Producers don’t fear GST but effect on inflation unknown

In the recent Technical Paper on the proposed 9% Goods and Services Tax (GST), the government stated that primary resource industries, such as producing mining companies, would benefit from the replacement of the present federal sales tax with the GST in 1991. Why should this be the case? Mining companies do not pay the present 13.5% sales tax on the majority of their purchases, such as production machinery and equipment and production and processing supplies.

The answer is that mining companies do pay sales tax at present on items such as computers used for administration purposes (accounting, financial modelling), small motor vehicles, various supplies. Further, many of the suppliers to mining companies presently bear federal sales tax on certain of their purchases, and this cost is reflected in their charges for goods and services.

The GST is designed to eliminate the sales tax component from most capital and operating costs incurred in production activities. Although mining companies will have to pay the GST on virtually all goods and services purchased, they will be entitled to the input credit refunds where the purchases are in respect of either taxable or tax-free sales. All sales of production will fit into one of these two categories of sales. All export sales will be tax-free; that is, no GST will be charged to the purchaser.

Similarly the first sale of investment grade precious metals by a domestic refiner will be tax-free. Other domestic sales of mine production will be taxable to a purchaser, but this tax will give rise to input credits to the purchaser if acquired for use in a commercial activity.

Conceptually, the removal of direct sales tax costs from some purchases and the removal, over time, of sales tax costs embedded in some suppliers’ charges, will reduce the producer’s costs. Since producer prices are set in the international market place, the reduction in costs will flow to the bottom line.

This is not the whole story since other costs will increase. The GST will require that producers charge GST on taxable sales to customers and claim an input tax credit for GST paid on their purchases. The amount — the difference between the tax charged on sales and the tax paid on purchases — will be remitted (or refunded if the tax paid on purchases exceeds the tax charged on sales) on a periodic basis.

The producer will be required to register as a “vendor” and will have to adapt its systems and procedures to identify and keep track of GST paid on purchases and to identify and charge tax on taxable sales. Accurate record keeping through the purchasing functions will be particularly important. Accordingly, GST compliance will add somewhat to administrative costs.

GST will also affect the producer’s financing requirements. Most Canadian mine production will be tax-free, either because it is exported or because it is the first sale of investment quality precious metal by a Canadian refiner. Accordingly, many producers will be in an excess input credit position, paying GST and filing for and awaiting refunds. They will have to finance the refundable amounts until they are received from the government. This will be, of course, the case where a mine is in the development stage.

Some services required by producers will be “tax-exempt”; that is, the supplier will not charge GST but will not obtain input credits for the GST it pays. Examples of such “tax-exempt” services include credit services such as guarantee fees, foreign currency transactions, interest rate products, insurance and underwriting. There will be pressures on the costs to producers as the suppliers of such services attempt to maintain their margins.

Unfortunately, many of the income tax rules relating to automobiles, meal and entertainment expenses and employee benefits have also found their way into the GST as limits to input credits. This will not give rise to significant cost increases but will be an administrative nuisance.

Larger and more successful producers may find their input credits limited in another way. If their financial revenues such as dividends and interest exceed $10 million or 10% of total revenues, then part of their operations will be deemed to be an exempt financial services activity for GST purposes. GST paid on purchases related to these “financial” activities will not be claimable as an input tax credit. These rules may also have a negative impact on groups organized with a holding company above the operating mining company.

The most critical GST impact from the producing mining company’s point of view will be an indirect one: what will happen to labor costs. The GST will cause an increase in the inflation rate in Canada when implemented in 1991. The government hopes the increase will be limited to 2.25%; other commentators suggest the increase will be much higher.

If the implementation of GST triggers a wage spiral, producing mining companies will be particularly hard hit. Their revenues are fixed by international market prices and by the exchange rate for the Canadian dollar.

Some costs, mainly capital costs, of the producer will be reduced by the removal of the present federal sales tax. Other costs will increase, in particular administrative, financing and financial services costs, but probably leaving a net benefit to producing mining companies as a group.

An obvious planning point is to defer until 1991, where practical, the purchase of such things as computers (other than for process control) automobiles and building supplies that are presently subjected to federal sales tax. A less obvious planning point will be to become familiar with the GST impact on major suppliers. This information will be required to negotiate price reductions when suppliers experience sales tax savings.

The unknowns are the increase in domestic inflation that will be caused by the implementation of GST, the resulting pressure on labor costs and the effect on the exchange rate for the Canadian dollar. We are not so foolhardy as to make any predictions on those questions.

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

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