Peter L. Mitchell Professional Corporation

Canadian GST Issues for Non-Resident Importers

Non-residents often act as importer of record for goods brought into Canada. They pay any duties owing plus, in most cases, the 5% federal component of GST. Non-residents who are registered for GST generally recover this tax as an input tax credit. However, the majority of non-resident importers are not registered.

This article discusses:

the general GST registration rules for non-residents;
special rules that allow an unregistered non-resident to recover GST paid on importation by passing the right to an input tax credit through to a Canadian customer or commercial service provider; and
when a non-resident is required to register and collect GST on certain sales of goods in Canada (generally to Canadian consumers from a Canadian warehouse).

Where registration is required

Under the general rules, a non-resident is required to register if they carry on business in Canada or make supplies from a permanent establishment situated in Canada[i]. These non-residents recover the GST paid on importation by claiming input tax credits (where available) in the same manner as Canadian residents.

Voluntary registration

A non-resident who regularly solicits orders for the supply of goods for export to, or delivery in, Canada may register voluntarily[ii] and claim input tax credits. However, non-residents are often reluctant to register. They do not want to deal with the administration of collecting tax on sales made in Canada and filing returns. They also wish to stay off the radar of the Canada Revenue Agency.

Input tax credit transferred to the customer

There are special rules in section 180 of the Excise Tax Act (“ETA”) which allow an unregistered non-resident to indirectly recover tax paid on importation. These rules are useful but can be awkward to apply in practice. They provide relief in two situations: (a) where the goods are resold unused to a customer in Canada, and (b) where a taxable “commercial service”[iii] is performed on the goods in Canada by a registrant.

Section 180 allows the input tax credit to be claimed by the Canadian customer or commercial service provider provided that person obtains evidence that the tax was paid by the non-resident. This is generally a copy of the customs accounting document. Some importers are reluctant to provide this document because it may disclose their cost and may include unrelated import items.

A customer or commercial service provider who is unfamiliar with section 180 may be reluctant to apply it. They may not believe they could be entitled to an input tax credit for GST paid by someone else. Providing a copy of the section may not help because some of the language is obscure to anyone other than a tax practitioner.

Section 180 is easier to read when you take out the portions that are not relevant to a particular situation. For example, the portion that is relevant where the goods are sold to a customer in Canada reads as follows.

For the purposes of determining an input tax credit[iv] of …. a particular person, where a non-resident person who is not registered under Subdivision D of Division V

(a) makes a supply of tangible personal property to the particular person and delivers the property, or makes it available, in Canada to the particular person before the property is used in Canada by or on behalf of the non-resident person,

(b) has paid tax under Division III in respect of the importation of the property …. and

(c) provides to the particular person evidence, satisfactory to the Minister, that the tax has been paid,

the particular person shall be deemed

(d) to have paid, at the time the non-resident person paid that tax, tax in respect of a supply of the property to the particular person equal to that tax.

The term “particular person” refers to the Canadian customer of the non-resident. Where the conditions in paragraphs (a), (b) and (c) are satisfied, paragraph (d) “deems” that that the tax paid by the non-resident is paid by the customer. This deeming allows the customer to claim an input tax credit.

In my experience, reluctance by a customer to use section 180 may often be resolved by having the importer’s tax advisor communicate with the customer’s tax advisor, who then provides reassurance to the customer.

Electronic commerce rules

Under a complex set of “electronic commerce” rules that became effective on July 1, 2021, a non-resident who does not carry on business in Canada is required to register and collect GST if the non-resident makes more that $30,000 per year of “qualifying tangible personal property supplies” to persons in Canada that are not registered (generally consumers). A qualifying tangible personal supply includes any sale of goods made in Canada other than (a) an exempt or zero-rated supply or (b) a supply sent by mail or courier to an address in Canada from an address outside Canada.

The main intent of these rules is to ensure that GST is collected where sales are made by non-residents to Canadian consumers from a warehouse situated in Canada.

Where a non-resident is registered (either through these electronic commerce rules or voluntarily), the non-resident collects GST on qualifying tangible personal property supplies made directly (for example, through its own website) or through a “distribution platform operator” (for example, Amazon). The non-resident may claim input tax credits.

Where an unregistered non-resident makes qualifying tangible personal property supplies through a distribution platform operator, the distribution platform operator collects and remits GST/HST. Through a mechanism similar to section 180, the distribution platform operator may claim an input tax credit for GST paid by the non-resident on importation or purchase of the goods.

If you have any questions on the issues discussed in this article, please give me a call at 403-805-7945 or email me at plmprofcorp@shaw.ca.

[i] Subsections 240(1) and 132(2) of the ETA.

[ii] Paragraph 240(3)(b) of the ETA.

[iii] A “commercial service” is defined to mean any service in respect of tangible personal property other than a financial service or a service of shipping the property supplied by a carrier.

[iv] Or a rebate under section 259 or 260.

The Boundaries of the GST Residential Property Exemption

The sale of a residence such as a house or apartment building is generally exempt from GST once it has been occupied as a place of residence. However, this exemption has limits and does not always apply where one might intuitively think it should. In other words, if it looks like a house and smells like a house, it isn’t always taxed as a house.

The residential property exemption generally applies to a “residential complex”[1] that has been occupied. A residential complex includes a building or part thereof (“residential building”) which contains one or more “residential units”, plus the common areas and land that are reasonably necessary for the use and enjoyment of the building as a place of residence.

