GST on judgments and settlements – a review of GSTR 2001/4 ten years on

chrissievers.wordpress.com*

23 October 2011

Introduction

In 2001 the ATO released GST Ruling GSTR 2001/4 (GST Ruling) which outlines the Commissioner’s views as to the GST treatment of court orders and out of court settlements.  This was a very comprehensive document which sought to clarify the difficult issues arising in this area.

Ten years on, it is timely to look at those cases which have considered the issues discussed in the ruling and to assess the continued relevance of the Ruling.

This paper will first provide a summary of the GST Ruling and outline its essential principles.  It will then consider a number of decisions of the Courts which were handed down subsequently and which dealt with the following issues:

• Damages
• Judgments
• GST on legal costs

GSTR 2001/4

Taxable Supply

The two central planks of the GST system are the concepts of “supply” and “consideration”.  A “supply” is defined widely to mean “any form of supply whatsoever”: s 9-10(1) of the A New Tax System (Goods and Services Tax) Act 1999.  Sub-section 9-10(2) extends the meaning of supply to include the following matters:

• a supply of goods;
• a supply of services;
• a provision of advice or information;
• a grant, assignment, or surrender of real property;
• a creation, grant, assignment or surrender of any right;
• a financial supply;
• an entry into, or release from an obligation:
• to do anything;
• to refrain from an act; or
• to tolerate an act or situation;
• any combination of two or more of the above matters.

Consideration (which includes monetary and non-monetary consideration) is defined to mean “any consideration in connection with the supply”.  The concept “in connection with” is defined to include a payment made “in connection with” and “for the inducement” of a supply.

By combining those two elements, the concept of “taxable supply” in s 9-5 is founded on the making of a “supply for consideration”.  The focus is therefore on finding a relevant “nexus” between the consideration and a supply.

Settlements and supplies

In considering whether there has been a supply by virtue of an out-of-court settlement, the GST Ruling focuses on the relevant “nexus” between the compensation payment and one or more of the following supplies:

Earlier supply[1] – this usually occurs where the subject of the dispute between the parties is an earlier transaction in which a supply was made involving the parties.

• Example          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

Current supply[2] – this is a new supply created by the terms of settlement.

• Example          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 se its trade name in the future.  The supply of the right to use the trade name is a current supply.

Discontinuance supply[3] – terms of settlement will generally provide for the plaintiff to release the defendant from some or all of the existing claims (indeed many terms of settlement contain mutual releases) and for a notice of discontinuance to be filed.  The Commissioner considers that these terms can create one or more of the following “supplies”

• Surrendering a right to pursue further legal action;
• Entering into an obligation to refrain from further legal action;
• Releasing another party from further obligations in relation to the dispute.

These are regarded as “discontinuance supplies”.

Damages

The GST Ruling makes the important concession that a number of disputes relate to matters which do not constitute a supply[4], for example:

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

As stated in paragraph 73 of the GST Ruling:

“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 characterized 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.”

Consideration and the search for the requisite “nexus”

The GST Ruling considers that it is not sufficient that there be a supply and a payment.  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, one which is beyond an approach based on contract law.  This broad approach is arguably consistent with the definition of consideration “for a supply” extending to any consideration which is “in connection with” the supply.

The question is determining whether there is a sufficient nexus between the compensation (the consideration) and one or more of the “supplies” referred to above, namely:

Discontinuance supply[5];

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 – the GST Ruling considers these supplies to be in the nature of a term or condition of the settlement, rather than the subject of the settlement.  Every terms of settlement will usually contain at least one ‘discontinuance supply’.

The GST 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 GST 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”.

Earlier supply[6];

Where the only supply (other than a discontinuance supply) in relation to terms of settlement is an earlier 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.

• Example    Using the Widget Company example.  If the terms of settlement provided for the retailer to pay Widget in full for the toys, there is a sufficient nexus between the supply of the toys and the compensation.

Current supply[7]

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.

• Example    Using the Beaut Enterprises example.  If the terms of settlement provided for a payment for the right to use the trademark in the future, that payment would likely be regarded as consideration for the supply of the right to use the trademark.

