The Harmonized Sales Tax (HST) in both Ontario and British Columbia will have huge ramifications for the insurance industry. Ramifications that could grow into the hundreds of millions of dollars. To boot, some of those cost implications could affect earnings for 2009.
Insurers will be hit in three areas by the HST: operating costs, claims costs and reserves.
Ontario and British Columbia will be joining Nova Scotia, New Brunswick, and Newfoundland and Labrador in combining the provincial sales tax with the federal Goods and Services Tax (GST) to create the harmonized sales tax (HST).
Effective Jul. 1, 2010, Ontario and British Columbia businesses will be subject to one sales tax as opposed to two, and one set of tax rules instead of two and one level of government instead of two, according to the Ontario Ministry of Revenue.
In a nutshell, “HST is GST on steroids,” Dave Schlesinger, national service leader for KPMG’s indirect tax practice, said.
Under HST, most taxes paid on business inputs would be refunded to the business through input tax credits — savings that can be reinvested and passed on to consumers, the Ministry says.
Insurance companies, however, do not currently charge GST as they are considered exempt. This means insurance companies are not entitled to claim an input tax credit (ITC).
Currently insurance companies are liable for any GST they might be required to pay for products or services used in the course of conducting business. When the HST comes in to effect, this cost will rise from five per cent to 12 per cent in British Columbia and to 13 per cent in Ontario.
According to a Gowling Lafleur Henderson LLP newsletter, “Insurance providers may be doubly affected, as the Budget materials indicated that Ontario would maintain some form of tax at a rate of eight per cent on the same kinds of insurance as are currently subject to Retail Sales Tax, generally property insurance other than automobile insurance. The Budget materials do not note that insurers will have an entitlement to recover the HST they pay on inputs as a consequence. Indeed, when Newfoundland and Labrador maintained a similar 15 per cent unrecoverable tax on insurance, they did not provide corresponding relief to insurers, though Newfoundland and Labrador did recently repeal this additional tax on insurance.”
Effect on insurers
But what does all this mean for the insurance industry, which, like all financial institutions is unable to collect or remit HST in most instances?
“At IBC we know it will have a meaningful impact on insurers,” Grant Kelly, director of policy development and chief economist for Insurance Bureau of Canada, said. To determine just how much of an effect, the IBC hired Deloitte & Touche LLP to do the math. In the first full year of harmonization, the estimated impact of HST, based on information provided by IBC, its members and Deloitte data, is $210 million in Ontario and $29.5 million in British Columbia — a total of $240 million in additional costs. Those numbers projected out to 2015 will be $227 million in Ontario and $32 million in B.C., according to Danny Cisterna, a partner at Deloitte.
The figures in British Columbia are lower partly because insurance companies do not handle auto claims and furthermore because legal services were already subject to provincial sales tax.
The claims side will be hit hardest, Kelly says. When looking at the estimates and drawing out the impact directly related to claims, the industry will be looking at an impact of roughly between $170 and $190 million every year in Ontario. In 2007, the industry paid $326 million in claims, which going forward will increase about $170 million to $496 million in Ontario alone. This is due to an increase in the cost of services, including legal fees, which are currently not subject to PST, adding an extra eight per cent on every service used to settle a claim, Kelly says.
In British Columbia, of the $29.5 million estimated cost increase, $21.2 million of that will be related to claims, Cisterna notes.
Impact on reserves
Insurance companies sold a number of policies without anticipating the possibility of additional cost in settling claims under the HST environment, Jim Falle, CFO of Aviva Canada, says. When reserves were set for 2009, the impact of HST on the costs was not anticipated, and now that legal and medical and other costs will be subject to HST, earnings for 2009 have been hit.
The actuary must take into account when reserves are set, how much the claims are going to cost after HST, so there will be an impact on reserves in 2009 for claims settled after Jul. 1, 2010.
