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| Settlements, court orders and GST |
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Contact: Peter Hill
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Settlements are a case of let the supplier beware!
It is May 2000. Your business has been involved in a protracted dispute with a supplier arising from problems with equipment installed in 1997. A Statement of Claim has been lodged with the court, and a preliminary hearing is scheduled for August 2000.
The supplier is now prepared to negotiate a settlement in your favour, but your lawyer has advised that unless a settlement is concluded before 1 July 2000, your business will be liable to GST in respect of any amount payable by the supplier under the terms of the settlement.
Your first response is: What? Is this true?
The answer is yes. This article explains why and the GST traps for any business to avoid in concluding legal disputes by either settlement or court order.
It should be noted upfront, however, that the views expressed in this article are at direct odds with the only statements so far made by the Federal Government as to the operation of the GST law as it affects this whole area of doing business. These statements were made in the explanatory memorandum accompanying some amendments to the meaning of "consideration" for GST purposes, and are discussed critically at the conclusion of this article.
A settlement is a supply
No doubt about it. When a business sues another business (or anyone for that matter) it is doing something. If the business doing the suing then agrees to settle instead, it is essentially entering into an obligation to refrain from doing something - from pursuing the legal action. And that fits neatly into the definition of "supply" for GST purposes - specifically section 9-10(2)(g)(ii) of the GST Act.
In the above example, by agreeing to settle its dispute with the supplier of the equipment, the business has become the supplier in a separate transaction.
Is a settlement a taxable supply?
There are several aspects of a transaction that need to exist before it can be said a taxable supply has been made, hence giving rise to a GST liability in the hands of the supplier.
Enterprise test
The bridge between supply and taxable supply will be partly constructed if the dispute between the parties is in connection with the aggrieved party's business. In many cases the connection will be obvious, such as a dispute over delivery of damaged goods or loss of profits from a disruption to trade, but in essence much of the income tax law precedents for determining if legal expenditure is deductible will be relevant.
In the example above, the dispute concerns an item of equipment used by the business which has instituted the legal action. The costs incurred in taking the action will normally be deductible, notwithstanding the equipment is of a capital nature (the dispute is concerned with the use of that equipment). Similarly, the actions taken by the aggrieved party in rectifying the problem will be sufficient to pass the requirement for a taxable supply that the supply be done in the course or furtherance of the enterprise (the business).
Consideration
A supply needs to be made for consideration before it can be a taxable supply. As mentioned above, one of the amendments to the GST law, in December 1999, was to the meaning of "consideration". The change makes it clear that a payment in compliance with a settlement relating to proceedings before a court or similar body able to make orders can be consideration for GST purposes.
The connection then has to be made with a supply. This is easy. A business agreeing to settle a legal dispute is doing so for consideration, being the payments to be made by the other party.
Some would argue that a settlement involving the losing party doing something other than paying money involves a supply by that party. In other words, the losing party has entered into an obligation to do something (a supply). As consideration, that party receives an undertaking by the successful party to cease all legal action.
It is arguable whether that view goes anywhere. This is because the real issue is whether a taxable supply exists, and this needs consideration that can be valued to be evident. Placing a market value on the agreement by the successful party to cease all legal action is nigh impossible, especially when the settlement involves both a cash payment by the losing party and the creation of an obligation for that party to do something else as well (requiring an apportionment of that market value).
In any event, note that when the Federal Government amended the meaning of "consideration" it did not also go further and make the connection with an identifiable supply. This point becomes important later in this article.
Connection with Australia
This test will be satisfied, in the context of settlements, if the thing being supplied is done in Australia. This stems from the definition of "connected with Australia" in section 9-40 of the GST Act.
In many situations it will be obvious "the thing" is done in Australia. In many cases it won't be so obvious. For example, one party may be in Australia, the other overseas. Where is the entering into an obligation to refrain from pursuing legal action (the supply) done if:
- the action would otherwise have been heard in an overseas court?
- the process of negotiating and concluding the settlement is carried out by phone, fax and e-mail?
In such cases, the supply of the settlement will still be connected with Australia if the enterprise to which the settlement is related is carried on in Australia.
It is therefore important to recognise that the issue of where the underlying transaction giving rise to the settlement took place is irrelevant when determining if agreeing to settle will be the making of a taxable supply.
By extension, this also means that a business transaction does not have to be taxable supply for a settlement of a dispute relating to that transaction to be a taxable supply.
This conclusion is at odds with what the explanatory memorandum accompanying the change to the meaning of "consideration" says about the way the GST law generally operates. See further the discussion at the end of this article.
