ELECTRICITY DEREGULATION IN ONTARIO

GST and Electricity Deregulation in Ontario

The long process leading to the deregulation of the Ontario electricity market, first announced in 1997, will finally reach its conclusion on May 1, 2002. Electricity deregulation is a complex process, and Ontario has moved at a cautious pace, anxious to avoid the pitfalls that have arisen in some other jurisdictions such as California.

Ontario electricity market participants will be fully aware that the term 'deregulation' is somewhat of a misnomer. There will certainly be an abundance of regulations for participants to comply with, as set out in the Market Rules. In the Canadian context, electricity market deregulation brings an additional dimension that participants will need to consider -- the GST.

The GST will have implications in three important areas. First, with deregulation, activities previously performed within Ontario Hydro and accounted for simply as internal bookkeeping entries will become market transactions between separate legal entities.

Consequently, these activities will for the first time be subject to GST. Second, the new market is expected to include a number of participants from the US, both buying and selling electricity, many of which will be dealing with the GST for the first time.

Finally, the new market will result in retailers selling electricity directly to consumers, typically invoicing through local distribution companies. This gives rise to certain GST issues for the parties involved.

The GST in the IMO-Administered Markets
The operation of a provincial electricity system involves more than the production of energy. Numerous functions must be coordinated to ensure that generators produce the quantity demanded by users, at the price they are willing to pay, and the electricity is delivered by the transmission and distribution systems to the location where it is needed. In addition, safeguards must be built into the system to ensure the reliability of the system, so that if there is an unanticipated increase in demand, or a sudden drop in output, additional energy sources can be brought quickly on line to avoid disruptions.

Under the previous system, all these functions were undertaken within Ontario Hydro. In the new competitive market, they will be performed by numerous independent participants, each charging for the goods and services they provide. The coordination of these functions is the responsibility of the Independent Electricity Market Operator (the 'IMO').

The IMO will administer physical markets in which electricity will be purchased and sold, and various so-called 'ancillary services', required to ensure the reliability of the system, will be procured. In addition the IMO will operate a financial market, which will allow participants trading energy in the physical markets to hedge their risks due to changing price levels.

The Physical Market for Electricity
The IMO will administer a real-time market for energy. During each 5- minute interval, the IMO may receive hundreds of bids and offers from buyers and sellers of energy, determine a market-clearing price, and allocate electricity purchase- and sale- quantities to market participants based on their bids and offers.

The nature of the product and the mode of operation of the market pose unique problems for the GST. Legally, the IMO does not take ownership of the electricity. Typically, under the GST, intermediaries simply pass on documentation pertaining to a transaction to the legal buyer or seller. However, in the Ontario electricity market, it is not possible to match a particular seller with a particular buyer. Faced with this peculiar situation, the Canada Customs and Revenue Agency ('CCRA') ruled that the IMO would be treated as a principal to the market transactions, buying and reselling the electricity. This pragmatic solution addressed what would otherwise have been a major administrative problem for the IMO, for participants, and perhaps for the CCRA.

One particularly noteworthy issue in the physical market for electricity concerns the treatment of Physical Bilateral Contracts ('PBCs'). PBCs are contracts for the purchase and sale of energy directly between two market participants for a negotiated price independent of the IMO market price. Although the transaction is entered into outside the IMO market, the IMO performs a role in settling the transaction. Specifically, the Market Rules provide that the seller in a PBC will notify the IMO of the PBC, specifying the quantity of energy traded, and the location and time interval of the trade. The IMO will then credit the purchaser, and debit the supplier, the market value of the energy sale at the location/interval specified in the PBC.

Based on the GST ruling from CCRA, the credit to the PBC purchaser and the debit to the PBC supplier issued by the IMO will not simply nullify any charges otherwise payable to and from the IMO for the physical energy withdrawal and injection by the PBC buyer and seller respectively. This would have required complex cross-referencing of PBC amounts with physical transactions across all meter locations in the province. In this regard, it should be recognized that the physical amounts withdrawn and injected may not match the PBC quantities, either with respect to the energy quantities traded or the location/interval specified. The GST treatment of PBC settlement amounts as independent from related physical transactions will generally not have a significant GST implication for participants located in Canada, as the PBC amount and the offsetting charge for the physical transaction will both be subject to the same 7per cent tax rate. However, where the purchaser is a non-resident, the GST impact will be asymmetrical -- the charge to the non-resident for a physical withdrawal will be zero rated, while the IMO's payment to the participant for the corresponding PBC supply will be taxable at 7 per cent.

