RBC – Taxable Personnel Services or Exempt “Arranging For”

(As originally published in GST & Commodity Tax Journal, January-February 2006)

The definition of “financial services” in the Excise Tax Act (the “ETA”), and the manner in which the GST applies to financial services and related administrative services is complex.  Moreover, the “included by not included” approach found in the definition itself, together with the extraordinarily obtuse use of the “at risk rules” in the regulatory exclusions has made this area of the GST a gray zone to even the most seasoned of practitioners.

The recent Royal Bank case illustrates some of the basic concepts, as well as the difficulties facing financial institutions in attempting to recover input tax credits (“ITCs”) in situations where the CRA would like to view their ultimate activities as in the nature of “exempt financial services”.

The Facts

At each of the Royal Bank of Canada ’s (alternatively the “Appellant”, or RBC) branch offices, one or more employees were designated to function as the individuals who provided certain services to Royal Mutual Funds Inc. (“RMFI”), a wholly owned subsidiary.  RMFI managed various mutual funds, and was obliged to provide management and administrative services to those funds under contract with a mutual fund corporation and trustee.

The services provided by RBC to RMFI were provided by branch level employees of RBC, who would, from time to time, physically meet with and deal with members of the public who wished to acquire mutual funds, all at the branch level.  Accordingly, the services could generally be regarded as being related to the sale of mutual fund units to the public, and to the provision of continuing customer service.

The Appellant provided these services, which it styled as various “branch services,” to RMFI pursuant to a Master Servicing Agreement (the “MSA”).  The “branch services” were defined to mean the “the provision of Personnel, branch offices, computer services and other necessary services” of the Appellant, to permit the sale of the various mutual funds and “continuing customer service.”

RMFI did not have any employees or engage any persons to perform functions at the branch offices, other than those persons provided by the Appellant, nor did it appear to lease or own any office space (apart from the use made of the Appellant’s branches by the persons providing the branch services).

As banks are precluded by the Bank Act from distributing mutual fund securities, RMFI appeared to have existed as a subsidiary of the Appellant in order to indirectly distribute and manage the funds, with the Appellant thus providing the “branch services” to RMFI within this regulated environment. 

In terms of GST compliance, the Appellant took the position that its supply of the branch services was taxable for GST purposes, and collected and remitted GST on the consideration received for them – and also claiming full ITCs for the underlying inputs necessary to provide the branch services.

The Minister assessed the Appellant for the ITCs claimed, on the basis that the branch services supplied to RMFI were not taxable, but “exempt financial services”.  The Minister’s position appeared to be that the branch services supplied were financial services because the Appellant arranged for “the issue, granting, allotment, acceptance, endorsement, renewal, processing, variation, transfer of ownership or repayment” of mutual fund units, which were financial instruments. 

The assessment also included interest and a penalty under section 280 of the ETA.

The Issues

On subsequent appeal to the Tax Court of Canada (the “TCC”), the issue was straight-forward:

(1) Were the “branch services” taxable, or were they exempt “financial services”?

(2)  If taxable, was the Appellant subject to the penalty provided for in a section 280 of the Act, or were its actions duly diligent, and not subject to penalties?

The Decision

Justice Bowie began his analysis with the basic issue of the taxable or exempt nature of the supplies made by the Appellant.

As most readers will already appreciate, “financial services” are defined in subsection 123(1) of the ETA to mean, among other things:

"financial service" means …

(d)   the issue, granting, allotment, acceptance, endorsement, renewal, processing, variation, transfer of ownership or repayment of a financial instrument, 

…

(l)    the agreeing to provide, or the arranging for, a service referred to in any of paragraphs (a) to (i), or

(m)  a prescribed service.  

Excluded from the definition would be, among other things, the following prescribed services (pursuant to paragraph (t) of the same definition above):[1]

(a)    the transfer, collection or processing of information, and

(b)   any administrative service, including an administrative service in relation to the payment or receipt of dividends, interest, principal, claims, benefits or other amounts, other than solely the making of the payment or the taking of the receipt.

 Accordingly, the Appellant’s position in the TCC was that it did none of the things included in the “financial services” definition, and in fact, the branch services fell into the express “exclusions” listed just above – being in the nature of the “administrative services” specifically excluded from the definition of financial services by paragraph (t) of that definition.  In taking that position, the Appellant argued that what it provided to RMFI were effectively personnel services, together with the use of office space within which the personnel worked.  The Appellant relied on the MSA and argued that its provisions made the bank staff “dual employees” within the meaning of the Principles of Regulations published by the provincial securities regulators, such that when selling or otherwise dealing with mutual funds they are acting on behalf of and are employed by RMFI as well as by the Appellant.[2]  The MSA stated that personnel are employees of the Appellant and are nominally employees of RMFI when engaged in mutual fund sales activities, and also defined “personnel” to mean persons engaged by RMFI to distribute mutual funds and provide customer service, and includes persons employed by the Appellant pursuant to the Principles of Regulations.