The definitions of residential complex and residential unit are indeed complex. However, their application is straightforward in most cases. This article deals with the following types of properties along the boundary of these definitions, where the complexity comes into play.

Buildings that have become uninhabitable
Buildings that have been demolished to make way for new construction
Combined residential and non-residential use
Land attributable to a residential building
Hotel-type properties
Properties with a mixture of short- and long-term rentals
Bed and breakfast operations
Vacation properties with short-term rentals and/or personal use

A residential building must exist and be habitable at the time of sale

The courts have held that a structure is not a residential building if is under construction, but not yet habitable, or if it was previously habitable but has deteriorated to the point where that is no longer the case. In Yakabuski[2], the Tax Court of Canada found that the sale by a corporation of a property that included a house that had been seriously damaged by fire, and partially demolished, was taxable. Justice Margeson made the following summary comments:

When reviewing all of these terms with their clear common-use meaning, the Court is satisfied that that which was transferred according to the Contract of Purchase and Sale had to be capable of being used as a place of residence and that which was being transferred had to be a detached house or part thereof that was last occupied or supplied as a place of residence or lodging for individuals. These terms are almost synonymous with the term “inhabitable”.

Further, a piece of vacant land that was formerly improved with a residential building is no longer a residential complex once the building no longer exists. In Leowski[3], the Tax Court found that the sale by a corporation of vacant land on which a house had recently been demolished was not a residential complex and was thus subject to GST. Justice Bowman made the following summary comments:

I do not think that the property was a “residential complex” as defined. Paras. (a), (b) and (c) refer to a part of a “building”. The plain meaning of “building” does not include a plot of vacant land, even if it has been preloaded with sand in anticipation of constructing a building on it.

A contractor who is purchasing an existing house with the intention of demolishing it and building a new one for sale may save tax by selling the property to his purchaser before demolishing the existing house.

Building designed as a residence is used for commercial purposes

Where a building that was designed for use as a residence, or was formerly used as a residence, is converted exclusively to commercial use (e.g., as an office building or showroom), the building is no longer a residential complex.

For example, assume that a law firm purchases an older house from an individual who formerly lived there. The purchase is exempt because, at that time, it is still a residential unit. It was last occupied by an individual as a place of residence. The law firm then proceeds to renovate the entire building for use as its offices. Once they start work, the building is no longer a residential complex. It has been occupied for commercial purposes. A future resale will be taxable.

Combined residential and non-residential use

A residential complex may include only part of a building or part of a plot of land. Common examples include an apartment building that has retail space on the main floor, or a a large working farm property that contains a farmhouse. Where one of these “dual use” properties is sold, the residential and non-residential portions are deemed to be separate “supplies”[4]. If the non-residential portion is taxable, the sale proceeds must be allocated between the two parts.

An exception to this “dual use rule” occurs where a building owned by an individual is used primarily as a place of residence[5]. In that case, the commercial use is ignored, and the entire building treated as a residential complex[6]. A sale is exempt. An example would be a three-storey building where the owner and his or her family live in the upper two storeys and operate a retail store on the ground floor.

However, if the commercial use is primary, the dual use rule applies. If the facts in the previous paragraph were reversed, such that two storeys were used commercially and one as a residence, the portion of a sale price attributable to the commercial stories would be taxable, while the portion attributable to the residential storey would be exempt.

Land Attributable to a Residential Building

The CRA generally accepts up to half a hectare of land as being attributable to a residential building, and thus form part of the residential complex. They will allow a larger portion only in limited circumstances, such as where there is a minimum residential lot size required by the local municipality, or where land is required for access to the building. The CRA’s views on this matter, including six useful examples, are set out in paragraphs 10 through 17 of Memorandum 19.2.1.

Where a property involving more land than may be included in a residential complex is sold, the excess portion of the land is deemed to be a separate supply under the dual-use rule. If the supplier is a corporation, partnership or trust other than a personal trust, this excess portion is taxable.

If the supplier is an individual or personal trust (such as an estate) the excess portion may be taxable or exempt, depending on the circumstances. The applicable exempting provision[7] is complex and often difficult to apply in practice. The issues surrounding it will be discussed in a separate article.

Hotel-Type Properties

The definition of residential complex excludes a building, or part of a building:

that is a hotel, motel, inn, boarding house, lodging house or other similar premises;
that is not a house or condominium unit owned by an individual and used primarily as a place of residence (see above); and
all or substantially all of the room rentals are, or are expected to be, for periods of less than 60 days.

Properties that meet all three criteria are referred to below as “hotel-type properties”. All room rentals are taxable, even if they are for a period of more than 60 days. The sale of a hotel-type property is taxable.

The CRA provides the following guidelines for hotel-type properties in its Policy Statement P-099:

The determination of whether an establishment is a hotel, motel, inn, boarding house, lodging house or other similar premise, should be based on considerations involving all the following guidelines, but not all the guidelines necessarily apply to a given establishment since they may depend on the type of establishment and location of the establishment in question. Where applicable, the conditions described in these guidelines should generally be present throughout the year.

the establishment normally provides temporary accommodation rather than a permanent place of residence;
where required by municipal and/or provincial regulations, the establishment is licensed for business for the purpose of providing a temporary place to stay;
the establishment is available for rental to the public on a temporary [transient] basis;
where appropriate, there is a common registration area;
the rooms or suites in the establishment are furnished by the supplier;
depending on the nature of the establishment, housekeeping services and other facilities are available such as restaurants, meeting rooms, stores, etc.;

It is generally a requirement in all cases that there be a clear intention to operate the facility as a hotel/lodging or similar establishment.

