Where a business provides both taxable and exempt services, claiming ITCs can become a thorny issue that generally requires an attribution of inputs between the business’ supply of exempt and taxable services.  Section 141.01 of the Excise Tax Act (“ETA”) creates a framework for allocating ITCs for non-financial institutions.  These rules require registrants to allocate ITCs in a manner that is “fair and reasonable”, which predictably leaves significant room for interpretation. 

In the recent decision in Sun Life Assurance Company v. The Queen (2015 TCC 37), the Tax Court of Canada considered whether ITC allocation in respect of leased office space was “fair and reasonable” under section 141.01(5).  The decision is notable for what it says regarding the concept of intention in allocating ITCs for the purposes of section 141.01(5). 

 Although the allocation rules in section 141.01 no longer apply to financial institutions (section 141.02 now address ITC allocation for financial institutions, which was implemented subsequent to the periods at issue in this case), the case is still important for other businesses that have blended commercial and exempt supplies.

Sun Life is a financial institution that sells various financial products, many of which are sold through advisers who are independent sales contractors (“Advisers”).  The services provided by the Advisers are exempt financial services under the ETA.  During the relevant periods, Sun Life leased property from third parties (on which it paid GST) to be used as financial centres for its business to house Sun Life employees. Sun Life subleased portions of the financial centres to its Advisers, for their use as office space.  Sun Life charged the Advisers rent to approximately recover the effective cost of the office space.

During the relevant periods, significant portions of the financial centres remained vacant.  It was the evidence of Sun Life’s only witness that this vacant space was kept available for potential new Advisers.  The space could not be subleased to third parties other than Advisers, but in some cases could eventually become used by Sun Life employees.

Sun Life was entitled to ITCs in relation to its business of subleasing of the office space to the Advisers because the subleasing was a taxable supply.  However, to the extent that its lease was attributable to exempt supplies (i.e. financial services), ITCs could not be allocated for same.  Sun Life initially filed GST returns for the relevant periods claiming ITCs in respect of the leased space sublet to the Advisers in the amount equal to the GST collected from the Advisers on the rent Sun Life charged the Advisers.  

Sun Life subsequently revised its ITC allocation method for the relevant periods by determining the area acquired for the use of Advisers in each leased premises – including the area of any vacant space held for such use – and then grossed up that area by factors intended to attribute to the Advisers their share of the common spaces. This was divided by the total area of the lease, the percentage of which was applied to the total GST Sun Life paid in rent, to determine ITCs (the “New Method”). Essentially, the core difference between the methods was that the New Method attributed the vacant office space to its business of subleasing to the Advisers and therefore claimed ITCs in respect of same. This resulted in approximately $1.3 million in additional ITCs claimed for the relevant periods.

Revenu Québec (“RQ”) took the position that the New Method was not “fair and reasonable” for a variety of reasons including that the vacant space was improperly attributed to Sun Life’s taxable supply of the sublease to its Advisers. RQ also appears to have taken issue with the allocation of common areas to Sun Life’s taxable services, seemingly on the basis that the subleased common areas were used by the Advisers in the course of their exempt supplies rather than because they were tenants.

The Tax Court of Canada (“TCC”) reviewed the allocation provision under section 141.01(2) of the ETA, noting that it focuses on Sun Life’s purpose in acquiring property or a service and noting that the explanation must be neither improbable nor unreasonable.  Section 141.01(5) requires Sun Life to determine the extent to which the property or service is acquired for the purpose of making taxable supplies and to use a fair and reasonable method to do so.  The TCC held that the determination of whether a method is fair and reasonable is based on the view of an objective observer with knowledge of all the pertinent facts.  Further, the tax authority cannot simply substitute its approach for that of the taxpayer simply because it is more fair and reasonable. 

The TCC confirmed that although Sun Life was engaged in exempt activity, it was making a taxable supply by contracting space (including common areas) to Advisers despite the fact that the Advisers were not engaged in commercial activity.

With regard to attributing the vacant space to Sun Life’s subleasing business, the TCC accepted the “uncontradicted testimony” of Sun Life’s only witness that the vacant space was reserved for the use of Advisers to accommodate the growth of the financial centres.  The TCC accepted that attributing the purpose of making taxable supplies for consideration to the vacant space is fair and reasonable because it accurately reflects Sun Life’s purpose with respect to the direct use of that vacant space.

Despite the fact that the vacant space could eventually be used for a different purpose (i.e. for use in making taxable supplies such as use by a Sun Life employee) there was no evidence that this occurred during the relevant periods and if such a change in use occurred, the vacant space would be removed from the pool of space reserved for the Advisers, such that ITCs would no longer be claimed for that space.  Further, the fact that there was a significant amount of vacant space reserved for Advisers does not alter Sun Life’s purpose in acquiring that space.  The vacant space required for sublease to Advisers is a business judgment that is best left to Sun Life “absent a sham or window dressing or similar vitiating circumstances….”

In the result, the TCC allowed the appeal, accepting that Sun Life’s new method for ITC allocation was fair and reasonable. 

This is a reasonable outcome on the facts of this case.  As a preliminary point, where a business that engages in exempt activity leases space to third parties, such lease will be considered a taxable supply even if the third parties themselves are exclusively engaged in making exempt supplies.  To the extent that RQ seems to have suggested otherwise, the TCC properly (and predictably) addressed this. From a policy perspective, this is the appropriate approach, as there is a flow through to the government of GST paid by the third parties that they cannot recover due to their exempt activity, in turn, resulting in no inherent loss of tax revenue. 

More interestingly, as the TCC noted, the purpose for which a registrant acquires property or services is the central factor in the allocation of ITCs under section 141.01 of the ETA.  Where there is no evidence of use outside of commercial activity, the intention of the recipient is central.  Accordingly, to a certain extent, the ball lies in the recipient’s court to establish what its intent was in acquiring the vacant input.  Furthermore, possible future use of vacant space in providing exempt services appears to be irrelevant in the determination of intent while the property remains vacant.

That being said, as the TCC noted, where there is evidence that contradicts the purported intention of the recipient (which could theoretically be derived from the actual use of the property or evidence of some type of sham), the allocation method will likely be considered not fair and reasonable.  Accordingly, this will be a very fact-driven analysis. Had there been such evidence here, the case likely would have been decided differently.

Analyzing intent can be a difficult exercise due to its inherently subjective nature.  In doing so in the context of real property and the ETA, a creative practitioner should consider reviewing the abundant [informal procedure] caselaw regarding new housing rebate claims, where the TCC often has to determine the intention of the recipient.