Markets for Ancillary Services
The IMO also will buy a number of ancillary services from suppliers to ensure the reliability of the system. Some ancillary services, such as various types of operating reserves (guarantees of supply), will be traded in a real-time market similar to that for electricity. Others such as regulation, voltage control and reactive support, will be purchased in a procurement market. Supplies of ancillary services to the IMO are subject to GST at 7 per cent, regardless of the location of the supplier.

The IMO recovers its costs in purchasing these ancillary services by charging load participants 'uplifts' to their purchases of electricity. These uplifts are taxable in the same fashion as is the electricity itself -- 0 per cent for exported electricity, and 7 per cent otherwise.

Financial Markets
In addition to operating the physical real-time and procurement markets, the IMO will operate a financial market to allow participants to reduce their risks from changing energy prices. Specifically, the IMO will administer a Transmission Rights Market that will provide participants the ability to hedge against the possibility of price differences arising between Ontario and neighbouring jurisdictions in the United States. It is also planned that the IMO will operate a financial Energy Forward Market, in which participants will pay or receive settlement amounts based on the difference between the forward market day-ahead price for energy and the actual hourly energy price determined the following day. The settlement amounts paid to, or received from, participants in the Transmission Rights Market, as well as in the envisaged Energy Forward Market, will be GST-exempt as payments for financial services.

IMO Accounting/Documentation Issues
The IMO will be responsible for issuing all documentation to participants pertaining to their transactions in the IMO markets. The IMO will issue preliminary settlement statements on a daily basis, ten business days following the date of the transaction. Final settlement statements, incorporating any necessary adjustments to the transaction data in the preliminary statements, will follow a further twelve business days later.

The IMO will issue invoices to participants on a monthly basis. The invoice will cover transactions in a calendar month and will be issued ten working days after the end of the month (concurrent with the issuance of the preliminary statement for the last trading day of the month). Because of the timing of the invoice, it will be based partly on final statement data and partly on preliminary data (for dates during the latter part of the month for which the final settlement statement is not available as of the date of the invoice). The invoice issued in the following month will include any adjustments that are made after the issuance of the invoice. Participants in a net debit position must pay the IMO within two days of the invoice date. The IMO in turn will pay participants in a net credit position two days thereafter.

In the above process, the IMO will be issuing sales documentation covering both its sales and its purchase transactions. Accordingly, the statements and the invoice will include two charge codes for GST -- Charge Type 900 for GST payable to the participant (e.g., for sales to the IMO), and Charge Type 950 for GST collectible from the participant (e.g., for sales to the participant). To the extent that suppliers typically track and issue their own invoices for their sales, the issuance of the invoice by the IMO may represent a significant procedural change. In effect, the role for suppliers will become that of receiving and reconciling the IMO invoice against their own production data. The fact that each invoice will be a mix of final and preliminary statement data may create some additional complexity in this process.

Issues for Non-Resident Participants
The new market is anticipated to attract a number of non-resident participants intending to make supplies into, or withdraw energy from, the Ontario market. Non-resident participants in the market will have to prepare carefully for GST. Under the Market Rules all non-resident participants in the market will be obliged to register for the GST. This applies to all participants, both generators selling electricity into the market and load participants purchasing energy from the market.

This is a significant change from the current situation where for example, such non-resident suppliers and purchasers typically would not be required to be registered and charge GST. It should be noted that GST registration generally will not have any direct implications for corporate income tax purposes. However, GST registration may affect the tax status of otherwise non-taxable supplies by the non-resident, such as sales of certain types of intangible personal property to other non-residents. Hence, care must be taken to avoid potential pitfalls.

Implications For Non-Resident Suppliers
Non-resident suppliers of electricity will face two sets of issues regarding the GST. First, they will be required to report to Customs and remit GST on their imports of electricity. In this regard, there will be a simplified monthly reporting and payment system for electricity importers. Importers will have two options to choose from -- filing their report and paying Customs on the 25th of the month for all imports in the preceding calendar month, or filing the report on the 24th of the month, with payment on the last day of the month. (Hence, by filing the report one day earlier, the importer can delay its payment by approximately one week.) In each case, the import data filed with Customs will be based on the same mix of preliminary and final statement data used by the IMO in the monthly invoice. As a result, where a non-resident only sells electricity into the Ontario market, they should be able to use the information on the IMO invoice in completing their report to Customs.

