GST on judgments and out of court settlements – is GSTR 2001/4 still relevant?

(Published in the Australian GST Journal, (2013) 13 AGSTJ 16)

Extract

I have received numerous queries from practitioners regarding the GST implications of court orders and settlement agreements. Often there is no easy answer, but in each case I refer to the Commissioner’s public ruling GSTR 2001/4. Twelve years have passed since the ruling was published and it is time to assess the continued relevance of the principles outlined in the ruling. A review of the cases shows that the principles stand up pretty well in the context of court judgments. However, in light of the recent decision of the High Court in Commissioner of Taxation v Qantas Airways Ltd [2012] HCA; (2012) 291 ALR 653, the goal posts may have shifted significantly in the context of out of court settlements.

Introduction

In 2001 the Commissioner released GST Ruling GSTR 2001/4 “Goods and services tax: GST consequences of court orders and out-of-court settlements” (the Ruling) which outlined the Commissioner’s views on the treatment of court orders and out of court settlements under the A New Tax System (Goods and Services Tax) Act 1999 (the GST Act).[1]  Given that there were only a handful of authorities at the time dealing with GST, the Ruling was comparatively short and was based around some fundamental principles, including the following:

• The need to find a relevant nexus between the payment and a supply[2] made pursuant to a court judgment or a settlement agreement for there to be a taxable supply.[3]
• Damages are not a supply.
• The mere existence of releases by the party receiving the payment (referred to as “discontinuance supplies”) to give effect to a settlement of a claim for damages will generally not give rise to a taxable supply.

Twelve years have passed since the Ruling was released. During that time there has been a number of decisions of the Courts (both State and Federal) dealing with the impact of GST on judgments, damages and costs. Further, in recent years the High Court has on two occasions considered the GST treatment of contracts. In light of these cases, it is appropriate to assess the continued relevance of the Ruling to both court judgments and the entry of parties into contractual arrangements to resolve disputes.

This paper provides a summary of the Ruling and outlines its essential principles.  These principles are then considered in the context of court judgments and out of court settlements, having regard to the authorities.  On the whole, I consider that the principles in the Ruling have stood up pretty well in the context of court judgments, including damages, judgments and legal costs.

In contrast, in light of the recent observations of the High Court in Commissioner of Taxation v Qantas Airways Ltd [2012] HCA; (2012) 291 ALR 653, some of the principles dealing with out of court settlements may now be doubted, in particular the principle that the existence of a “discontinuance supply” will generally have no GST consequences. Further guidance on this difficult issue may be provided by the Federal Court in the forthcoming appeal in A.P. Group Limited and Commissioner of Taxation [2012] AATA 617[4] dealing with the question of whether incentive payments made by motor vehicle manufacturers to dealers were consideration for a supply by the dealers.

THE RULING

The focus of the Ruling is on judgments of a court or a settlement agreement between the parties – both of which resolve the dispute between the parties. Out of court settlements include any form of dispute resolution where the terms are agreed between the parties.

The Ruling analyses the concept of “supply” and the “nexus” that must exist between the payment and a supply in order to establish the relationship of a “supply for consideration” within s 9-5(a).[5]

Out of court settlements and supplies

Noting that the statutory definition of “supply” is very broad, the Ruling states that in the context of an out of court settlement, a supply referred to under any of the paragraphs within subsection 9-10(2) could be related to an out of court settlement.[6] The Ruling groups these supplies into three categories, being “earlier supply”, “current supply” and “discontinuance supply”.

Earlier supply

An “earlier supply” will exist where the subject of the dispute is an earlier transaction in which a supply was made involving the parties. The Ruling refers to the following example of an “earlier supply”:[7]

Widget Company supplies to a retailer.  A dispute between the parties over payment for the toys is subsequently resolved through an out-of-court settlement, with the retailer paying all monies owed.  The supply of the toys, being the subject of the dispute, is an earlier supply because it occurred before the dispute arose.

Current supply

A “current supply” is one that it is created by the terms of settlement. The Ruling refers to the following example of a “current supply”:[8]

A dispute arises over a claim by Beaut Enterprises Pty Ltd that Plagiariser Pty Ltd is using their trade name.  Negotiations between the parties follow, resulting in Beaut entering into an agreement with Plagiariser that allows Plagiariser to use its trade name in the future.  The supply of the right to use the trade name is a ‘current’ supply.

Discontinuance supply

The Ruling observes that terms of settlement will generally provide for the plaintiff to release the defendant from some or all of the existing claims provided the terms of settlement are complied with.  Where a dispute involves court proceedings, the terms of settlement may provide for each party to release the other from such claims and obligations. Also, where proceedings have been commenced, a notice of discontinuance may need to be filed with the Court.

The Ruling considers that the types of supplies which may be created under these conditions of settlement may be characterised as:[9]

• Surrendering a right to pursue further legal action [paragraph 9-10(2)(e)];
• Entering into an obligation to refrain from further legal action [paragraph 9-10(2)(g)];
• Releasing another party from further obligations in relation to the dispute [paragraph 9-10(2)(g)].

These supplies are referred to in the Ruling as “discontinuance supplies”.

Damages

The Ruling takes the view that a number of disputes relate to matters which do not constitute a supply, being claims for damages arising out of the following:

• property damage;
• negligence causing loss of profits;
• wrongful use of trade names;
• breach of copyright;
• termination or breach of contract;
• personal injury.

