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Credit Union Taxation
Income taxes were first levied on credit unions in Canada in 1972. Prior to that, credit unions were exempt from all income and capital taxes. In many countries today, they remain tax-exempt. For example in the United States, credit unions do not pay federal or state income taxes and, in many states, sales taxes. This reflects the non-profit nature of credit unions - “not for profit, but for service”.
The 1972 changes brought credit unions into the tax system but maintained differences between the way large banks and credit unions are taxed. These differences recognized us as the small businesses we are; our relationships with our customer/members; the restrictive characteristics of our capital; and the regulatory restrictions which prevent credit unions from operating in more than one province (thereby imposing costly operating structures). Over time, differences in taxation between credit unions and banks have been either eliminated completely or narrowed considerably. By the design of the rules, as credit unions grow in size and in strength, the tax gap between banks and credit unions narrows.
A significant difference between banks and credit unions is the income tax rate. Banks pay the regular corporate rate of tax. Credit unions pay the small business rate until they grow into the regular corporate rate. In general terms, the small business rate applies until a credit union’s tax-paid retained earnings reach five per cent of amounts owing to members, including deposits and shares. This is an incentive for credit unions to achieve minimal levels of permanent capital. It is particularly important for credit unions to have a core level of retained earnings because the other source of capital - shares invested by members - is less permanent, being redeemable at par on resignation or death of members.
Credit unions are growing rapidly out of the small business tax rate as their capital positions improve and as their product mix changes. Members’ preferences for mutual funds and other securities instead of traditional deposits is hastening this. Access to the small business rate is dependant on the relationship between retained earnings and deposits and shares. As fees increase, especially from the sale of mutual funds and other securities, yet deposit growth stagnates, the ratio of retained earnings to deposits increases and the regular corporate tax rate applies. Only the standard $300,000 of income remains subject to the low rate, although it too is reduced or eliminated where taxable capital exceeds $10 million.
This tax rate difference applies only to credit unions and not to their subsidiaries or affiliates. Separate corporate entities which are created to meet new demands of the marketplace for trust services, specialized lending, mutual fund management, securities sales, etc. all pay tax at regular corporate rates.
Turning to taxable income, all of the tax rules relating to calculation of income of a financial institution apply also to credit unions. Rules regarding valuation of securities, loan loss reserves, and calculation of interest apply equally across the board.
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The primary difference between calculating taxable income for a bank and credit union is that credit union dividends are deemed to be interest. They are deductible by credit unions and are received as interest by members. As a result, members are not entitled to dividend tax credits. (Shares listed on a stock exchange are excepted.) Therefore, a credit union’s income is ultimately taxed at the marginal rates of its members. This rule recognizes the similarity between amounts deposited by members and amounts invested by members in shares which are redeemable at par. Both are treated equally.
Another distinctive feature when calculating taxable income is the deduction of patronage allocation-type payments. These payments take the form of (i) bonus interest on deposits or (ii) rebates of loan interest, and are calculated just after the end of the year when the financial position of the credit union is determined. As it is common practice in our sector to adjust interest earned or paid after year-end, the tax rules acknowledge this and allow a current deduction. Bonus interest is, of course, taxable in the hands of members. Loan interest rebates are taxable to members if the related loan is a business loan and not taxable if it is a consumer loan. Other financial institutions may achieve similar tax results by offering rewards programs or package deals for customers and accruing the amounts at year-end.
Yet another difference is an elective technical provision which ensures that (i) taxable dividends or (ii) capital gains which are earned by national or provincial central credit unions (centrals are defined as credit unions) can be passed through to member centrals or credit unions without losing their tax-preferred status. This prevents a tax penalty when, for example, the proceeds from the tax-free portion of a capital gain (50%), which has been realized by a central, subsequently is distributed to another central or credit union.
Capital taxes levied by the federal government apply the same rules to credit unions and banks. Exemption thresholds, for example the $10 million capital exemption for Part I.3 tax (the federal government is completely eliminating this tax by 2008), eliminated the liability for many small credit unions. However, as the trend to consolidation of credit unions into larger units intensifies and as more credit unions raise share capital through preferred share offerings, the number of credit unions paying no Part I.3 tax steadily decreased.
Credit unions remain exempt from provincial capital taxes.
Several aspects of the tax system work to the detriment of credit unions and must be considered in any review of their tax burden. What may be seen as an advantage of one aspect may be offset by a disadvantage somewhere else.
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First, some important tax incentives are not useful to credit unions or their members because of the unique characteristics of our capital. Credit union shares are generally redeemable at par, without creating capital gains for our members. A successful credit union pays distributions to members which, as described above, are usually fully taxable. But an investor in a successful bank is rewarded by the tax system to the extent that 50% of the gain on investment in shares is tax-free. Similarly, the now defunct $100,000 capital gains exemption rewarded investors in a bank without any comparable benefit to investors in a credit union.
Second, credit unions pay proportionately more GST than their large competitors. Virtually all GST paid by a credit union or bank is a cost of doing business because it does not qualify for input tax credits. A large bank will inevitably supply services from in-house departments, without incurring GST costs, that a small credit union will have to source from outside suppliers GST-taxable. While this is somewhat mitigated by a GST exemption for supplies of services made within the credit union system, the added cost to the credit union system is substantial for services such as marketing, legal, accounting, human resources, training, data processing, etc. Of course, this is exacerbated in provinces that harmonize their sales taxes with the GST.
Third, because each credit union is a separate taxpayer, there is no effective means of utilizing losses within our system. A multi-branch bank operates its branches within a single corporation. Losses in unprofitable branches offset income in profitable branches and income tax is paid on a net amount. In a similar size credit union system, at any point in time there will be tax losses locked in unprofitable credit unions which cannot be shared with other credit unions. Effective tax rates on aggregate system income will be higher than otherwise expected.
Fourth, the complexity of dealing with tax issues is becoming extremely burdensome for small financial institutions. In its drive to achieve perfection and fairness in the tax system, the Department of Finance has produced very complex tax rules. While these may be comprehensible to a staff of tax professionals at a large bank, small financial institutions with limited in-house expertise face difficulties keeping abreast of change. In smaller communities, there is a scarcity of professional advisors who can assist. Examples of recent complex rules include those relating to valuation of securities, loan loss reserves, and yield-to-maturity calculations to report interest on T5s.