Is the supplier registered for GST?
A year from now this requirement for a taxable supply to exist will often be obviously met. But consider this: assume as of May 2000, the successful party in the example at the start of this article is not be registered for GST, or even required to be registered.
If on 1 July 2000 that business is not registered but deemed to be registered at that time (because the registration turnover threshold of $50,000 was breached but not acted upon) it will have a potential taxable supply being made on settlement of the dispute on or after that date.
There is nothing to prevent a GST liability arising in respect of a settlement of a dispute that started before 1 July 2000.
There is absolutely nothing in the GST legislation that seeks to draw any connection between a settlement and the status of either the underlying transaction the cause of the dispute or the registration status of the successful party at the time of that earlier transaction.
This means that a settlement can be a taxable supply even if:
- the underlying transaction was entered into and concluded before 1 July 2000;
- the legal action giving rise to the settlement was initiated before 1 July 2000;
- the successful party was not registered or deemed to be registered until immediately prior to the settlement occurring; or
- the underlying transaction involved the making of a GST-free or input taxed supply.
In terms of timing and registration, all that matters is that the settlement occurs on or after 1 July 2000, and that at that time the successful party is either registered for GST or should be.
When is the supply made?
This leads us to the transitional question of when the supply of a settlement is made. If the supply occurs before 1 July 2000, there can be no taxable supply.
Section 7 of the GST Transition Act kick-starts GST by providing that GST is payable to the extent a supply is made on or after 1 July 2000. Even though the terms of any particular settlement can call for certain actions to be performed by the successful party (the supplier) that cannot be performed all at the same time, it is hard to imagine any supply of an agreement not to do something (to continue legal action) being performed other than at one point in time.
In other words, the supply is the act of entering into the obligation to refrain from pursuing the legal action. This is fundamentally a contractual issue, but the question still begs: when exactly is it supplied?
Consider again the facts in the example at the start of this article, with the following developments:
The parties agree on a Terms of Settlement. The successful party will withdraw all legal action against the supplier of the equipment in return for the payment of an amount of $250,000, being:
a) $200,000 for the withdrawal of the legal action; and
b) $50,000 towards the legal costs incurred by the successful party.
Under the Terms, the successful party is not obliged to do anything unless and until the amount of $250,000 is deposited in a nominated bank account. The agreement is signed by both parties on 25 June 2000. The agreed amount is deposited in the bank account on 5 July 2000.
Has a supply been made on or after 1 July 2000?
This is an example of a conditional contract. The ATO has flagged conditional contracts as a topic for a forthcoming draft GST ruling. When it is released, it is expected to reflect the view that a supply pursuant to a contract cannot be seen to be made until such time as the contract becomes unconditional. This makes sense.
The contract in the example becomes unconditional on the payment of the consideration, which occurs after 1 July 2000. Therefore, the supply is made within the GST net.
This is a classic example of one party's GST liability arising only because of actions of another party. Had the losing party paid the $250,000 before 1 July 2000, no liability to GST would have arisen.
That result is only a transitional issue, but the Federal Government refused to amend the GST Transition Act to provide suppliers caught out by it with a recovery mechanism.
Covering the GST liability
The real issue for successful parties in settling a legal dispute is making sure the amount negotiated as settlement takes into account any GST liability arising in the hands of the successful party.
In the absence of any specific reference to GST in a Terms of Settlement, the amount negotiated will be deemed to be a GST-inclusive amount.
In a lot of cases, the losing party in a negotiated settlement will be obtaining an input tax credit for one-eleventh of the settlement amount. In many cases it will also be clear that in settling the dispute, the successful party will be making a taxable supply.
But in many other cases, input tax credits will not be available to the losing party. It is hard enough negotiating a settlement amount without adding 10% to it - parties negotiating a settlement in their favour should therefore have regard to the GST consequences for the other party at the earliest possible opportunity.
In many other cases, it will not be certain that a settlement, when made, will be a taxable supply.
Some parties may decide it is sufficient to provide in the Terms of Settlement a clawback clause should the successful party be determined to have a GST liability in respect of the settlement. Some parties may instead decide a private ruling is required from the ATO before any agreement is reached. Too bad GST rulings are not currently binding on the Commissioner.
The same outcomes will prevail if the successful party is actually negotiating with the other party's insurance company. As for the GST issues relating to the transactions between the insurance company and their client, we covered (pun intended) these in GST Today , Issue 13, November 1999, [13.1].
Legal costs paid by the losing party
Consider again the example above. Is the consideration for the supply of the settlement $200,000 or $250,000?