Non-resident suppliers that do not use customs brokers to handle their reporting and payments will generally be required to post security with Customs based on their average monthly imports into Canada.

Second, as a GST registrant, each non-resident supplier will be required to charge GST on their sales into the IMO grid, and file regular GST returns on which it will remit the GST collected less input tax credits claimable.

Consequently, to the extent that the amount of GST paid by a non-resident supplier to Customs will offset the GST it must collect on its sales, the net tax remitted with the return will typically be a relatively small amount. Non-residents that do not have a permanent establishment in Canada will be required to post security with the CCRA, based on their estimated net tax payable over the year.

The cost of compliance and the requirement for non-resident suppliers to post security will be offset somewhat by certain cash-flow benefits arising from the operation of the GST. Each month, the IMO will pay suppliers the GST on the invoice well before it must be paid to Customs. Consequently, while the GST brings some compliance pain, it may also bring some offsetting cash flow gain to non-resident suppliers.

Non-resident load participants
GST compliance should be relatively straightforward for non-resident load participants. Purchases for export will be zero-rated. Where a non-resident purchaser makes only zero-rated purchases, and does not make any taxable supplies, it would be able to file nil returns. Participants with taxable sales in Canada less than $6 million annually can file on a quarterly basis.

GST Implications of Deregulation at the Retail Level
In addition to the GST issues arising in the operation of the IMO-administered markets, deregulation will also give rise to significant GST issues at the retail level. Under the deregulated system, consumers will have the option of purchasing electricity from retailers other than their local electricity distribution company. However, a combined bill covering both the distributor's charge and the retailer's charge for the electricity will be issued to the customer, typically by the local distribution company.

The issuance of such a combined invoice by the distribution company gives rise to some GST complications and additional liabilities on the parties. Distribution companies and retailers can choose between two methods of remitting the tax on the retailer's sales, but both approaches have certain drawbacks.

Under the GST, where the distribution company issues a combined invoice to the customer, it has a legal obligation to remit not only the tax billed in respect of its own distribution charge, but also the actual amount of tax collected on behalf of the retailer on the electricity sale.

Based on CCRA's administrative policy, the distribution company's requirement to remit the tax collected on behalf of the retailer ceases when it turns over the proceeds of the sale and the associated GST to the retailer for it to remit. However, if for any reason the retailer does not remit its tax payable, CCRA can assess the distribution company for failure to remit the tax it collected on the retailer's behalf.

The distribution company can limit its potential liability if it arranges with the retailer to remit the tax payable on the total amount of the combined bill. In this case, however, it is the retailer that may be exposed if the distribution company fails to remit the tax on the retailer's portion. Further, under the current GST rules, under this remittance mechanism, there would be no GST bad debt relief available, either to the distribution company or the retailer, in the event that a customer defaulted on the amount payable for the electricity. (At the time of writing, this apparent unintended pitfall is being reviewed by the Department of Finance.)

Similar problems would arise where a combined invoice is issued by the retailer on behalf of the distribution company.

Conclusion
The Ontario electricity market will certainly be the focus of much attention come May 1, 2002, when the long-awaited deregulation becomes effective. Included among the many preparations for the deregulation initiative has been a considerable effort by the IMO and by the CCRA to develop a workable set of rules for handling the GST. Nevertheless, the GST will pose an additional set of issues for participants, particularly non-resident participants, to consider. While the GST will not be the prime focus of attention of industry observers on implementation day, it will certainly be an issue that participants will need to prepare for carefully to ensure a smooth transition to the new market.

In large measure, the requirement to register stems from the changing role of the non-resident supplier. In the regulated system, a non-resident supplier would be selling to a specific purchaser (e.g., Ontario Hydro), which would act as importer of record and handle the payment of GST to Customs on the importation.

In contrast, in the new market, a non-resident supplier will be participating in the Ontario market making sales to unidentified purchasers. (Note that legally, the IMO is not the legal purchaser of the electricity.) Hence, it is the non-resident supplier that must account for GST to Customs and therefore, must be registered to recover the tax paid. With regard to non-resident purchasers, for certain transactions (e.g., PBCs), a load will be treated as making supplies into the market, thereby necessitating their registration.

Brian Wurts is Senior Manager with PricewaterhouseCoopers LLP in Toronto. ET