Damages[8]

Because the Commissioner takes the view that a dispute over damages does not constitute a supply, if a payment under terms of settlement is wholly in respect of a claim for damages (ie, there is no earlier supply or current supply), the payment will not be consideration for a supply.  This is the case, even if there is a discontinuance supply.

• Example    Bluey’s Waste Removal contracts for a three month period with the local Council to collect waste from specified sites and removing it to the Council’s rubbish tip.  One of Bluey’s trucks is badly damaged at the tip due to the actions of Council staff.  Bluey takes legal action to recover $50,000, being the cost to repair the truck and loss of productive time.  The dispute is settled with the Council agreeing to pay Bluey $37,000 and Bluey agreeing to take no further action.  No part of the $37,000 is consideration for the supply.

Apportionment and attribution

Apportionment

The Commissioner takes the view that compensation payments should be apportioned between those supplies to which there is a sufficient nexus.  Further, if the terms of settlement seek to apportion the compensation between supplies, the Commissioner will accept that apportionment to the extent it is made on a reasonable basis[9].  Where no dissection is made and the payment is a lump sum, the payments should nevertheless be apportioned on a reasonable basis[10].  The Commissioner considers that the apportionment is not reasonable, the general anti-avoidance rules may apply.

• Example          Using the Beaut Enterprises example.  If the payment under the terms of settlement is $100,000, being a payment to compensate for past wrongful use of the trademark and a payment for the future use of the trademark, the payment will need to be apportioned between the damages component (not subject to GST) and the right to the future use of the trademark (subject to GST).  The payment will need to be apportioned on a reasonable basis.  For example, if the statement of claim sought $50,000 damages for the wrongful use of the trademark, it may be reasonable to use that apportionment.  Alternatively, it may be appropriate to use industry standards to calculate the fees for the future use of the trademark.

Attribution

The GST consequences of a payment made under terms of settlement may be:

Attribution of GST payable in the tax period the payment is made.  This may occur where the compensation is consideration for a current supply or the compensation is consideration for an earlier supply and the recipient has not yet paid GST on the supply (eg, the supplier accounts for GST on a cash basis).

• Example          Using the Widget Company example and assume the price for the toys was $110,000 and no consideration had been paid at the time the dispute was entered into.  If the terms of settlement provided for the retailer to pay Widget in full for the toys, GST would be payable on the full $110,000 (ie, $10,000).

An adjustment for GST in respect of changes to consideration for a supply.  This may occur where the payment is consideration for an earlier supply and the recipient has already paid GST on the supply and the compensation differs from the consideration upon which GST was paid.

• Example          Using the Widget Company example and assume that the price for the toys was $110,000 and Widget had paid GST on the full amount, being $10,000 (for example, if Widget was registered on an accruals basis and had provided a tax invoice).  If the terms of settlement provided for the retailer to pay Widget the sum of $88,000 for the toys, there would be an adjustment of Widget’s GST liability to reduce it to $8,000.

No attribution or adjustment required.  This will occur where the compensation payment is not consideration for a supply (eg, a payment for damages), the compensation payment is consideration for a supply that is GST-free or input taxed or the compensation payment is equal to the amount of consideration on which GST has been previously attributed.

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[11].

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.

Court decisions 

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

In this case the second defendant submitted that the costs order should exclude GST charged by the barrister to the client (who was briefed on a “direct access” basis) on the basis that 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.  At ([25]) the Court said as follows: “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.”

This decision is consistent with the views of the Commissioner in the GST Ruling.

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

This case involved a claim for damages for conversion by the plaintiff of the defendant’s goods .  The issue in this particular decision concerned the measure of damages.

One of the goods was sold for $10,000, of which $9,091 was received, after payment of GST.  Damages of $10,000 was awarded, being the market price (inclusive of GST) of the goods.  The Court justified its decision by reference to old English authority and (at ([17]) the Court said: “…because the function of damages for conversion is compensatory, it is the price to a purchaser of the goods which is the appropriate measure of damages.  Thus, it is the market price, inclusive of GST, which is the measure of damages.  This is consistent with the view which has been arrived at 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.

This decision does appear to be consistent with the GST Ruling.  The decision does not purport to impose GST on the judgment for conversion (as giving rise to a taxable supply), rather the decision clarifies that the appropriate measure of damages should not exclude the GST paid by the plaintiff at the time of the sale.