The courts have tended to take a broad view of whether a building is a hotel-type property. For example, Koppert[8] involved a chalet in Whistler, BC that was available to the public for temporary accommodation. A local management company arranged the rentals. The occupants would either be mailed the key or could pick up the key at a place arranged by the management company, who provided cleaning services upon the departure of each occupant. The Tax Court found that the chalet was a “similar premise” and therefore a hotel-type property.

Properties with both Short- and Long-term Rentals

The third criterion for hotel-type properties is satisfied where “all or substantially all of the [rentals] provide, or are expected to provide, for periods of continuous possession or use of less than sixty days”.

The CRA interprets the phrase “all or substantially all” as meaning 90% or more. Therefore, in their view, where more than 10% of the rentals are for 60 days or more, the building is not a hotel-type property and is a residential complex. A common example is an apartment hotel that has a mixture of short- and long-term stays. Rentals of units for less than a month are taxable, while rentals for a month or more are exempt[9].

The sale of such a “mixed stay property” is exempt if the owner did not claim partial input tax credits for the acquisition or capital improvement of the property. If the portion of short-term rentals is low, or the property was acquired exempt, the owner might consider not claiming these input tax credits to preserve the exemption on resale. Partial input tax credits related to the portion of short-term rentals may still be claimed for operating costs.

If the owner claims partial input tax credits for purchase or improvement of a mixed stay property, a future sale will be taxable. However, the seller may claim at that time an input tax credit for the previously unclaimed portion of the tax paid on purchase or improvement[10] (i.e., the portion that related to the long-term rentals).

Some properties that are generally rented on a short-term basis have the occasional rental for 60 days or more. If these longer rentals comprise slightly more than 10% of the total rentals, the property is technically not a hotel-type property. It may be difficult to determine the status of a property where rentals for more than 60 days comprise slightly more than 10% of the total in some years and less in others.

Bed-and-Breakfast Operations

A building where a bed-and-breakfast is the primary use is an example of a dual use property. The bed-and-breakfast portion is a hotel-type property. The smaller portion where the owners and their family live is a residential complex. For example, where a property used 70% as a bed-and-breakfast and 30% as a residence is sold, the two parts are treated separately. The bed-and-breakfast portion is taxable, while the residential portion is exempt.

However, if those numbers are reversed, such that the residence comprises 70% of the space, the sale is entirely exempt under the exception to the dual use property rule discussed above.

Vacation Properties with Short-term Rentals and/or Personal Use

Many individuals own a house or condominium unit in a vacation or resort area. Where such a property is held strictly for investment purposes, and rented 90% or more on a short-term basis, it is generally a hotel-type property. A sale is taxable. Conversely, if the use is entirely personal as a primary residence or second home, the property is a residential complex. A sale is exempt.

Many vacation or resort properties involve a combination of personal and short-term rental use. A common example is a condominium resort hotel where the owner of a unit puts it in a “rental pool” when he or she is not using it personally. Where the primary use of the unit is personal, the entire property is a residential complex. A sale is exempt. However, where the primary use is for short-term rental, the entire property is generally a hotel-type property (and not a residential complex). A sale is fully taxable. The dual use rule does not apply because there is no separate portion of the property that is used exclusively as a residence (as is the case, for example, with a bed and breakfast). The seller may claim at that time an input tax credit for any previously unclaimed portion of the tax paid on purchase or improvement[10] (i.e., the portion that related to personal use).

There have been many disputes between registrants and the CRA over how to calculate residential vs. short-term rental use of vacation and resort properties. The main source of conflict has been how to allocate periods of vacancy when the unit is available for rental and not being used personally. These periods are often significant for seasonal properties. The issue mainly arises in respect of input tax credits for tax paid on the purchase or improvement. However, it also applies in determining whether the primary use is as a residence.

The CRA’s position, set out in their Info Sheet GI-025, is that periods of vacancy are disregarded, and one simply compares the days rented to the days used personally. Owners tend to allocate the periods of vacancy to the commercial activity of hotel-type rentals, arguing that the unit is available for rent and the owner must continue to pay the management fees and other operating costs. There have been a few court cases on this issue to date, but none has provided guidance on finding a compromise between the two extremes.

If you have any questions on the issues discussed in this article, please give me a call at 403-805-7945 or email me at plmprofcorp@shaw.ca.

[1] Ss. 123(1) of the ETA.

[2] 2008 TCC 27

[3] [1996] TCJ No. 829 (QL), [1996] GSTC 55

[4] Subsection 136(2) of the ETA.

[5] of the individual, a relative or a former spouse or common-law partner of the individual

[6] Paragraph (c) of the definition of “residential complex” in ss. 123(1) of the ETA.

[7] Subsection 9(2), Part I, Schedule V to the Excise Tax Act.

[8] [1998] G.S.T.C 128

[9] S. 6, Part I, Schedule V to the ETA.

[10] Ss. 193(1) of the ETA.