Kelly notes that in a report from Baron Insurance Services, commissioned by the IBC, Barb Addie, principal of Baron Insurance Services , estimated that of the $170 to $190 million in additional claims costs going forward, $250 million must be booked in Ontario in 2009. In British Columbia, the impact on claims reserves will be roughly $20 million.
“So it’s an instantaneous negative impact,” Kelly says. The year 2009 has already been a down year, and to add an additional $270 million will have a meaningful impact on the year’s financial results.
“There’s the one-time hit this year relating to the retroactive nature of bringing HST into account,” Falle says. “The reason it’s retroactive is that when we sold the policies for these things, we didn’t know that HST was going to be in place, so we have no opportunity to price that cost into the products.”
Another cost impact will be in areas where GST was paid but PST was not charged. Because HST will apply in much the same way the GST currently does — to goods and services — any goods and services currently subject to GST at five per cent, will be, for the most part, subject to between 12 and 13 per cent (depending on the province) going forward.
A cost savings will come in situations where GST was not paid previously — such as for independent adjuster services — and thereby HST will also not be accrued. And then finally, there will be no cost impact in instances where companies were previously paying both GST and PST, and this would simply be amalgamated into HST and the cost remains the same, Schlesinger notes.
There are other factors that can influence cost, such as whether a company is located in a harmonized or non-harmonized province, whether the risks are in harmonized, non-harmonized or across multiple provinces, Schlesinger says. “There’s a series of levels of complications,” he says. “To understand the full ramifications, because there are so many costs, you have to understand how it affects your specific operations and uniqueness of your operations.”
An insurance company must determine what the costs will be now, so that it is aware of how to determine what premiums will be on a go-forward basis, Schlesinger says. “Pick out those places that you are paying GST and not PST and basically take that number and multiply it by 2.6 and that’s your new cost, or multiply it by 1.6 and say that’s my additional costs,” Schlesinger says. “That’s the simplest way.”
HST will build on the already cascading taxes in the insurance product, Kelly points out. When a claim is settled, the PST and GST paid out is embedded in the claims numbers. The loss ratios include these taxes, and when those claims numbers are turned into premium numbers, corporate taxes are built in on top of that. Once insurance companies come up with a premium number, they add a premium tax, which on every insurance dollar ranges from three to four per cent. Furthermore, in Ontario and Quebec, on non-auto another eight per cent is levied at the top, which means that the eight per cent is paid on a figure that already includes premium tax, PST, GST and corporate tax. “There i
s a massive cascading (of taxes) in the insurance product,” Kelly says.
Another example of the tax-on-tax concern is in respect to retail sales tax applicable to certain insurance products. Ontario currently assesses a provincial sales tax on certain p&c insurance products, other than automobile insurance, and certain group insurance. Ontario has said it is not going to repeal this when HST is implemented. “It will not be HST, but that will be, if you will, a living on of the provincial sales tax on these products, which is where the industry has, in my mind, a real concern because effectively . . . it’s creating cascading taxes,” Cisterna says. “Under HST now, as an insurance provider, I will have more tax to pay and I still have to charge tax to my customers, and if I pass those increased costs on through increase premiums, then that increases the base for which I’ve got to collect this eight per cent tax. It’s total tax cascading and that’s something that I do know that the industry has lobbied the government on and to me, in my view, that’ a very legitimate concern.” It is, effectively, tax on tax, and very inefficient from a pure tax policy perspective. “The reason they did that simply is because they can’t afford to give up that revenue,” Cisterna adds. According to industry data, it is estimated that the government collected $612 million of retail sales tax on p&c insurance products in 2007 alone.
When the HST was implemented in Nova Scotia, New Brunswick, and Newfoundland and Labrador, the effect on independent adjusters was minimal. At most, Fred Plant, president of Plant Hope Adjusters, esti mates that the cost of doing business increased by at most one per cent.
“We’re an exempt service,” he says. “So the vast majority of the service that we provide is exempt. We never charged GST before on our bills, so when they added GST and PST together to create HST back in 1997, it didn’t change anything.” He adds, however, that adjusters must be aware that HST is applicable to some of the services provided — excluding insurance companies — which means that those companies must be billed HST. Effectively, an adjuster must collect and remit HST for work done for a company other than an insurance company. The customer is defined by who the invoice is made out to, Plant says.