Keen v Telstra Corporation Limited [2006] FCA 834; 153 FCR 28; 230 ALR 313; 63 ATR 400 (costs)

In this case 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 Ms Keen had to pay to her solicitors in addition to the amount of costs allowed under the scale in the schedule to the rules.

The Federal Court noted that there was no provision in the Federal Court Rules which allowed GST to be added and the provisions, in their natural meaning, provided that the only amounts allowable are those fees set out in the schedule.

The Court did refer to some decisions of State Courts which considered this question, but arguably provide conflicting views.  In Thornton v Apollo Nominees Pty Limited (2005) 59 ATR 244 Evans J of the Supreme Court of Tasmania considered the rule that allowed in a bill of costs for taxation an amount referable to the GST paid or to be paid by the party entitled to the costs order.  However, in Merringtons Pty Ltd v Luxottica Retail Australia Pty Ltd (unreported, Supreme Court of Victoria, 16 June 2006) Master Wood found that the absence of such a rule was not significant because a disbursement had to represent an out-of pocket expense and that the rule merely embodied a principle that a party ought not to obtain more on a party/part taxation than that they are ultimately required to pay.

The Court dealt with the GST issue by finding that the fees in the schedule of costs include GST, noting it would be doubly compensatory were a further and separate disbursement be allowed on a taxation of costs in respect of GST.  Further, (at [45]) the Court appeared to approve of the views in the GST Ruling that the payment of costs are not consideration for a supply.

The Court did not the possible injustice of such an approach, given that a person (as in the present applicant) who was not entitled to input tax credits would be worse off than a business conducting litigation.

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

This was a taxation of costs matter where it was contended that the registrar erred in reducing the amount ordered 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 on the costs of solicitors and others.

The Court had issues with the approach of the registrar to make a “sweeping application” of a 1/11th reduction.  This included the fact that some of the fees were not subject to GST (e.g. filing fees) and the professional costs were allowed and claimed in accordance with the relevant Scale of Costs.  The Court referred to the decision in Keen v Telstra Corporation (and the cases referred to in that judgment) and found that (at [138]) “the proposition that, where costs are being allowed in accordance with a scale and the scale fixes a particular amount, it is that amount which is to be allowed is certainly well established, and the effect of these authorities is that the operation of the GST system and the input tax credit system is not a basis for reducing the scale amounts.”

The Court did note (at [140]) that if the effect of an input tax credit meant that costs assessed on the standard basis plus the input tax credit came to an amount greater than the plaintiff had in fact paid, the the costs would have to be abated under the indemnity principle so that the client did not recover more in total than was actually paid.

The Court (at [130]) raised the interesting question of whether the award of a costs order (in circumstances were the party had previously paid the entire legal costs and claimed an input tax credit) would give rise to an increasing adjustment under Division 19 of the GST Act.  Further, as the GST Ruling did not deal with the issue, the Court proceeded on the assumption that no such adjustment arises.

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

The Court of Appeal (at [9]) addressed the respondent’s contention that the appellant’s claim at first instance should be reduced by a GST input tax credit applicable to the professional costs incurred by the appellant.  The Court agreed with the views of the Court in Hennessey Glass and found that the necessity 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 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.  As noted by the Court (at [51]) “…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 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.

This decision is consistent with the GST Ruling.  The claim by the respondent appears to have been in respect of an “earlier supply” (which would have been subject to GST) and the claim by the appellant was simply the claim for damages (no GST).  One of the issues on appeal was whether the trial judge was correct in including an allowance for GST on the rectification costs incurred by the respondent.

The Court of Appeal (at [147]) accepted that while the respondent may have to pay GST in connection with the goods and services it acquired for the purpose of making good the damage to its premises, it would be able to recover that amount back by way of input tax credits.  Therefore, the GST component of those payments would not ultimately be a loss that it suffered and that the GST should not have been included in the damages.

Adamson v Ede [2008] NSWSC 767 (damages)

The Court found that an award of damages on a quantum meruit basis should include GST.  The plaintiff was not an employee of the defendant and accordingly the services were subject to GST as a taxable supply.

This decision is consistent with the GST Ruling as the damages would be characterised as consideration for the “earlier supply” of services by the defendant to the plaintiff.

Nemeth v Prynew Piling v Prynew [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 Court found that the judgment should include GST.