Managing Customs in a Small or Medium Size Organization

Most small and medium sized organizations do not import often enough to hire a full-time customs manager. The job tends to be a part-time responsibility of someone in accounting or logistics or, in many owner-managed businesses, the President. The biggest challenge for this part-timer is having sufficient knowledge of trade and customs matters to provide the customs broker with complete and accurate information.

This article describes the basic knowledge that a customs manager needs to make the best use the more extensive knowledge possessed by their customs broker. It also provides links to articles that provide more in-depth information and links to outside sources of knowledge.

Importers tend to assume that brokers have all the knowledge required to prepare the customs entry documents. Brokers do know a lot about customs and trade. However, their knowledge of a particular import shipment is generally limited to the information on the customs invoice and other transaction-related documents provided to them. They do not review underlying legal documentation, such as purchase and sale contracts, and they don’t have much time to ask probing questions.

For example, if a customs invoice states that the price includes installation of a machine on site in Canada, the broker will ask for the information necessary to deduct the installation costs in determining the value. However, if the invoice simply describes the machine, the broker will assume the price includes delivery only. It is up to the importer to be aware of both the terms of the purchase contract and that the installation portion of the price may be deducted. If he is not, and the goods are dutiable, the importer will overpay.

Customs and trade knowledge falls into three broad categories: valuation, origin and tariff classification.

Valuation

Where transaction value forms the basis of valuation, as it does for 90% of imports, there are a number of statutory additions and deductions from the invoice price. Both are often missed because the customs manager lacks knowledge of the underlying contracts and/or the adjustment requirement. The most common deductions are:

Transportation charges and insurance from the place within the country of export from which the goods are shipped directly to Canada, and
Costs for construction, erection and assembly after importation.

The most common additions are:

Selling commissions and brokerage;
Certain royalties and license fees payable after importation;
Subsequent proceeds payable to the purchaser; and
Assists (goods and services provided free to the exporter).

All of the adjustments to the invoice price are described in the article entitled The Basics of Customs Valuation. The article also identifies the situations where transaction value may not be used.

Origin

The person managing customs at an importer should know the basic principles of origin. Every good that crosses a border anywhere on earth has an economic nationality known as its “non-preferential origin”. This is generally the country where the good was manufactured. However, a good must be “substantially transformed” by the manufacturing process for origin to be conferred. Not all forms of manufacturing meet this test.

A common misconception is that goods originate in the country from which they are shipped. That is not true. A pair of soccer boots manufactured in Indonesia, stored a warehouse in the United States and subsequently sold to a customer in Canada, remains of Indonesian non-preferential origin. This may or may not be clear on the customs invoice provided by the American exporter.

The rules of origin that confer preferential tariff treatment under a free trade agreement are not based on the principle of substantial transformation. Rather, they are product specific according to their tariff classification, and often quite detailed. The rules for determining “preferential origin” under the USMCA are summarized in this article. While the details of origin rules are different for other free trade agreements, the general framework is similar for all.

A common misconception among importers is that receipt of a certification of origin under a free trade agreement from the producer or exporter is a guarantee that the goods qualify for preferential (often duty free) treatment. This is not the case. If the producer has not done the work necessary to substantiate that the goods qualify under the rules of origin, or mistakenly concluded that they do, the importer is the person who is assessed for any duties, interest and penalties owing.

The fundamentals of preferential and non-preferential origin are discussed in the article entitled The Basics of Origin in International Trade.

Tariff classification

Tariff classification is the area where study and legwork by the importer may pay the most dividends. Most brokers are experienced at classification. However, they cannot know your goods as well as you do. They can’t walk out to the warehouse to look at them and they don’t have access to the people that use them or to the product literature. Studies by customs authorities around the world have generally found that a quarter to a third of imported goods are misclassified. These errors, generally caused by poor communication within an organization, or between the importer and broker, often lead to costly assessments or overpayments of duties and taxes.

The basics of tariff classification, described in this article on the Harmonized System, are not difficult to learn. However, it takes time and experience to get used to the nuances of the system. Not all goods are specifically listed in the Nomenclature, which looks like the Manhattan phone book. Some goods are classified in obscure places; many may be classified in more that one place. If you are willing to put in the effort, you may generate significant savings in duty, interest and penalties. Your broker will be more than happy to review your work and conclusions.

Organization of the customs management function

The person managing customs at a small or medium sized organization should be the primary, and preferably only, contact with the customs broker. That manager would co-ordinate input from others in the organization to ensure that the broker has the information to properly carry out his or her primary tasks; i.e., preparing complete and accurate customs entry documents and having the goods promptly released at the border. The customs manager should report to a senior executive, likely the Vice-President Finance or Controller, who takes an interest in ensuring that customs and trade issues are properly addressed in the organization.

GST Recovery for Non-Resident Importers

Most commercial goods that enter Canada are subject to the federal goods and services tax (GST), the Canadian VAT. The current rate is 5% of the duty paid value. The major exceptions are for certain basic groceries, prescription drugs and biologicals, medical and assistive devices and products of agriculture and fishing. The full list of exceptions may be found in Schedule VI and Schedule VII to the Excise Tax Act.

For most business inputs such as raw materials, capital equipment and goods acquired for resale, this GST is recoverable as an input tax credit. The credit is claimed by a registrant on its regular periodic return, as a deduction against tax collected on sales made in Canada. However, importers involved in certain businesses (for example: financial services, rental of residential real estate, health care and education) may not be able to recover the tax, or may be able to recover only part of it.