The basis for this view is found at [73], which provides as follows:

The most common form of remedy is a claim for damages arising out of the termination or breach of a contract or for some wrong or injury suffered. This damage, loss or injury, being the substance of the dispute, cannot in itself be characterised as a supply made by the aggrieved party.  This is because the damage, loss, or injury, in itself does not constitute a supply under section 9-10 of the GST Act.

Court orders and supplies

The focus of the Ruling is on the GST treatment of payments made in compliance with orders of a Court.

The Commissioner does not consider that a court, in giving judgment, makes a supply for GST purposes. Further, the extinguishment of a judgment debt by its payment does not constitute a supply by the judgment creditor. The Commissioner referred to with approval the decisions Interchase Corporation Ltd v ACN 010 087 573 Pty Ltd and Ors [2000] QSC 013 per White J; Shaw v Director of Housing and State of Tasmania (No 2) [2001] TASSC 2; (2001) 10 Tas R 1 per Underwood J and Walter Construction Group Limited v Walker Corporation Ltd & Ors [2001] NSWSC 283; (2001) 47 ATR 48 per Hunter J.[10]

Having regards to the types of supply outlined above in the context of out of court settlements, the Commissioner considers that:[11]

• an earlier supply may be the subject of dispute resolved by a Court;
• a current supply may arise as a result of a court order; and
• there will be no discontinuance supply in relation to a dispute resolved by a court order.  This is because the terms of the resolution of the dispute are imposed by the Court, and not reached by agreement between the parties.

Costs

The Commissioner considers that the payment of costs as part of a terms of settlement is not consideration for an earlier supply or a current supply.

However, any costs amount should take into account any entitlement to an input tax credit that the other side may have.  Of course, this will only be relevant where the party concerned is registered for GST or required to be registered.

Consideration and the search for a “nexus”

The Ruling states that it is not sufficient that there be a supply and a payment.  In this context, the Ruling considers that the effect of subsection 9-15(2A)[12] is that the fact that a payment is made in compliance with a court order, or with a settlement relating to proceedings before a Court will not, without more, prevent it from being consideration for a supply.[13]

The Ruling considers that GST is not payable unless there is a supply “for” consideration, ie, there must be a sufficient nexus between the supply and the payment.  The Commissioner takes a broad approach to the nexus test as shown at [90] which states as follows:

The Commissioner considers that, in the context of the GST Act, the expression ‘you make the supply for consideration’ in paragraph 9-5(a) means the same as ‘there is consideration for the supply you make’.

In the context of out of court settlement and court orders, the Ruling looks at whether there is a nexus between the payment and one or more of the categories of “supplies” referred to above.

Earlier supply

Where the only supply (other than a discontinuance supply) in relation to terms of settlement or a court order is an earlier supply, and there is a sufficient nexus between the payment made and that supply, the payment will be consideration for the supply.

Current supply

Where the only supply (other than a discontinuance supply) in relation to terms of settlement is a current supply, and there is a sufficient nexus between the compensation paid under the settlement and that supply, the compensation will be regarded as consideration for the supply.

Discontinuance supply

The Ruling observes that in most cases, the “discontinuance supply” will have no separately ascribed value and will merely be an inherent part of the legal machinery to add finality to the dispute –these supplies are in the nature of a term or condition of the settlement, rather than the subject of the settlement.  In this context, every settlement agreement will usually contain at least one “discontinuance supply”.

The Ruling considers that most cases where the only supply is a “discontinuance supply” will involve the settlement of a claim for damages – in that case the compensation would be received in respect of that claim (which is not a supply).

The Ruling does leave some room to tax compensation received solely for a ‘discontinuance supply’, but only if “there is overwhelming evidence that the claim which is the subject of the dispute is so lacking in substance that the payment could only have been made for the discontinuance supply”.[14]

Court judgments – A REVIEW OF THE CASES

There have been a number of decisions of State and Federal Courts dealing with the GST impact on judgments, damages and costs orders. A number of these decisions are considered below. The principles outlined in the Ruling generally appear to have stood up well.

Vrkic v Otta International [2003] NSWSC 641 (costs)

Costs were awarded against the second defendant who submitted that the costs order should exclude GST charged by the barrister to the first defendant because the defendant would be entitled to an input tax credit.  The Court did not accept the submission, essentially on the basis that there was no evidence that the first defendant would be entitled to an input tax credit.  In coming to this view, Campbell J made the following observations (at [25]):

An order for costs is intended to provide an indemnity, or partial indemnity.  There is no evidence as to whether the first defendant is a company which would be entitled to receive any benefit from any input tax credit.  Without such evidence, there is no reason to cut down what would ordinarily be the full measure of the indemnity.

Bennett v Goodwin [2005] NSWSC 930; 62 ATR 515 (damages on conversion of goods)

This case involved a claim for damages for conversion. The plaintiff sold the defendant’s goods which were located on the plaintiff’s property and offset the proceeds against a debt owed by the defendant to the plaintiff. The defendant claimed that the plaintiff sold the goods at less than market value and was entitled to a greater credit against the debt.

One of the goods was sold by the plaintiff for $10,000, of which $9,091 was retained after the plaintiff paid GST.  The Court awarded damages of $10,000 (being the market value of the goods) notwithstanding that the plaintiff only received $9,091. This was because function of damages for conversion is compensatory and it is the price to the purchaser which is the appropriate measure of damages. The Court also referred to the view in England that purchase tax payable in connection with the sale of an item ought properly be included in the market value of an item when assessing damages for the conversion of that item: Martin v London County Council [1947] KB 628.