Bowie , J. rejected the Appellant’s arguments on these points.  He concluded that that the MSA, and the nomenclature used by the provincial regulators, could not change the legal character of the relationship.  In his view, the individuals working at bank branches were clearly employees of the bank:  there was no evidence that RMFI in any way instructed or controlled the employees in performing the branch services, other then their initial training; employees never entered into a contract of employment with RMFI; they were not paid by RMFI, nor was the Appellant reimbursed for their salaries in proportion to their time spent on providing services to RMFI.  Similarly, the Appellant did not provide office space to RMFI.  The arrangement was simply that the employees deal with the mutual fund business of RMFI in the branch where they do other work for the Appellant. 

Further, and rather than accepting any characterization of the supplies as that of “personnel services”, Bowie, J. chose to characterize the services that the Appellant provided to RMFI as that of “arranging for” the distribution of mutual funds, together with the providing of ongoing customer services.  In doing so, Bowie , J. rejected the Appellant’s arguments to the contrary, based on the Privy Council’s decision in Databank Systems Ltd., which held that certain computer services to a bank were not financial services to the customer, but were simply an input to the supply of a financial service by the bank.[3] 

Bowie , J. also rejected as unpersuasive, arguments based on a CRA policy that defined the term “arranging for” as provided in the definition of “financial service”, and the Appellant’s argument that it could not be distributing or arranging for the distribution of mutual funds because it is precluded from doing so by the Bank Act – referring in this respect to the Supreme Court of Canada’s decision in Continental Bank,[4] for the observation that the Appellant’s activity “is what it is, whether or not it contravenes the Bank Act.” 

Finally, Bowie , J. also rejected the Appellant’s argument that the branch services are excluded from the definition of “financial services” because they are “administrative services” within the meaning of paragraph (t) and the regulations.  Bowie, J. held that the exclusion is intended for ancillary services such as data processing, record keeping and the like, but not for those activities specifically enumerated for inclusion in the definition.

In conclusion, Bowie , J. viewed the branch services was exempt “financial services” and, accordingly, regarding any ITCs taken on their inputs as precluded under the ETA.

On the subject of penalties, Bowie , J. concluded that the Appellant did not make out the requisite due diligence defence.  In Bowie J.’s view, the evidence before the Court fell far short of showing, as required, that the Appellant took all reasonable steps to determine the correct interpretation of the law.  In fact, the evidence showed that the Appellant had decided not to avail itself of an election under section 150 of the Act that would have the effect of deeming the branch services to be financial services, preferring instead to treat them as taxable, and claiming ITCs.  There was no evidence, however, that the Appellant took steps to obtain a ruling, or even an independent opinion as to the proper treatment of the transactions for GST purposes.

Commentary

On one view of the case, it is a good primer on the definition of “financial services”, and the inner workings of financial institutions.

On a deeper view of the case, is an interesting look at what would be the most obvious way in which a financial institution might attempt to contract for various services on a “non GSTable” basis – that is, to attempt to “cost share” employee services.  While many cost sharing arrangements are no doubt in place in the financial services sector (and in many others where the ultimate recipients of the services are exempt entities), there has been some theoretical difficulty in attempting to cost-share on personnel, especially since the Federal Court of Appeal’s decision in Glengarry Bingo.[5] 

While RBC’s arguments tended towards the suggestion that there was an ineffective cost-sharing arrangement for personnel set out in the MSA (i.e., not completely effective per Glengarry Bingo – otherwise the underlying services would not have attracted GST at all per the definition of “services”), it also appeared that the fundamental position of RBC was that the services were taxable in nature.  Perhaps a bit of an internal contradiction. 

Either way, it seemed that the only way in which RBC could rationalize its taking of ITCs was to point toward a taxable supply as an output.  If one were planning the event from the get go (which it does not appear was done, since the TCC observed that RBC has not even obtained an independent opinion prior to embarking on the course of action it did), one might revisit the possibility of creating a “dual employee” relationship – albeit that might be quite a monumental task given the position set out in Glengarry Bingo, and Bowie J.’s own observations in RBC.  If a dual employment relationship were successful, however, it would still not result in any ITC entitlement, in the “exempt supplier” context, but would ensure that the cost of the services bore no additional GST.

Overall, Bowie J.’s dismissal of RBC’s characterization of the arrangement serves to remind tax advisors in planning (or defending) these types of positions, it is not enough to simply rely on an agreement between the parties.  As the RBC decision tends to illustrate, even if we all agree that the world is flat, our agreement will be disregarded by the Courts if the truth of it is not otherwise supported.  Or in other words, the mere nomenclature of an agreement by itself, will not govern – thus, Bowie J.’s conclusion that notwithstanding the wording of the MSA, and its clear attempt at creating a taxable “personnel services” arrangement, the effective result of the arrangement was to provide exempt financial services.

However one chooses to view the case, it also serves as some vindication of the ETA’s ultimate policy of treating supplies by financial services entities as exempt of GST, and thus precluding any GST ITCs on related inputs.  Try as we (as advisors) may to attempt to structure alternative arrangements to allow financial institutions to claims ITCs, the TCC appears to have served notice that it will be extremely skeptical when it comes to the review of these sorts of positions.

Authors:

Robert G. Kreklewetz & Simon Thang

Millar Kreklewetz LLP