Where a non-resident of Canada acts as importer of record, claiming an input tax credit often requires some thought and extra work.

GST Registration for Non-Residents

A non-resident is required to register for GST purposes if it is carrying on business in Canada or making sales from a permanent establishment in Canada. Most non-resident importers do not reach these thresholds.

A non-resident who regularly solicits orders for the supply of goods for export to, or delivery in, Canada may register voluntarily for GST purposes. That is the easiest and most direct means of claiming input tax credits. However, non-residents are often reluctant to register. They do not want to deal with the administration of collecting tax on sales made in Canada and filing returns in a foreign jurisdiction. They also wish to stay off the radar of the Canada Revenue Agency, which also administers income taxes.

Credit claimed by the customer – section 180

Fortunately, section 180 of the Excise Tax Act provides an alternative. Where a non-resident is not registered, an input tax credit for the tax it paid on importation may generally be claimed by its Canadian customer. The customer then reimburses the non-resident. The non-resident must provide to the customer evidence that the tax was paid. This is usually a copy of the customs accounting document.

Initially, a customer who is unfamiliar with section 180 may refuse to apply it. The customer does not believe that it could be entitled to claim an input tax credit for GST paid by someone else. Providing a copy of the section does not help because it applies to other situations that are not relevant here. Further, some of the language is obscure to anyone other than a tax practitioner.

Section 180 is easier to read when you take out the non-relevant portions, as follows:

For the purposes of determining an input tax credit of …. a particular person, where a non-resident person who is not registered under Subdivision D of Division V

(b) has paid tax under Division III in respect of the importation of the property …. and

(c) provides to the particular person evidence, satisfactory to the Minister, that the tax has been paid,

the particular person shall be deemed

(d) to have paid, at the time the non-resident person paid that tax, tax in respect of a supply of the property to the particular person equal to that tax.

The term “particular person” refers to the customer of the non-resident. Where the conditions in paragraphs (a), (b) and (c) are satisfied, paragraph (d) “deems” that that the tax paid by the non-resident is paid by the customer. This deeming allows the customer to claim an input tax credit on its GST return.

If you have any questions on the issues discussed in this article, please give me a call at 403-805-7945 or email me at plmprofcorp@shaw.ca.

Russia Sanctions at NATO’s Weakest Point

Prior to Covid, the Baltic Sea was a popular cruise destination for travelers from North America and Western Europe. Saint Petersburg, with its Hermitage Museum and window into the mysteries of Russia, was the highlight for many.

Few people who live outside that region are aware that Saint Petersburg is not Russia’s only port on the Baltic Sea. There is also Baltiysk, situated further south in the small, isolated Kaliningrad oblast (province) surrounded by Lithuania and Poland. Kaliningrad is important to Russia militarily, partly because Baltiysk is the home of its Baltic warship fleet. Cruise ships do not call there. Baltiysk remains free of ice all winter; Saint Petersburg, 600 km. further north, does not.

It is impossible to travel overland between Kaliningrad and the rest of Russia without passing through either Lithuania or Poland and Belarus. Lithuania and Poland are members of NATO and the European Union. Belarus is heavily influenced by Russia and an ally in its war against Ukraine. Lithuania became an independent democracy following the dissolution of the Soviet Union in 1991. At that time, it agreed to allow goods and persons to transit through its territory between Kaliningrad and Belarus via an agreement known as the “Kaliningrad transfer”.

That narrow stretch of Lithuanian territory, just north of its border with Poland, is NATO’s weakest point. Should Russia decide to extend hostilities to other neighboring states, it would form a tempting target. Success would mean that the Baltic states of Estonia, Latvia and Lithuania, former members of the Soviet Union situated between Saint Petersburg and Kaliningrad, would be isolated from the rest of NATO and the EU. The other members of NATO, including Canada and the United States, would be obligated by treaty to defend them.

Shortly before Lithuania joined in 2004, the European Union established rules for the free transit of persons and goods through EU territory between separate parts of non-EU nations. The Kaliningrad transfer has been one of the main uses of these rules, though it has rarely been used for goods since 2004. The tension with Russia that surrounded the establishment of these rules are summarized in this excellent 2020 article from the Lithuanian media.

As part of sanctions against Russia announced on April 8, 2022, the European Union prohibited the road transport of Russian goods within EU territory, including in-transit movements between separate parts of Russia. However, an exception was made for the Kaliningrad transfer (except for goods specifically sanctioned, such as those intended for military, aviation or space use). The fact that the European Union was unwilling to risk provoking Russia by canceling the Kaliningrad transfer along with its otherwise severe sanctions shows how politically sensitive that narrow land corridor has become. As Russia has built up its military presence in Belarus, military experts in North America and Western Europe have called for NATO to bolster its defenses there.

Recently, private donations from Europeans, mainly those in former Soviet or Soviet influenced republics, have been used to purchase military supplies collected in a warehouse in Lithuania and shipped through that corridor to another warehouse in eastern Poland. The supplies are then transported to defense forces in Ukraine.

I would like to acknowledge the significant contribution that my friend and colleague Enrika Naujoke made to researching this article. Enrika is a director of a customs brokerage firm in Klaipeda, Lithuania and co-founder of the Customs Clear e-learning platform and customs journal.