The Court did not deal with the relevance (if any) of the purchaser being entitled to claim input tax credits with respect to the GST on the purchase price.

Keen v Telstra Corporation Limited [2006] FCA 834; 153 FCR 28 (costs)

The applicant submitted that Order 62 Rule 12(1) of the Federal Court Rules should be construed so as to permit the taxing officer to add, as a disbursement, the GST which the plaintiff had to pay to her solicitors. The applicant effectively asked that the scale of costs be “grossed up” for GST.

The Federal Court noted that there was no provision in the Federal Court Rules which allowed GST to be added to the costs allowed under the rule and the provisions. The Court compared this to the position in Tasmania where the rules permit the Supreme Court to allow in a bill of costs an amount referable to GST. This rule was considered in Thornton v Apollo Nominees Pty Limited (2005) 59 ATR 244 by Evans J.

The Court found that the provisions of the rules were quite clear. In their natural meaning, the rules provided that the only amounts allowable were those fees set out in the schedule. Further, the fees set out in the rules necessarily represented the “price”, for the purpose of both the rules and the GST Act, and therefore included GST as part of the price. In this context, the Court referred to the Explanatory Statement to the rules[15] which noted that the costs were increased by 9.5% ‘on account of the goods and services tax’.

The Court did note the possible injustice of making the costs GST-inclusive, given that a person (as in the present applicant) who was not entitled to input tax credits would be worse off than a business when recovering costs of litigation.

Hennessey Glass and Aluminum Pty Ltd v Watpac Australia Pty Ltd [2007] QDC 57; (2007) 69 ATR 374 (costs)

This proceeding involved review of an assessment of costs made by a Senior Deputy Registrar. The plaintiff contended that the registrar erred in reducing the assessment by 1/11^th on the basis that this represented the GST component of costs and the order needed to reflect the fact that the plaintiff was entitled to an input tax credit for the GST paid by it’s professional costs and outgoings.

The Queensland District Court had issues with the approach of the registrar to make a “sweeping application” of a 1/11th reduction to the assessment.  This included the fact that some of the fees were not subject to GST (e.g. filing fees) and that the professional costs were allowed and claimed in accordance with the relevant Scale of Costs.  The Court came to the conclusion that the operation of the GST system and the input tax credit system is not a basis for reducing the scale amounts for professional costs.

Nevertheless, referring to the indemnity principle, the Court found that it was reasonable to refer to particular outlays, being the approach of Master Wood in Merringtons Pty Ltd v Luxottica Retail Australia Pty Ltd (Unreported, Supreme Court of Victoria, 16 June 2000). Under that approach, where GST has been passed on and claimed as an input tax credit, the amount recovered under an assessment on a standard basis should be the amount of the outlays net of GST. The Court concluded that the registrar ought to have reduced the assessment by 1/11^th for outlays (being payments other than solicitors’ professional fees) in which GST had been paid – being all the outlays save for filing fees.

ChongHerr Investments Ltd v Titan Sandstone Pty Ltd [2007] QCA 278 (costs)

As part of submissions by the parties as to costs, the respondent claimed that the appellant’s costs should be reduced by an input tax credit applicable to the professional costs incurred by the appellant.

The Queensland Court of Appeal (at [9]) agreed with the views of the Queensland District Court in Hennessey Glass and found that the necessity to give credit for an input tax credit applied not to solicitors’ professional fees, but that it did apply to outlays which attracted GST.

Moraghan v Cospak Pty Ltd [2007] VSC 483 (GST on damages)

This case involved a claim for damages with respect to a contract for the purchase and delivery of wine. Cross-claims were filed by the appellant and the respondent. One of the issues was whether the judgment for damages attracted GST and whether the judgment ought to have been exclusive of GST.

The Victorian Supreme Court found that the damages award to the respondent should include GST and in doing so, appeared to accept the submissions of the claimant that GST should be included because the claim was for goods sold and delivered under a term obliging the purchaser to pay GST and the invoiced amounts that make up the respondent’s claim were inclusive of GST.  Lasry J observed that (at [51]) “…in a case such as this where a court is involved in determining the commercial relationship between the parties and GST is part of that commercial relationship, then GST was correctly included in the order…“.

The Court also found that the damages award to the appellant should exclude GST because the claim was in the nature of a damages claim rather than the supply of goods or services.

Adamson v Ede [2008] NSWSC 767 (damages)

This was an appeal against the order of a Magistrate to award the amounts of $13,408 and $4,752 to the plaintiff. The amounts included GST of $1,128 and $432 respectively. The amounts were awarded on a quantum meruit basis in respect of services provided by the plaintiff to the defendant.

The New South Wales Supreme Court found that the GST was properly included. The plaintiff was not an employee of the defendant and accordingly the services were subject to GST as a taxable supply.

Nemeth v Prynew Piling Pty Ltd [2009] NSWSC 511 (damages)

An issue in this case was whether GST should be included in the judgment given against the defendants.  The damages related to rectification costs incurred by the plaintiffs on their private residence and the plaintiffs submitted that they would not be entitled to claim input tax credits for the GST on those costs so the damages should include GST.  The New South Wales Supreme Court found that the judgment should include GST.