The difference occurs when an adjuster must purchase a product which currently is only subject to five per cent GST, will now be subject to the higher HST. But, Plant notes that the “biggest component of our cost of doing business is labour and that is not affected by this in any shape, way or form.”
He does add while there is nothing at this time to suggest that adjusters will begin to charge HST, it is a good time for adjusters to reflect on who they do work for and how that customer is billed. If a bill should have HST on it, and it is not added, and the government inspects the records, the adjuster will be required to pay the HST that should have been collected originally, out of pocket. “You’ve got noting to lose by charging it properly to the customers,” Plant says.
For service providers who will be required to bill HST to insurance companies, there might be additional costs incurred when financing this extra tax. Because of the process insurance companies go through before paying for service, there is often a delay in payment, which means that the provider, who is required to pay the taxes to the government immediately, is effectively financing the tax until payment is received from the insurer. “We are having to pay before we collect it,” Chris Giffin, partner at Giffin Koerth, says. “We have significant receivables out there, which means that the financing cost is significant. One way or another it’s either going to eat into our profitability or we are going to have to pass it on, not only the increased cost of the HST but also the cost of financing it.”
Mitigating the HST burden
When it comes to adjusting claims, Mike Firth, national leader indirect tax services at PricewaterhouseCoopers, notes there are a few things adjusters and insurance companies should bear in mind after the HST is implemented. First things first, and insurance company or adjuster should always determine whether the insured is able to recover HST — this should be determined during the first discussion with the insured after the loss. When working on a claim, an adjuster will be handling areas such as replacement goods and service providers. Because these are subject to GST, PST and in mind- 2010, HST, the insurance companies’ cost can be reduced if the insured is able to recover all or part of the HST costs incurred. The easiest will be if the insured is able to recover all the HST, then the cost of the claim, minus the HST, is paid to the insured, Firth says. There are other insureds who will be able to recover part of the HST incurred. Once it is determined how much HST the insured can recover, then again, the cost of the claim, minus the portion of HST the insured is able to recover, will be paid, he continues. Both of these situations will reduce the cost to the insurance company, with no loss to the insured. Additionally, if the claim is for the rebuilding or substantial rebuilding of a home, a new housing rebate applies which means that a portion of the HST incurred on the cost of rebuilding the home is recoverable, Firth says.
Because property and casualty insurance is HST-exempt costs incurred related to that premium are not recoverable in Canada. However, the premium is zero rated outside of Canada, which means that it is still a tax charged at the zero rate, Firth says. “When you look back to your costs, there’s a huge difference, because if you have a zero rated premium, any costs that the insurer incurs related to that zero rated premium can be recovered, because the insurer actually made a taxable supply at zero,” Firth adds. As an example, this means that if an insured has an auto accident in the United States, any HST costs incurred relating to the claim are considered part of the zero rated premium and therefore the insurance company is able to claim that back on its return. An adjuster, when handling this type of claim, should be flagging all the HST costs, Firth points out. “That, I think, is an aspect that frequently gets overlooked,” Firth says. “If the loss adjuster isn’t aware of that, if the insurer’s loss adjusting policies don’t mandate that, the tax just gets paid, and it gets baked into the claims cost for that file and it’s gone forever.”
Falle suggests while insurance companies don’t currently qualify for input tax credits, he believes there is an opportunity to collect. “There are certain elements of insurance where we charge provincial sales tax, so in theory there should be an opportunity and our guys are just exploring this right now,” he says. “We should be able to get input tax credits for some elements of this because for the province to fail to allow us to do this would represent a tax on tax.” He goes on to say that there is precedent within the GST and PST, where the government generally allows input tax credits where there is cascading impact from the taxes. However, these opportunities are minimal.