The Hidden Implications of FTA Origin Audits

Importers who claim preferential tariff treatment under a free trade agreement (“FTA”) are generally familiar with the certificate of origin provided by the exporter or producer of the goods. In most FTAs, importers are required to have this certificate in their possession at the time the preferential treatment is claimed.

Many importers assume that the certificate of origin is the end of the story or that it shields them from liability should the goods subsequently be found not to originate. Unfortunately, this is not the case.

It is the importer who must pay the duties owing plus interest, and perhaps also penalties, should the certificate be invalid. This can come as an expensive surprise. For example, assume a Canadian importer purchases $10 million of goods from a German supplier over four years. They have certificates from the producer which state the goods originate under CETA and are thus duty free. A verification audit determines that the goods did not qualify under the CETA Rules of Origin, and are subject to the MFN rate of 6.5%. The assessment of duties would be $650,000. With penalties and interest, the total bill could be over a million dollars.

Where preferential tariff treatment under an FTA is critical to an importer, they might consider negotiating a provision in the sales contract whereby the exporter guarantees that the goods originate and agrees to pay the duties, interest and penalties assessed if they do not. At a minimum, the importer should take reasonable steps to ensure that the producer has done the work necessary to conclude that the goods originate. They should also review the certificate for “red flags”. For example, a producer who states that a complex piece of machinery is “wholly obtained or produced” in the countries that are party to the FTA likely doesn’t understand origin very well. That category would only apply of every part and all the raw materials in them came from those countries.

The customs authority in the importing country (“Importing Authority“) has the right to initiate the verification or audit of a claim for preferential tariff treatment. This generally begins with the Importing Authority requesting from the importer a copy of the certificate of origin and perhaps other information. If the Importing Authority requires further information, they will contact the exporter, producer and/or suppliers of raw materials to the producer. Under some FTAs, such as the USMCA and CPTPP, this is done directly. For example, the Canada Border Services Agency (“CBSA“) has the right to contact an exporter, producer or supplier in the United States or Mexico to initiate a verification audit under the USMCA. Under other FTAs, such as Canada’s agreements with the European Union (CETA) and the United Kingdom (CUKFTA), the Importing Authority contacts the customs authority in the exporting country, who in turn conducts the verification audit of the exporter, producer or supplier.

A verification audit usually begins with a questionnaire such as Form B231 that was sent by the CBSA to producers in the United States and Mexico where an origin claim under NAFTA was based on tariff shift. When it is published, the corresponding USMCA questionnaire should be virtually identical. A corresponding CETA, CUKFTA and CPTPP questionnaire would be similar. The key information requested is:

a description of the finished good, with product literature and tariff classification;
a description of the production process;
a list of the raw materials, segregated between originating and non-originating, and their suppliers, and
the tariff classification of non-originating raw materials.

A producer who has done the work necessary to substantiate origin should not have trouble completing the questionnaire. It would have kept documentation and analysis in generally the same format. If the customs authority is satisfied that the questionnaire has been properly completed and reached the correct conclusion, the verification audit would likely end there and there would be no adjustment to the duties paid.

An exporter, producer or supplier who receives a questionnaire is not obligated to respond. However, if they do not, the result will likely be an assessment against the importer.

If the exporter, producer or supplier does respond, but the customs authority is unable to conclude from it that the goods originate, it may request a visit of the producer’s production facilities. Again, the producer does not have to consent. However, if they do not the importer will likely be assessed.

Should the importer be assessed at any of these stages, including after a visit by the customs authority to the producer’s premises, they will have the right to appeal.

The CBSA has set out the details of origin verification procedures for NAFTA (predecessor to the USMCA) and other free trade agreements in its Memorandum D11-4-20, and for CETA and CUKFTA in Memorandum D11-4-21. The details for CPTPP have not been published in a Memorandum but are set out in Articles 3.27 and 3.28 to the Agreement.

Restrictions on trade with Russia and Belarus

Effective March 2, 2002, goods originating in Russia and Belarus are denied Most Favoured Nation (MFN) treatment on importation to Canada, leaving them subject to the 35% General Tariff rate. The only other country with this infamous distinction is North Korea.

It is important to note that the 35% tariff applies to goods that “originate” in Russia or Belarus – in general terms. where they are manufactured. Such goods retain their Russian or Belarusian origin status if they are exported to Canada from another country.

The meaning of the term originate is discussed in an article elsewhere on this website. The duty to take reasonable care that the country of origin is correctly declared on the customs documents rests with the importer. You cannot simply rely on a statement from the exporter.

On the same day, Canada prohibited the export and import of goods to or from the so-called Donetsk People’s Republic and Luhansk People’s Republic and the areas of eastern Ukraine that they control. A similar ban has been in place for the Crimea region for some time.

These trade restrictions form part of a series of sanctions applied by Canada both before and after Russia’s invasion of Ukraine on February 24, 2022. A full list of the sanctions can be found on Global Affairs Canada’s website, separately for Russia and Belarus.

Background

MFN is the key privilege of being part of the World Trade Organization. Each member agrees apply the same basic tariff schedule to all of the other 163. Canada was an original member of the predecessor General Agreement on Tariffs and Trade (GATT) in 1947. Russia joined the WTO in 2012 after 19 years of negotiations following the disintegration of the Soviet Union.

