents.

THE STATE FARM CASE

The roots of the current HST/GST issue can be found in the State Farm case that was decided by the Tax Court of Canada in 2003. The Canadian branch of State Farm had paid management fees for various administrative services to its head office in the United States without self-assessing GST on them. The Tax Court found that the head office services provided by State Farm to its Canadian branch were an exempt supply of financial services and, as a result, it was not necessary for a self-assessment of GST to be made. The GST statute included a provision intended to treat the branch as a separate person, but the Tax Court found it was ineffective.

The State Farm case was never appealed by CRA and most insurers assumed the issue of the payment of GST on head office management charges was conclusively settled. However, on November 17, 2005, the federal Department of Finance introduced proposed legislative changes that were intended to reverse the effect of the State Farm case. The changes were intended to be effective from the date of the press release.

Unfortunately, the press release lacked sufficient detail about the changes and draft legislation was not released until 2007. The legislation was finally included in the 2010 federal budget and was subsequently passed.

It appeared at the time that CRA was simply trying to impose a level playing field with respect to the providing of management services. If a management service was provided by a Canadian resident, it would be clearly subject to HST/GST. However, if the same management service was provided by the head office of a foreign insurer, it would not be subject to HST/GST, based upon on the State Farm case.

It appears that CRA wanted to discourage Canadian insurers from providing management services from their head offices to their Canadian branches without payment of HST/GST. Unfortunately, the 2010 legislation was drafted in such a manner that it (possibly inadvertently) opened the door to the assessment of HST/GST on related party unlicensed reinsurance as well. 

THE CONCEPT OF LOADING

The Canadian insurance industry received a big surprise late in 2012 when CRA began to reassess certain insurers for HST/GST on the “loading” portion of the reinsurance premiums paid to related unlicensed reinsurers retroactive to 2005. The position taken by CRA was that the loading under a related party unlicensed reinsurance agreement was similar to a head office management service and should be subject to HST/GST.

Until these reassessments began, most insurers had assumed that the 2010 legislative changes were only intended to ensure that HST/GST was paid on head office management charges, and not to charges between separate entities.

The definition of “loading” refers to the portion of the reinsurance premium that may be attributed to a number of different items, including administrative expenses, profit margin, claims-handling costs, management fees, operating expenses, processing costs and other types of costs or expenses incurred by the reinsurer. It is necessary to divide a reinsurance premium between the risk transfer charge (basically the expected loss ratio) and the loading. The risk transfer charge portion of a reinsurance premium is clearly a financial service and is exempt from HST/GST. The loading charge is taxable.

FAIRNESS ISSUES

Under Canadian law, there is no legal distinction between an insurance premium and a reinsurance premium. A reinsurance premium is simply considered to be an insurance premium paid by an insurer to a reinsurer. It is arguable a reinsurance premium (regardless of to whom it is paid) should still be considered to be an insurance premium and, as a financial service, should be totally exempt from HST/GST. CRA takes the position that the premium can be unbundled into a true premium (exempt) and an administrative service (taxable).

There are also potential issues of double taxation since head office management services are subject to HST/GST. Some of the same services may have also been part of the loading under related party unlicensed reinsurance agreements.

It is important to note that CRA has taken the position that HST/GST is only applicable to the loading on related party unlicensed reinsurance and not on related party licensed reinsurance or any type of unrelated third party reinsurance. This would appear to create an inconsistent result since the reinsurance premium paid to a non-related unlicensed reinsurer would not be subject to HST whereas an identical insurance premium to a related unlicensed reinsurer would be subject to it.

One reason why CRA may have singled out related party unlicensed reinsurance transactions is due to concerns about transfer pricing. However, an approval from the Office of the Superintendent of Financial Institutions (OSFI) must be obtained for any related party unlicensed reinsurance agreement.

One of the requirements of this approval is that evidence must be provided to OSFI that the reinsurance agreement has been entered into on fair market terms and conditions. As a result, it is much more difficult for a Canadian insurer to transfer profits to a related party using a reinsurance agreement.

LOBBYING EFFORTS

Once Canadian insurers realized CRA was serious about imposing the HST/GST on a retroactive basis, significant lobbying efforts began. The Insurance Bureau of Canada, as well as other industry groups, began to actively lobby CRA and the Department of Finance.

Some of these lobbying efforts appear to have partially paid off. CRA has recently agreed that ceding commissions and the margin for risk transfer on quota share reinsurance agreements will not be considered to be loading. However, CRA has not yet set out its position on excess of loss and stop loss reinsurance agreements. The confirmation that a ceding commission on a quota share reinsurance agreement is not loading is a significant concession by CRA since it can represent a fairly large portion of the premium and is intended to cover the acquisition costs of the business that has been ceded. 

A MOVING TARGET

It is still not clear how the HST/GST payable on related party unlicensed reinsurance issue will ultimately be resolved. The only real remedy for the current situation may be a test case challenging the 2010 legislation in the courts. It would be necessary for an insurer that had been reassessed by CRA with respect to the HST/GST to challenge the reassessment in the Tax Court (and likely in higher courts on appeal by the unsuccessful party).

It is likely that it will be many months, or possibly even years, before total certainty is obtained regarding this issue. Until CRA provides a final interpretation of what it considers to be “loading” under a reinsurance premium, it will not be possible for a definitive assessment of the retroactive tax liability to be determined.

It was necessary for the 2012 audited financial statements of all Canadian insurers with a potential HST/GST exposure to include a tax provision that ordered to reflect the tax liability on a retroactive basis back to 2005. Most Canadian insur
ers have included this tax provision in their audited financial statements, but have not yet actually begun to remit HST.

It is clear that the tax liability of Canadian reinsurers with respect to HST/GST for related party unlicensed reinsurance is still a moving target.

Until the HST/GST issue is resolved, Canadian insurers should carefully evaluate their use of related party unlicensed reinsurance to determine whether or not it still makes sense, assuming that GST/HST may be payable on the loading component of the reinsurance premium.

In summary, the position taken by CRA with respect to related party unlicensed reinsurance can be criticized based on the following factors:

1. the retroactive application back to 2005;

2. confusion over whether the legislative amendments were intended to apply to related party unlicensed reinsurance or just to head office management charges;

3. a lack of clarity over the definition of “loading”;

4. difficulties in calculating the components of a reinsurance premium (eg., the amount that covers the risk transfer); and

5. basic principles of fairness (the applicability of HST/GST to a financial service, as well as to only certain types of reinsurance agreements).

This is clearly an evolving issue for the Canadian insurance industry and the final resolution of it will be both interesting and important.