The Beach Retreat Pty Ltd v Mooloolaba Yacht Club Marina Ltd [2009] QSC 84; [2009] 2 Qd R 356 (costs)

This case involved an application by the defendant for fixed costs on an indemnity costs plus an amount for GST.  It was agreed between the parties that each of the applicants was entitled to input tax credits and that the assessed indemnity costs were less than the actual costs paid, even if 10% was added to the assessed figure.

The Court did not accept the “misconceived” submission of the defendant that the reasoning in ChongHerr Investments and Hennessey Glass required the Court to add an amount which equated to notional GST on the professional costs.  As each of the defendants were entitled to an input tax credit for the GST each of them paid, the Court found that it was appropriate to ignore GST on indemnity costs. In coming to this conclusion, the Court was fortified by the Practice Statement issued by the Commissioner.[16]

Gagner Pty Ltd trading as Indochine Cafe v Canturi Corporation Pty Ltd [2009] NSWCA 413; (2009) 236 FLR 401; (2009) 262 ALR 691 (damages)

This case involved a negligence claim by the respondent against the appellant for damage caused by water flowing into the respondent’s shop from the appellant’s shop.  The trial judge found that the escape of water was caused by the negligence of people for whom the appellant was vicariously liable. The appeal related to the measure of damages payable by the appellant to the respondent.

The New South Wales Court of Appeal (at [134] per Campbell JA (Macfarlane and Sackville AJA agreed)) accepted the appellant’s argument that while the respondent might have to pay GST on the goods and services it acquired to make good the damage to the premises, it would be able to recover those amounts by way of input tax credits.  Thus, the GST component would not ultimately be a loss and it was wrong to include that component in the award of damages.

Campbell JA (at [149]) referred to a number of authorities where awards of damages for a tort included GST on the individual items that made up the quantum (referring inter alia to Bennett v Goodwin, Nemeth v Pryunew Pty Ltd and Vrkic v Otta International discussed above).  However, the Court observed it was important that in each of those cases the recipient of the damages or the beneficiary of the costs order was not registered for GST and therefore not entitled to any input tax credit. In those circumstances there would be a net loss including the GST paid.

His Honour (at [151]) stated the following principle:

In summary, as the GST legislation currently stands, if the plaintiff in an action for tort is registered for GST purposes, and stands to receive an input tax credit for any GST payments incurred in making good its damage, and there is no impediment to the plaintiff receiving the full benefit of the input tax credit, that GST amount should be excluded from the quantum of damages recoverable.

The respondent, in the alternative, contended that the damages award itself would be subject to GST. The Court did not accept this argument. In coming to this finding, Campbell JA referred to the Ruling with approval (at [157]-[158]):

157 An essential prerequisite for there being an obligation to pay GST concerning (relevantly for present purposes) a supply of goods or services is that there is a “taxable supply”. Under section 9-5 GST Act, an essential prerequisite of there being a “taxable supply” is that “you make the supply for consideration”. The Australian Taxation Office has issued a public ruling, GSTR 2001/4 concerning the GST consequences of court orders and out-of-court settlements. It states, at para [60], that “a court, in giving judgment, does not make a supply for GST purposes.” Nor is there any relevant “taxable supply” involved in the events that led to litigation such as the present. At [71]-[73] the ruling considers situations, including “claims for damages arising out of property damage” and concludes:

“This damage, loss or injury, being the substance of the dispute, cannot in itself be characterised as a supply made by the aggrieved party. This is because the damage, loss or injury, in itself does not constitute a supply under section 9-10 of the GST Act.”

158 Nor would a judgment in the present case, of itself, generate a liability for GST. The ruling says, at [61]:

“The payment, in money, of a judgment debt will not of itself be a supply for GST purposes. It is excluded from being a supply under subsection 9-10(4).

Peet Limited v Richmond (No 2) [2009] VSC 585; 76 ATR 644 (damages)

In an earlier judgment, the Victorian Supreme Court determined that the plaintiff was entitled to recover certain amounts from the defendant by way of quantum meruit. The plaintiff sought an order grossing up the amount of the damages award by 10%, to allow for GST.  Alternatively, an order was sought whereby the defendant would indemnify the plaintiff for any GST it may be found liable to pay on the judgment sum. The basis of the plaintiff’s claim was that unless the judgment took into account its liability to pay GST, its award would be diminished and it would receive 1/11^th less than the Court intended.

The Court agreed with the plaintiff. Justice Hollingworth (at [77]) referred to the Ruling with approval and agreed with the plaintiff (at [78]) that:

“…because the very nature of a quantum meruit award is payment for services rendered at an earlier point in time, it is probable that orders made by this court will constitute consideration for an “earlier supply” and so are likely to give rise to a GST liability.”

Importantly, the Court noted that it was not being asked to determine, as between the plaintiff and the Commissioner, whether there was a GST liability.  The award was to fairly and reasonably reflect a liability which was expected to arise upon payment of the judgment sum.  Further, the Court acknowledged the difficulties in ordering that the defendant provide an indemnity for GST, unless the order was coupled with the obtaining of a private ruling from the Commissioner.

Taking a practical approach to the issue, the Court found that the fairest and most efficient way of dealing with GST was for the defendant to pay 1/10^th of the awarded sum to the plaintiff upon receipt of a tax invoice and the plaintiff would provide to the defendant documentary evidence of remitting GST within 30 days of doing so. Any amount not so remitted would be refunded to the defendant.

