Individual investors will dislike the new goods and services tax

With apparently no recognition of the irony of the date, on Friday the 13th of October, the government proceeded to the next stage in the implementation of the Goods and Services Tax by releasing draft legislation respecting the tax. There are no major differences between the draft legislation and the previously released Technical Paper.

The GST is proposed to be implemented on Jan 1, 1991, at the rate of 9% on the vast majority of goods and services consumed in Canada. It is to replace the present federal sales tax which is imposed on certain manufactured goods. The GST is designed to be paid by the ultimate consumer or purchaser. Although it will be collected by businesses or vendors throughout the production and distribution chain, most businesses will be entitled to recover the GST they have paid by way of an input tax credit system.

How will the implementation of the GST affect the Canadian investor?

An individual investor in Canada is also a consumer of goods and services for his own account. As a consumer, he will not like the GST. The cost of most services will simply increase by the 9% GST rate; such things as haircuts, theatre tickets, club memberships and home renovation labor. The costs of goods not presently subjected to federal sales tax will also increase by about the GST rate — all clothing, for example. (Buy your new leather coat with the sable collar before implementation of the GST in 1991.)

The tax inclusive prices of manufactured goods will change, depending on the relationship between the GST, the replaced federal sales tax, and market forces. The prices of some products might actually decrease after 1990. The Conference Board of Canada has estimated the net increase in consumer costs (that is, loss of disposable income) will be $7.3 billion if a GST of 9% is implemented in 1991.

The government has estimated the tax will result in a one-time increase in the inflation rate (read permanent decrease in the standard of living) of 2.25% in 1991. This estimate reflects the tax rebates to be given to lo wer income Canadians. Since few investors will be in the lower income group, an investor’s cost of living increases will be higher, perhaps much higher. On a given cash flow, the Canadian investor will have to cut back on either consumption in Canada or investment activities.

The other side of the coin is that the GST is intended to be a tax on consumption, not a tax on income and not a tax on investment. The GST will not apply to interest, dividends or capital gains. It will not apply directly to the purchase or sale of shares or bonds or investment-grade precious metals.

However, in carrying out his investing activities, the investor is a consumer of services. Some of these services are tax-exempt, that is, the supplier will not charge GST on the service to the investor, but the supplier will not obtain an input credit for the GST paid on his own costs. These suppliers are likely to attempt to increase their charges to maintain their margins.

Examples of such tax-exempt services are bank credit services, currency products, guarantee fees, insurance, brokerage fees. Other services will carry a direct GST liability, e.g., the fees of accountants and lawyers, account administration fees, safekeeping and custodial fees and investment advisory fees, including the fees charged to mutual funds by the fund manager. The investor will not be entitled to recover the GST paid on these taxable services. It will not make any difference whether the investments are held personally through an investment holding company: there will be no refund of the GST paid.

Although the GST will not apply directly to shares or bonds or precious metals, it will apply to many other forms of investment. The full purchase price of works of art bought in Canada and the full value of such works imported into Canada will be subjected to GST. This tax cost will also apply to most other “collectibles.” There may be a trend toward purchasing and storing such investments outside of Canada. The proposed rules applicable to investment in Canadian real estate are quite complex and are different depending on whether it is a commercial, industrial or residential, and further between new and used residential buildings.

The proposed implementation of the GST in 1991 will add considerable complexity and uncertainty to the evaluation of investment in Canadian equities. There is the question of the over-all effect on the Canadian economy, both in the transition period and longer term. Then there is the differing effect on various industry sectors and on corporations within each sector. It might be expected that businesses supplying services directly to consumers in Canada, such as the hospitality industry, will experience a reduction in demand for their products. On the other hand, exporters will benefit from the change to the GST.

As for the mining industry, the exploration and development sector will face some increased financing costs whereas the producing sector should benefit from the reduction in the tax component of input costs, provided these gains are not offset by GST-induced wage inflation. As has always been the case, the successful producers will be those that remain cost-competitive in the international market.

Barry Dent and John Playfair are tax partners with Ernst & Young.

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