A question of loyalty: loyalty programs can be a boon to business, but make sure the tax considerations are handled carefully.

Nowadays, everybody's wallet is bulging with retailers' loyalty cards, or their key chains look like they belong to a dungeon master, what with all the extra key fobs attached to them. It seems there is an epidemic of loyalty or points programs out there designed to encourage customers to shop at a particular store or to purchase a particular brand of products.

In their efforts to attract new customers and keep existing ones, companies have developed incentives that involve everything from "frequent flyer" programs, to ones that offer free goods or services, price discounts, or gifts after certain purchase thresholds have been met. Rewards can range from discounts off your next purchase, to free coffee, car washes, airfare, or even new cars. It is even possible to donate your points to charitable organizations.

Although such programs can be a boon to business, companies that offer them need to understand how the federal and provincial sales taxes in Canada work. Getting this right can mean a much more pleasant visit the next time the taxman comes knocking.

GST/HST treatment

This has been the subject of several Canada Revenue Agency (CRA) rulings in the past. Generally, the position taken by the CRA is that points are intangible property, and intangible devices in electronic format can be treated as coupons for GST/HST purposes. Therefore, the GST/HST rules that apply to coupons will also apply to points awarded under a customer loyalty program.

The coupon rules are found in section 181 of the Excise Tax Act. Under these provisions, when the points or coupons redeemed offer a fixed percentage or a fixed dollar amount off the cost of taxable (other than zero-rated) goods--and for which the retailer or manufacturer doesn't expect to be reimbursed by another party--there are a couple of options available regarding the amount of tax to be collected.

First, the value of the points may be treated as a full or partial cash payment towards the goods or services--this method does not reduce the selling price on which the GST/HST must be calculated. Alternatively, the value of the points may be treated as a discount that reduces the selling price before the tax is calculated. In the first instance, the discount amount would be considered tax-included and the organization that bears the cost of the coupon or points redemption would be eligible to extract a portion as an input tax credit.

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However, as a condition of many points programs, the redemption of the points is only allowed once a specified number have been accumulated. When this is the case, the option above will not apply, as the existence of any threshold means that the points value can't be stated as a fixed percentage or a fixed dollar amount. The points don't have a redeemable value until the threshold is achieved. In this case, the GST/HST must be calculated on the net amount payable for the supply of the goods or services after the price has been discounted by the redemption value of the points. For example, if 1,000 points can be used to reduce the cost of a car wash from $10 to $5, tax is only collected on the $5 charge.

Affinity cards

Affinity cards are credit cards issued by a financial institution providing the cardholder with benefits, often points, offered by the institution's affinity partner. These cards are offered to entice the cardholder to use the financial institution's credit, while playing on the cardholder's affinity to their favourite school affiliation, sports team, or charitable organization. When points are redeemed under these programs, the GST/HST treatment would work in the same manner as for the points programs discussed above.

There is usually a direct relationship between the use of the card and the popularity of the redemption awards offered by the affinity card partner. This means that both the financial institution and the affinity partner have a considerable interest in the recruitment of card users. The financial institution will often pay the affinity partner a fee or a portion of the amounts transacted on the card if the partner can arrange for the adoption of cards by customers. The ability of the affinity partner to attract customers will affect the tax status of the payments made by the institution to its partner--that is, the affinity partner may end up "arranging for" the supply of an exempt financial service, which is itself an exempt service. Merely distributing application forms with no further involvement will generally not constitute arranging for a financial service. However, if the partner distributes applications, obtains missing information from incomplete forms, and then screens and reviews them, the services performed will likely be considered arranging for other financial services and the payments to them will be exempt from GST.

If the services that the affinity partner provides are exempt from GST/HST, the partner may be restricted in its claim for input tax credits on its underlying expenses if its taxable revenues then turn out to be less than substantially all (interpreted by the CRA as 90%) of its total revenues.

Quebec

Quebec, which operates a provincial value-added tax very similar to the GST, has harmonized their rules for the treatment of points and coupons with those of the GST/HST. The main difference under the Quebec sales tax is that financial services are a zero-rated supply, rather than an exempt service, under the GST. This means financial services are taxed for QST at zero per cent, allowing providers of these services to claim input tax refunds for the QST they pay on their inputs.

Provincial sales tax

In the other provinces that impose a retail sales tax, a business operating a loyalty program that provides its customers with taxable goods or services will have to determine if it is acting as a "promotional distributor" or if it is merely offering the customer a price discount when the rewards are provided to its customer.

Generally, when points are redeemed to obtain discounts on items from the issuer's catalogue, they are treated the same as cash or a gift certificate and applied as payment towards the sale price after tax--they don't reduce the amount of tax to be collected. Since the points aren't offered for a specific product or service, the provinces generally take the position that the discount is not a reduction of the selling price, and tax must be collected on the full price before the award or discount is applied.

If points may be redeemed to get free items from the issuer's store or catalogue, the issuer would be considered a promotional distributor. By allowing customers to collect notional credits, it's operating the program for the larger purpose of promoting its wares or encouraging customers to shop at its establishment. As a promotional distributor, the issuer would be liable to pay PST on the purchase of the items offered in the program. Many companies get caught in this trap, as they often use tax-exempt goods from their normal inventory to fulfill their reward obligations. Organizations may then be required to self-assess the appropriate PST based on the jurisdiction the reward is provided in.

By Jeff Shaw, CMA, and Walter Gardisch, CMA

Jeff Shaw, CMA, is senior tax advisor and Walter Gardisch, CMA, is the director of Tax Interpretations & Support at Robert Brakel & Associates Ltd.