Reglon Pty Limited v Commissioner of Taxation [2011] FCA 805

This was the first case dealing with damages where the Commissioner was a party.  The Commissioner did file an appeal to the Full Federal Court, but the appeal was discontinued.

The Commissioner issued a GST assessment in respect of a judgment obtained by the taxpayer in the Supreme Court of New South Wales against the defendant for conversion of the taxpayer’s scaffolding.  The judgment was for $1,478,125 which was arrived at by reference to expert opinion as to the auction value of the scaffolding.

The Commissioner contended that the taxpayer had made a taxable supply of the scaffolding for the consideration of $1,478,125. It would appear likely that the Commissioner contended that the taxpayer made a “current supply” by virtue of the court order, being the transfer of the scaffolding.

The Court approached the issue of whether the judgment gave rise to a supply by looking at the nature of a claim in conversion.  In finding that there was no supply, the Court said as follows (at [26]):

The effect of the payment in full by Citadel of the judgment in conversion against it was to vest in Citadel the ownership of the Taxpayer’s scaffolding.  However, the mere obtaining of judgment in conversion against a defendant does not of itself affect the ownership of the converted goods.  Nor does the formal entry of judgment.  It is the satisfaction of the judgment that effects a transfer to the defendant of property in the goods that were the subject of the conversion.

And further (at [32]):

The payment made in satisfaction of that judgment resulted in ownership and was triggered by the payment of the judgment sum by Citadel.  That payment did not depend upon any action of the Taxpayer.  I do not consider that, in those circumstances, the Taxpayer may be said to have made a supply.  There was no taxable supply by the Taxpayer.[17]

Conclusions re court judgments

When regard is had to the cases outlined in this paper, the fundamental principles outlined in GSTR 2001/4 appear sound.  In a number of the cases the Courts referred to various parts of the Ruling with approval.

Having regard to the cases discussed above, the following principles can be distilled:

• In determining an award of damages, that award should be inclusive of GST where the claim relates to a commercial relationship in which GST was a part, for example a quantum meruit claim: Moraghan v Cospak Pty Ltd; Adamson v Ede; Peet Limited v Richmond (No 2).
• In determining an award of damages calculated by reference to costs incurred by the plaintiff (or to be incurred), the award should be inclusive of GST where the plaintiff is not entitled to claim input tax credits and exclusive of GST where input tax credits can be claimed: Nemeth v Prynew Piling Pty Ltd; Gagner Pty Ltd trading is Indochine Café v Canturi Corporation Pty Ltd.
• An award of damages will not be subject to GST: Gagner Pty Ltd trading as Indochine Café v Canturi Corporation Pty Ltd.
• The vesting of property in a successful plaintiff in a claim for conversion does not involve a supply of the property by the defendant: Reglon Pty Limited v Commissioner of Taxation [2011] FCA 805.
• An order for costs should not be adjusted to take into account the entitlement to input tax credits for solicitors’ professional fees, but an adjustment is appropriate for outlays which attract GST: ChongHerr Investments Ltd v Titan Sandstone; Hennessey Glass and Aluminium Pty Ltd v Watpac Australia Pty Ltd.[18]

A common theme from the cases is that when considering the interaction between GST and damages (and also costs), the “indemnity principle” generally demands that a plaintiff should not be disadvantaged by reason of having to pay GST, but also not be able to profit from an entitlement to input tax credits.

Out of court settlements

My research has not uncovered any authorities dealing directly with the question of the GST treatment of an out of court settlement. Nevertheless, given that an out of court settlement is simply a contractual agreement between parties, regard can be had to the approach of the Courts to the GST treatment of contracts.

In this context, the two most important decisions are those of the High Court in Commissioner of Taxation v Reliance Carpet Co Pty Ltd [2008] HCA 22; (2008) 236 CLR 342 and more recently in Commissioner of Taxation v Qantas Airways Ltd [2012] HCA; (2012) 291 ALR 653.

• In Reliance Carpet the question was whether the vendor under a contract of sale for real estate made a taxable supply in circumstances where the purchaser defaulted under the contract and the deposit was forfeited to the vendor.
• In Qantas the question was whether the airline made a taxable supply in circumstances where the customer had made a booking for a flight and paid the fare, but the customer did not take the flight because he or she did not present at the airport and the fare was retained by the airline.

Regard also needs to be had to the recent decision of the Tribunal in A.P. Group Limited and Commissioner of Taxation [2012] AATA 617 (noting the pending appeal to the Full Federal Court) where the Tribunal considered the question of whether GST was payable in respect of certain incentive payments made by motor vehicle manufacturers to dealers. The issue is whether those incentives were consideration for a supply made by the dealers.

The statutory test for taxable supply

The definition of “supply” in s 9-10 is very broad and the decisions in Reliance Carpet and Qantas make it clear that the definition includes the entry into obligations upon contract. The definition of “consideration” in s 9-15 is also very broad, including “any payment, or any act or forbearance, in connection with the supply of anything” (emphasis added). However, as recognised in the Ruling, it is not sufficient to simply identify a supply and consideration, there must be a “nexus” between the two. That nexus is found in the words “in connection with”.