The Beach Retreat Pty Ltd v Mooloolaba Yacht Club Marina Ltd [2009] QSC 84 (costs)

This was an application for 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 that the reasoning in ChongHerr Investmentsand Hennessey Glass required the Court to add an amount which equated to notional GST on the professional costs.  Further, the Court found that an amount for GST should not be added to the indemnity costs.

The Court (at [128]) referred to the GST Ruling and to the view that a costs order or settled amount should take account of any entitlement to an input tax credit of the parties.  Further, the Court acknowledged (at [140]) that while costs allowed in accordance with scale should not be reduced, if the effect of an input tax credit meant that costs assessed on the standard basis plus the input tax credit came to an amount greater than the plaintiff had paid, the costs would have to be abated.

Based on this decision, which is consistent with the earlier decisions, the views of the Commissioner in the GST Ruling about the adjustment of costs to take into account of input tax credits must be taken subject to the Sales of Costs in each jurisdiction.

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 the damage caused by water flowing into the respondent’s shop from that of the appellant.  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 Court of Appeal accepted 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.

In taking this approach, the Court acknowledged that awards of damages for a tort have included GST (referring inter alia to Bennett v Goodwin, Nemeth v Pryunew Pty Ltd and Vrkic v Otta International discussed above).  However, the Court found 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.

Importantly, the Court of Appeal (at [152]) 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 Court also rejected a submission that the damages award itself would be subject to GST.  In rejecting that submission, the Court referred to the GST Ruling with apparent approval.

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

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 Court (at [77]) referred to the GST Ruling and agreed with the plaintiff’s submissions that the award, which was by quantum meruit, was payment for services rendered at an earlier point in time and it was probably that orders made by the Court would constitute consideration for an “earlier supply” and 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.

A J Lucas Drilling Pty Ltd v McDonnell Dowell Constructors (Aust) Pty Ltd (No 2) [2010] VSCA 128 (GST-exclusive offer of compromise)

The successful party made an offer of comprise of $4m which was exclusive of any GST and the offer expressly sought to gross up any amount for GST.  The trial judge made an order of $3,607,925 exclusive of GST, an order for GST of $367,292 and for interest of $257,740.  If GST was included, the order was more than $4m and if excluded the order was less than $4m.

The applicant argued that the indemnity for GST in the offer referred to GST payable in connection with the acceptance of the offer (the “discontinuance supply” referred to in the GST ruling). As no GST was payable on that supply, it was contended that the order was for less than that provided for in the offer (i.e., less than $4m).

While the Court accepted that there were good arguments in support of the applicant’s contention, there was a real lack of clarity in the offer.  The GST indemnity could relate to the “discontinuance supply” or to the “earlier supply”.  Given this uncertainty, it was not possible to say whether the judgement was less favourable than the offer of compromise.

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

This is the first case dealing with damages where the Commissioner was a party.  The Commissioner did file an appeal to the Full Federal Court, but that appeal was discontinued on 13 October 2011.  To see this post and a discussion of this case press here.

The appeal related to the Commissioner’s GST assessment which was made as a result 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.  The Court found (at [32]) that the taxpayer did not make a supply, essentially because the transfer of ownership in the scaffolding was triggered by an operation of law and not by any act of the taxpayer.

Hopefully the Commissioner will issue a decision impact statement which may clarify the issues the Commissioner had with this decision.

Conclusion

When regard is had to the cases outlined in this paper, the fundamental principles outlined in GSTR 2001/4 appear sound.  Essentially, the Courts appear to have accepted the concepts of “discontinuance supply” (no GST), “earlier supply” (GST) and that damages do not give rise to GST (although there may be a GST component in the award itself).  The area of costs has received a suprising amount of attention by the courts, and the view of the Commissioner that costs should take account of an entitlement to input tax credits has received support (save for the issue of the fees set out in the various Scales of Costs).

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 able to profit from an entitlement to input tax credits.  Similarly, a defendant should not be able to profit where the plaintiff cannot claim credits.

All things considered, I believe that GSTR 2001/4 has stood the test of time well and should be regarded as one of the better GST rulings.

Chris Sievers

23 October 2011

*Disclaimer: The material and opinions in this document are those of the author and should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.