Insurance companies might be able to mitigate some of the increased claims cost through savings from suppliers, such as legal, towing and storage fees, which will now be subject to HST. “Many of the suppliers of these affected services may realize a cost savings as a result of the elimination of the unrecoverable Ontario Retail Sales Tax (ORST), and could pass on a saving in the form of a slight priced reduction to insurers,” Bill MacQueen, senior manager, commodity tax, at BDO Dunwoody LLP, says.
He goes on to note industry associations might want to voice concerns to provincial and federal ministers charged with rolling out the HST. These associations could lobby for tax breaks or rebates to offset the c
osts incurred by HST.
“You need to kind of do some formative impact review on your business, or what HST is going to do, ” Cisterna says. “We really do believe it’s enterprise-wide, so it’s not just a tax issue. If you think about the fact that (insurance companies) are going to be applying all this non-recoverable extra cost now . . . do they pass that on through higher premiums, can they even do that, what’s the impact on their claims reserves — that affects their bottom line. Understand where those big touch points are — what is causing the big increase in costs — so look at your major suppliers, take a look at that and see if there’s any way to negotiation better pricing from them going forward.”
Special attribution method
While insurance companies are not able to claim input tax credits, they are required to make an adjustment to the net tax calculation using a formula under the special attribution method, according to the Canada Revenue Agency (CRA).
This formula must be used to calculate the company’s tax liability for the eight per cent provincial part of HST for participating provinces.
“That method says we don’t care where you’re at and who you source your service from, you will have to, even if you bought something from someone who didn’t charge you HST they charged you GST, factor this in to your formula and pay a portion of what’s called Ontario HST and B.C. HST,” Cisterna says. “This formula says it doesn’t matter where your source it . . . [the formula] prevents you from being incented to go to that Alberta supplier because that supplier is only going to charge you GST. Once you put it in to your formula, you are going to pay the same amount of HST as if you bought it from an Ontario supplier.”
According to the CRA, the special attribution method is used to make an adjustment, determined by a formula, to the company’s net tax for the provincial part of HST. The adjustment is determined on the basis of where supplies of financial services are made rather than purchased.
As a result, there is no requirement for an insurance company, according to the CRA, to:
• track and allocate the extent of consumption or use of each property or service acquired in the participating provinces in order to claim input tax credits related to the applicable eight per cent provincial part of HST; and
• self-assess and account for tax on inputs acquired in a non-participating province for consumption, use, or supply in a participating province. There are exceptions to this rule.
To view the special attribution method — and how to calculate it — log on to: http://www.craarc.gc.ca/Epub/gp/rc4050/README.html (choose to view the publication either as a PDF or HTML document) and under the heading Completion instructions for the GST494 return see Section C -Calculation of the special attribution method.
While there is a reduction in some administration, dealing with only one government instead of two, one tax instead of two, etc., there are additional administrative areas, such as the special attribution method, Schlesinger says. “The problem is, if you make a mistake and you don’t do this right, any [margin of] error has increased,” he says.
What is being done
The government was fully aware that in implementing HST there would be winners and losers and that, in general, financial institutions would be losers because they are tax exempt, Kelly suggests. “We support the government and the idea of HST because, ultimately, from an insurance industry point of view, the more economic growth, .. the more things there are to insure, so eventually we win,” he says.
However, there is the retroactive one-time impact on 2009’s results which is of great concern, and this is where the IBC is focusing its discussions with the government. IBC has presented the government with a range of options to potentially mitigate the effect of the HST. But, as of press time Kelly was not at liberty to disclose what these options would entail.
“Governments understand our case, however, but as of yet I’m not in a position to tell you the odds that it will act,” he says.
Absent any movement by the government to provide relief, insurance companies will have to revisit the cost of premiums, Falle says. “It’s a very significant number for this company, so as a result how do we make sure that we continue to make the profit margins that we are expected to make on the product, and so that is going to be reflected in the pricing” he says. “How much and the impact, our actuaries are working through that right now. It’s certainly going to be a cost passed on to the consumer.”