The answer is quite straightforward. The consideration is $250,000, being the amount of the cash component ($200,000) and the value of the obligation to pay the successful party's legal costs ($50,000).
Even if the $50,000 component is paid directly to the lawyer, the relevant tax invoice for the losing party must come from the successful party. The lawyer can only issue a tax invoice to the recipient of their taxable supply, being their client - the successful party. This completes the "round robin" of tax invoices, and also conforms with the GST Act which does not require the consideration to come from the actual recipient.
But what the successful party must not do is provide the losing party with original fee notes (tax invoices) from their lawyer if the loser has agreed to pick up the tab, especially if the successful party accounts for GST on an accruals basis and has already claimed all relevant input tax credits.
The only real issue for the successful party is to make sure that if the other party is willing to pay some or all of the legal costs incurred in relation to the dispute, the amount agreed upon reflects the GST-inclusive cost of those legal services.
Court orders
In New Zealand in March 2000, a court awarded costs to a taxpayer (ironically, as against the Commissioner of Inland Revenue!) on a GST-inclusive basis. That is, the court accepted the argument put forward on behalf of the taxpayer that GST would be payable in respect of the underlying negotiated settlement reached between the taxpayer and the Inland Revenue, and held it was entirely appropriate to ensure the taxpayer's GST liability was incorporated into the amount of costs awarded against the losing party.
Before settling on the actual amount, the court also followed precedent in requesting copies of all of the taxpayer's lawyer's fee notes relating to the underlying dispute.
What will happen in Australia? Consider once more the example given earlier in this article, but assume settlement negotiations break down, the dispute is heard in court, and a decision is made in the favour of the aggrieved party. The loser must pay $250,000 in damages.
Has there been a supply of something at this point? One of the only things identifiable as a supply appears to be the entry, by the loser, into an obligation to do something, ie pay damages. That is a bit of a stretch, but in any event there seems to be no consideration involved in such a supply, so the issue is moot.
What about the successful party? They might be seen to be the recipient of a supply, being the creation of a right (to receive damages of $250,000). But who is the supplier?
The losing party did not create that right, the court did. In reality, however, there is just no way the courts are going to wear any GST liability simply through deciding cases.
The niggling factor is that the same amendment that made it clear a settlement payment could be consideration for a supply also made it clear that a payment in compliance with a court order could be consideration for a supply. But the legislation does not spell out what that supply is or if there indeed is one in this scenario.
Obviously, the Federal Government intended that GST would be payable on court orders and settlements, but the only feasible way it could work is if, on payment of a damages award, the successful party has made a supply, being a release from the obligation of the loser to pay.
Can we take guidance from the explanatory memorandum to the amendments discussed in this article? Unfortunately not, because the explanation of how the change to the meaning of consideration fits into the supply/taxable supply scenario is farcically wrong. What follows are the words of the explanatory memorandum and the reasons it is wrong:
Where the consideration relates to an underlying supply that was taxable, the consideration received will be subject to GST.
Apart from the classic mistake of believing it is the consideration that is subject to GST (instead of the correct position, which is that a taxable supply is subject to GST), there is absolutely nothing in the GST legislation that makes this connection between a settlement and the underlying transaction, as discussed earlier. The farcical nature of the Government's mistake is further demonstrated by the next statement:
If the claim relates to an enterprise carried on by a registered entity, the entity will be entitled to an input tax credit for the GST included in the consideration received.
Say again? Is the Federal Government really wanting to allow a doubling up of input tax credits for accruals method GST businesses winning legal disputes?
Where the subject of the claim of damages or compensation was in respect of a GST-free or input taxed supply, the consideration will take on the same characteristic of the underlying supply.
Once more the Federal Government is confused between consideration for a supply and the supply itself (same characteristic?). And again, there is nothing in the GST legislation that makes this connection with the underlying supply.
Instead we are forced to take a tortuous path through the concepts of supply and taxable supply to fill the gap, and it is very hard to do it when you are dealing with court orders, as opposed to settlements.
This is an area crying out for a specific statutory provision that simply puts into law the intent behind the comments in the above explanatory memorandum. And it should not be left to the ATO to make a non-binding GST ruling saying the same thing.
The ATO has been notably silent on this issue, and it will be very interesting to see the path it takes when the draft ruling on settlements and court orders and GST is released.
Subsequent legislative and regulatory changes may have impacted upon the subject matter of this article.
Peter Hill
BBus MTax FTIA
Managing Writer - ATP
ATP - GST
March 2001
March, 2001
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