The need for a connection or relationship between supply and consideration was recognised by the majority of the High Court in Qantas (at [14]):

The appeal turns upon the construction and application of [the GST Act]. In particular, in the phrase “the supply for consideration” (emphasis added), which appears in the definition of “taxable supplies” in s 9-5(a) and is set out below, the word “for” is not used to adopt contractual principles. Rather, it requires a connection or relationship between the supply and consideration.

The broad scope of the “nexus” was outlined recently by the Tribunal in AP Group where the Deputy Presidents stated as follows (at [102-103]:

102. The question is simply whether the payment is “in connection with” the supply of the vehicle to the customer. In American Express International Inc v Commissioner of Taxation [2009] FCA 683; (2009) 73 ATR 173, Emmett J said at [55]:

The phrase in connection with signifies, in its broadest sense, any relationship between two subject matters, no matter how remote. The phrase is capable of describing relationships ranging from the direct and immediate to the tenuous and remote.

103. However, that is not to say that, in the context of s 9-15 of the GST Act, a “tenuous” or “remote” connection with a supply will be enough to constitute consideration.

The view of the Commissioner is that there must be a substantial relation, in a practical business sense, between the consideration and the supply.[19]

Earlier and current supplies

The principles established in the Ruling continue to be relevant where an “earlier supply” or a “current supply” can be identified under a settlement agreement. This is because a “connection” or “nexus” exists between the payment made under the settlement agreement and the supply, meaning that the payment is consideration “in connection with” the supply.

That there may also be a “discontinuance supply” under the settlement agreement has no effect on the outcome (assuming the “earlier supply” or the “current supply” is taxable) because the discontinuance supply receives the same GST treatment.

Discontinuance supplies

In my view there is now real doubt whether the Commissioner’s view that the existence of a discontinuance supply (eg, where a settlement agreement resolves a damages claim) will generally not establish the existence of a taxable supply.

The decisions of the High Court in Reliance Carpet and Qantas make it clear that in determining whether there is a taxable supply, the statutory test prescribed by ss 9-5(a), 9-10 and 9-15 of the GST Act is to be followed. Looking to the words of the sections, that test is to:

1. identify a supply;
2. identify a payment; and
3. identify a “connection” between the two, so that the payment represents consideration “in connection with” the supply.

Where a settlement agreement is entered into, each of these elements is arguably satisfied, regardless of whether an “earlier supply” or a “current supply” can be identified. The discontinuance supply made by the defendant fall within the broad definition of “supply” in s 9-10. The payment under the settlement agreement acts to bind the parties to the contract (being contract law consideration) and is directly connected to the supply made by the defendant upon entry into the settlement agreement. That the consideration may also be connected with something that is not a supply (eg, a claim for damages) or that the “subject matter” of the settlement agreement is a claim for damages is arguably not relevant.

This effectively means that all payments made under settlement agreements will be consideration for a taxable supply (being the discontinuance supply) made by the recipient, regardless of whether an “earlier supply” or a “current supply” can be identified.

Given that this outcome directly conflicts with the views of the Commissioner in the Ruling, it is important to investigate this issue further.

The following matters arise for discussion.

1. Is the payment under the settlement agreement “in connection with” the discontinuance supply?
2. Should the discontinuance supply be ignored because the payment is “for” the damages claim?
3. Is the payment in the nature of damages, and therefore excluded from the definition of “consideration”?

Is the payment under the settlement agreement “in connection with” the discontinuance supply?

Whilst the High Court observed that the word “for” in the phrase “supply for consideration” does not adopt contractual principles, where parties look to enter into contractual arrangements the consideration will operate to bind the parties. In such circumstances, it is difficult to see how that consideration is not “in connection with” with those supplies made by the recipient upon entry into the contract.

Support for this view is found in the following observation of the High Court in Reliance Carpet when characterising the deposit (at [33]):

First, as to the consideration. The payment of the deposit by the purchaser to the taxpayer was “in connection with” a supply by the taxpayer, within the meaning of the definition of “consideration” in s 9-15(1)(a) of the Act. That connection is readily seen from the circumstance that, with the with the receipt of the written notice of the exercise of the option by the purchaser, and by force of cl 5 of the Option Agreement, the payment of the deposit obliged the parties to enter into the mutual legal relations with the executory obligations and rights laid out in the Contract.

In Reliance Carpet, the rights and obligations supplied to the purchaser upon entry into the contract included the obligation to transfer title to the purchaser upon payment of the balance of the purchase price and certain other obligations, such as to maintain the property in its present condition. In Qantas the rights and obligations supplied to the customer on making the booking did not include the promise of a flight, but those rights and obligations nevertheless constituted a taxable supply for which the fare was consideration. The conclusion of the majority of the High Court was as follows (at [33]):

The Qantas conditions and the Jetstar conditions did not provide an unconditional promise to carry the passenger and baggage on a particular flight. They supplied something less than that. This was at least a promise to use best endeavours to carry the passenger and baggage, having regard to the circumstance of the business operations of the airline. This was a “taxable supply” for which the consideration, being the fare, was received.

The approach of the High Court in Reliance Carpet and Qantas was to focus on the specific provisions in ss 9-5, 9-10 and 9-15[20] to establish the existence of a taxable supply. Adopting that approach, the scope of the statutory test is limited to identifying an act which falls within the broad definition of “supply”, identifying a payment and identifying a connection between the two.