Canada is one of many countries that have revoked Russia’s MFN status under the WTO’s national security exceptions, which allow a country to take “any action which it considers necessary for the protection of its essential security interests.” The implications of this action on trade with Russia are different for every country.

The basics of origin in international trade

The concept of origin for goods in international trade can be confusing, for several reasons. First, a good generally originates in the country where it is manufactured, which may not be the country from which it is exported. Second, not all forms of manufacturing confer origin. Third, there are two types – non preferential origin and preferential origin.

Customs duties may vary considerably depending on origin. For example, a pair of soccer boots imported into Canada is subject to duty at 17.5% if it originates in Indonesia but is duty free if it originates in Bangladesh.

Non-preferential origin

Non-preferential origin assigns a home country, or economic nationality, to every good that crosses a border anywhere on Earth. If the good is wholly composed of components or materials derived from a single country, that is its country of non-preferential origin. For example, wheat grown in Canada is of Canadian non-preferential origin, as is multigrain flour milled in Canada using only grains and other ingredients grown in Canada.

It becomes more complicated where a good contains components or ingredients from more than one country. In that case, the country of non-preferential origin is the country where the last “substantial transformation” in production occurs. Each country interprets this principle in a slightly different way.

The United States Customs and Border Protection (CBP) agency states that “substantial transformation means that the good underwent a fundamental change (normally as a result of processing or manufacturing in the country claiming origin) in form, appearance, nature, or character, which adds to its value an amount or percentage that is significant in comparison to the value which the good (or its components or materials) had when exported from the country in which it was first made or grown.”

In its March 2022 publication Guidance on Non-Preferential Rules of Origin, the European Union states that substantial transformation occurs “where goods underwent their last, substantial, economically-justified processing or working, in an undertaking equipped for that purpose, resulting in the manufacture of a new product or representing an important stage of manufacture.”

For the majority of manufactured goods, it is usually clear that a substantial transformation has occurred. The issues occur on the margins where the manufacturing or processing operations are less substantive. Unfortunately, there is no “bright line” test to determine when the threshold has been crossed. In its Guidance publication, the European Union states that the following operations do not confer origin:

operations to ensure the preservation of products in good condition during transport and storage (ventilation, spreading out, drying, removal of damaged parts and similar operations) or operations facilitating shipment or transport;
simple operations consisting of removal of dust, sifting or screening, sorting, classifying, matching, washing, cutting up;
changes of packaging or breaking up and assembly of consignments, simple placing in bottles, cans, flasks, bags, cases, boxes, fixing on cards or boards and all other simple packaging operations;
the presentation of goods in sets or ensembles or presentation for sale;
the affixing of marks, labels or other distinguishing signs on products or their packaging;
simple assembly of parts of products to constitute a complete product;
disassembly or change of use; or
a combination of two or more of the operations specified above.

In October 2018 the Law Offices of George R. Tuttle, located in San Rafael, California, published an excellent article summarizing the United Sates jurisprudence on the subject of substantial transformation. The article will be useful to anyone struggling with which side of the line their product falls. The following excerpts provide a sense of its substance.

“In recent years Customs and the courts have concentrated on change in use or character of the components or materials when processed into finished goods, and sometimes finding other various subsidiary tests appropriate to consider, depending on the situation at hand. …. Courts have held that when the properties and uses of a product are predetermined by the material from which it was made, no substantial transformation occurs.

“Character” is defined as the “mark, sign [or] distinctive quality” of a thing. …. For courts to find a change in character, there often needs to be a substantial alteration in the characteristics of the article or components. …. Changes that are deemed cosmetic are insufficient for a finding of substantial transformation.

In analyzing whether there is a change in use, the court has found that such a change occurred when the end use of the imported product was no longer interchangeable with the end use of the product after post-importation processing. …. When the end use was predetermined at the time of importation, courts have generally not found a change in use.”

The Canada Border Services Agency does not provide a definition of substantial transformation. However, they do say in Memorandum D-1-4 that “Certain operations such as packaging, splitting, and sorting may not be considered as sufficient operations to confer origin.”

Preferential origin

Preferential origin refers to the Rules of Origin in a free trade agreement. Canada has many free trade agreements with individual nations. However, the most important agreements are multi-national: the USMCA with the United States and Mexico, the CPTPP with ten nations around the Pacific Rim and CETA with the 27 countries of the European Union.

Where a good is wholly composed of components or materials derived from a single country, that is generally its country of preferential as well as non-preferential origin. For example, wheat grown in Canada meets the Rules of Origin under the CPTPP when shipped to Japan. Flour milled entirely in Canada from wheat grown in Canada meets the Rules of Origin under CETA when shipped to Germany, and under the USMCA when shipped to the United States.

However, where components or materials originate in countries other than the parties to a free trade agreement, the rules of origin under that agreement are not based on the principle of substantial transformation. Rather, the rules are generally product specific, detailed and often several hundred pages long. These “Product-Specific Rules of Origin” (“PSROs“) follow the Harmonized System (HS) of tariff classification. There are generally three main criteria for qualifying under the PSROs:

Tariff shift – a comparison of the tariff classification of the raw materials as they existed before production to the tariff classification of the finished good.
Regional value content – in general terms, the ratio of the value of production within the free trade area (e.g., the United States, Canada and Mexico with the USMCA) to the selling price or cost of the finished good.
Transformation – a transformation, such as a chemical reaction, that occurs within the production process.