The Commissioner’s written submissions in Qantas appear to be consistent with that approach (footnotes omitted):[21]

20. …[The fare] was received on or pursuant to the making of a contract between Qantas and a customer, by which Qantas supplied rights, obligations and services additional to the flight which was to have been provided. Each comprised “payment…in connection with a supply” of those rights, obligations and services, which was thereby a taxable supply attributable to that period.

…

36. The creation of those rights on the making of the contract, and the making of the reservation, are each included in the definition of a “supply” in subsection (1) of s 9-10 (“any form of supply whatsoever”) and in paragraphs (b), (e), (g) and (h) of subsection (2). As the unused fares were received in connection with the making of the contract and reservation, they comprise “consideration” (s 9-15(1)) for the supply of the rights and reservation, which is thus a taxable supply (s 9-5).

…

41. The statutory question posed by ss 9-75 and 9-15 is whether there was a supply of anything for which the unused fares were consideration (ie, in connection with which they were paid).

In the context of a settlement agreement, the statutory question would be whether there was a supply of anything for which the payment was consideration (ie, in connection with which they were paid). Taking such a prescriptive approach to the statutory test posed in ss 9-5, 9-10 and 9-15, it is difficult to see how the payment is connected to a discontinuance supply made on entry into the contract.

Should the discontinuance supply be ignored because the payment was “for” damages?

The basis for the Commissioner’s view in the Ruling that a “discontinuance supply” will generally not give rise to a taxable supply appears to be that the payment is “for” the damages claim and no part of the consideration is “for” the discontinuance supply. On this basis, the discontinuance supply is ignored. As stated in paragraph [106] of the Ruling:

In most instances, a ‘discontinuance’ supply will not have a separately ascribed value and will merely be an inherent part of the legal machinery to add finality to a dispute which does not give rise to additional payment in its own right. They are in the nature of a term or condition of the settlement, rather than being the subject of the settlement.

Paragraph [106] of the Ruling appears to justify disregarding the existence of the discontinuance supply by relying on the following factors:

• The discontinuance supply is not the “subject of the settlement”.
• The discontinuance supply has no separately ascribed value.

The “subject matter” of the transaction

The genesis of the search for the “subject matter” of a transaction in the context of GST is found in the principles established in the VAT regime in the UK and Europe by cases such as Card Protection Plan v Customs Comr (No.2) [2002] 1 AC 202.[22] Those principles have been adopted by the Federal Court[23] and recently by the Supreme Court of Canada[24] and the Privy Council.[25]

The need to identify what a payment is “for”, or the “essence” or “sole purpose” of the transaction, was accepted by the Full Federal Court in Qantas.

This approach was adopted by the Tribunal in AP Group.  The Commissioner had contended that the dealers had made supplies to manufacturers by performing or agreeing to perform the obligations imposed on them by the Dealer Agreements. In rejecting this contention, the Tribunal observed as follows (at [82]-[85]):

82. The Applicant notes in its written submissions that both this Tribunal and the Federal Court have, for GST purposes, “characterised supplies based on the true and substantial nature of the supply, a substance and reality approach, recognition that GST is a practical business tax and that what needs to be identified is the essence or sole purpose of the transaction”. Those submissions refer to AGR Joint Venture and Commissioner of Taxation [2007] AATA 1870; (2007) 70 ATR 466, which was referred to with approval in Qantas Airways Limited v Commissioner of Taxation [2011] FCAFC 113 (although we note that the Full Court’s decision in Qantas has been appealed to the High Court).

83. In this regard, the Commissioner responds in his written submissions as follows (original emphasis; footnotes omitted):

[W]hether AP Group made supplies to the manufacturers is not an enquiry assisted by an attempt to divine the ‘essence or sole purpose of the transaction’. While that kind of analysis in the past has been considered useful in deciding whether there is one supply or two; or the identity of a particular supply in respect of which consideration was provided; it has no logical role to play in identifying whether there was a supply at all. It simply deflects from the real question: whether AP Group made supplies in respect of which the incentive payments it received was consideration.

84. That seems a curious position for the Commissioner to take. It is hard to discover the merit in a proposition that the “essence” or “purpose” of a transaction should be disregarded at the stage of identification of a supply (is there are a supply?), but brought into focus only at the characterisation stage (what is the supply?). It seems to us that any criteria that are relevant to one stage are quire likely to be relevant to the other. And having regard to the essence and purpose throughout the enquiry is likely to lead to a GST outcome that reflects the realities of the commercial arrangement, rather than the “chaotic vista” that Mr Cordara predicted, where everything is a supply, everything is consideration, and everything is connected with everything.

85. In the context of the overall business relationships and contractual arrangements between the Applicant on the one hand, and the various manufacturers on the other, we do not think that the Applicant’s acceptance of the obligations or the making of the promises is properly viewed as the making of supplies to manufacturers. Instead they are part of the foundation underpinning the relationship, the background to the bargain the parties have made – in a sense, the rulebook by which the game is to be played. (emphasis added)

The approach taken by the Tribunal is consistent with that taken by the Commissioner in the Ruling. These various obligations are simply part of the machinery or background to the bargain and are not supplies in their own right (notwithstanding that they fall within the broad definition of “supply” in s 9-10).

The decision of the Tribunal was handed down before the High Court handed down its decision in Qantas.[26] The decision of the High Court appears to have changed everything.