For example, let’s say soccer boots manufactured (and substantially transformed) in the United States are imported into Canada. Some of the raw materials and components originated outside Canada, the United States and Mexico. The boots will be of United States non-preferential origin.

Under the PSRO that includes soccer boots (heading 62.02), the boots will be of United States preferential origin under the USMCA if they meet both a tariff shift test and a regional value content test whereby at least 55% of the cost of the boots must be incurred in Canada, the United States or Mexico. If the boots satisfy both tests, they may be imported into Canada duty-free. If not, the duty rate will be 17.5%.

Common misconception

A common misconception is that goods originate in the country from which they are shipped to the country of import. That is not true. For example, a pair of soccer boots manufactured in Indonesia, shipped to a warehouse in the United States, and subsequently sold to a customer in Canada, remains of Indonesian non-preferential origin. Further, they do not qualify for preferential duty free treatment under the USMCA.

The basics of customs valuation

The term “customs valuation” has a mysterious ring to it, as if it were based on some esoteric, perhaps dark principles. In fact, it is usually fairly straightforward. The valuation of 90% of imports is based on “transaction value”, the price payable on the commercial invoice issued by the exporter.

The trick is to recognize (a) the 10% of situations where transaction value may not be used and (b) where statutory adjustments to the invoice price are required. The situations where transaction value may not be used include where:

There is no sale for export (e.g., the goods are leased or have been owned by the importer for some time);
The vendor and purchaser are related and the relationship influences the price;
There are restrictions on the disposition or use of the goods by the purchaser (other than those imposed by law or geographical area of resale) which substantially affect the value;
The sale or price is subject to some consideration or condition with respect to the goods for which a value cannot be determined; or
The price cannot be determined.

The rules applicable in these special situations are discussed in Memorandum D13-3-1 published by the CBSA.

Some of the adjustments to the price payable are deductions, while others are additions. Both are often missed. Each adjustment is set out in subsection 48(5) of the Customs Act and described in summary in the CBSA’s Memorandum D13-4-7. There are also separate D Memoranda, referred to below, which discuss each in detail.

The following items are deducted from the price payable if they are included in it; i.e., they are incurred by the seller:

Transportation charges, expenses and insurance from the place within the country of export from which the goods are shipped directly to Canada (D13-3-3);
Costs for construction, erection and assembly after importation into Canada (D13-3-11);
Duties and taxes payable by reason of the importation or sale in Canada of the goods; and
Export packing required by the transportation company (D13-3-3).

The following items are added to the price payable if they are not included in it; i.e., they are incurred separately by the purchaser:

Transportation charges, expenses and insurance to the place within the country of export from which the goods are shipped directly to Canada (D13-3-5);
Amounts for commissions and brokerage, other than fees payable by the purchaser to his agent for the service of representing the purchaser abroad in respect of the sale (D13-4-12);
Export packing to market and protect the goods, not required by the transportation company (D13-3-3).
Royalties and license fees in respect of the goods that the purchaser must pay as a condition of the sale of the goods for export to Canada (D13-4-9);
Subsequent proceeds payable to the purchaser (D13-4-13); and
Goods or services supplied by the purchaser for use in the production of the goods, commonly known as “assists” (D13-3-12).

The adjustments to the price payable are summarized in fields 23 to 25 of Form CI1, Canada Customs Invoice. If one or more of these adjustments applies, the importer will usually enter the amounts there.

Canada’s customs valuation rules follow the Customs Valuation Agreement adopted by all members of the World Trade Organization in 1994. The World Customs Organization publishes a useful Brief Guide to the Customs Valuation Agreement, which provides an alternative commentary to the CBSA Memoranda referred to above.

The opportunities of CARM

If you import goods into Canada, you will have heard of the CARM initiative of the Canada Border Services Agency (CBSA). Your broker will be peppering you with emails to encourage you to register at the online portal, post a security bond and begin paying your duties and taxes directly. Unless you wish to account and pay shipment-by-shipment, prior to release, you will be required do these things by early next year. You will no longer be able to use your broker’s security bond or have your broker make payment for you.

CARM is an acronym for CBSA’s Assessment and Revenue Management System. It is designed to give the CBSA a more direct relationship with importers and increase the effectiveness of their audit and enforcement activities. The most positive feature for importers is the opportunity to become more directly involved in the customs process. If you wish, by early 2023 you may file your customs accounting declarations yourself through the CARM portal. The existing Form B3-3 will be replaced by a new electronic form yet to be published. Hopefully, the coding system will be made more user friendly to the importer by drop-down menus and similar tools.

I encourage importers to draft their own declarations for review by their customs broker. This requires some knowledge, which is provided elsewhere on this website in articles on the basics of tariff classification, valuation and origin. Knowledge allows you to better provide to your broker the complete and accurate information that he or she needs to obtain prompt release and avoid unpleasant surprises if the CBSA comes calling later. Online resources available to help you draft your own declarations and customs invoices are described in this article.

If you haven’t registered for CARM, I suggest you do that soon so you can get comfortable the system before you need to use it. You will find all your import transactions and monthly statements of account there now. You may continue to delegate to your broker substantially all customs accounting functions except payment. However, you must take action on the portal do do this.

CARM does not affect the release process. Importers and brokers will continue to provide the customs invoice, cargo control and other release package documents as they have in the past.