The majority of the High Court in Qantas observed that on appeal the decision in Reliance Carpet was treated as if it supported the contention by Qantas that the sole candidate for a taxable supply was the flight, for which the fare was pre-paid, to the exclusion of supply by reason of making of the contract of carriage upon payment of the fare. The majority rejected this approach in clear terms (at [27]):

[Reliance Carpet] provides no support for the proposition adopted by the Full Court in the present case that it was necessary to extract from the transaction between the airline and the prospective passenger the “essence” and “sole purpose” of the transaction.

The Commissioner’s written submissions to the High Court were to the same effect (footnotes omitted):

43. The Full Court justified its answer on the ground that “the actual travel was the relevant supply, and if it did not occur there was no taxable supply”. It embellished the premise by adding that the flight was “the essence, and sole purpose, of the transaction. The prospective supply is of air travel, dare we say, in the face of Reliance Carpet (at [13]), ‘nothing more or less’.”

44. None of these terms appears in the GST Act, and there is no warrant for importing them. What the Act does say is that “a supply is any form of supply whatsoever”, that “consideration includes any payment … in connection with a supply of anything”, and that a taxable supply is (relevantly) one made for consideration. There is no basis for limiting words of such explicit breadth by notions of essence, purpose or “relevance”.

In light of the clear words of the majority of the High Court, the Ruling’s focus on “the subject of the settlement” would now appear to be misplaced. The focus of the statutory test in ss 9-5, 9-10 and 9-15 is solely on identifying a supply and also consideration, being any payment in connection with a supply of anything.

The principles of “characterising a transaction” may still have operation where one or more of the supplies is input taxed or GST-free. However, where no such issue arises, the search for the “subject matter” or “essence” of a transaction would not appear to be relevant because the search is solely to identify “a supply”. This was certainly the position of the Commissioner in his submissions to the High Court, as reflected in the following extract from his submissions in reply (footnotes omitted, emphasis added):

3. Issues of characterisation (expressed as questions of “essential character” or of identifying a “relevant supply”) arise where the issue is whether the supply in connection with which an amount is received as consideration is a taxable supply, an input taxed supply or a GST-free supply. They do not arise in this case, where all potential supplies were taxable supplies, and the only issue for resolution is whether there was any supply at all in connection with the receipts taken into the calculation of the assessed net amounts.

No separately ascribed value to the discontinuance supplies

The Ruling’s reliance on the discontinuance supply not having a separately ascribed value would also appear to be misplaced.

Taking a prescriptive approach to the statutory test in ss 9-5, 9-10 and 9-15, there is no requirement that the consideration reflect the value of the supply to which it is connected. It is sufficient that there is a connection between the supply and the payment and any disparity between the value of the supply and the payment is irrelevant. This is illustrated by Qantas where the fare would be unlikely to equate to the value of the supply made.[27]

This is also reflected in the Commissioner’s written submissions to the High Court (footnotes omitted):

29. It is not necessary for taxpayers to value what is supplied, nor to identify whether there is more than one component of the supply (or more than one supply) in connection with which the consideration is paid, nor to allocate the consideration among any such components…it is the payment of consideration which determines when, and how much, GST must be paid.

In the context of settlement agreements (where there are no earlier or current supplies), the fact that no value was ascribed to the discontinuance supplies or that the value of those supplies was negligible and bore no relation to the payment made arguably has no relevance to the statutory question posed by ss 9-5, 9-10 and 9-15. It is sufficient that there is a supply “of anything” and that the supply is connected to a payment.

Is the payment under the settlement agreement in the nature of “damages” and therefore not consideration?

Where a settlement agreement is entered into to resolve damages claims, the payment may properly be labeled as “in the nature of damages”. However, this does not prevent the payment also falling within the definition of “consideration” in s 9-15.

In Reliance Carpet the taxpayer contended that the forfeited deposit was received by it “in the nature of damages”, with the consequence that there was no “supply” in connection with the forfeited deposit. The High Court rejected this contention, noting that no action had been taken by the taxpayer to recover any alleged damages for failure to complete the contract.

The High Court therefore did not expressly address the question of whether a payment that was “in the nature of damages” could also be “consideration”. However, the judgment appears to support that conclusion. The High Court made the following observation after reviewing the various characteristics of a deposit (at [28]):[28]

The circumstance that the deposit forfeited to the taxpayer had various characteristics does not mean that the taxpayer may fix upon such one or more of these characteristics as it selects to demonstrate that there was no taxable supply. It is sufficient for the Commissioner’s case that the presence of one or more of these characteristics satisfies the criterion of “consideration” for the application of the GST provisions respecting a “taxable supply”.

Applying this approach, it is sufficient if one of the characteristics of a payment made under a settlement agreement entered into to  resolve a damages claim satisfies the criterion of “consideration” – ie, it is a payment “in connection with” a supply made under the settlement agreement. It does not matter if another characteristic of the payment is that it is in the nature of damages.

Conclusion

Twelve years have passed since GSTR 2001/4 was published and a review of the cases shows that the principles stand up pretty well in the context of court judgments. However, there is now real uncertainty in its application to out of court settlements where those settlements resolve claims for damages and no “earlier supply” or “current supply” can be identified. This uncertainty flows from the decision of the High Court in Qantas in October last year. As noted recently,[29] tax specialists are divided as to the likely consequences of the decision, with some arguing that it fundamentally shifts the GST landscape in Australia. The views of the Commissioner in GSTR 2001/4 on “discontinuance supplies” may be one area which is impacted by the decision. If so, this will have a significant impact on all settlement agreements involving damages claims.