Edited version of your private ruling

Authorisation Number: 1012442223041

Ruling

Subject: Goods and services tax (GST) and out-of-court settlement

Question

Are you entitled to an input tax credit where you paid the other party the settlement amount of a certain amount of money?

Answer

No. However, you are entitled to a decreasing adjustment that reverses the entire GST liability you originally had on your sale of the goods.

Relevant facts and circumstances

You are registered for GST.

You account on an accruals basis.

You sold goods to the other party for a certain amount of money. You issued an invoice for your sale of the goods on a certain date.

GST was payable by you on your sale of the goods

You and the other party were involved in a dispute that was settled out-of-court.

The dispute was about defects in the goods.

As part of the out-of-court settlement agreement, you paid the other party a certain amount of money. The payment was comprised of the following components:

(a) part was reimbursement of part of the price of the goods

(b) part was compensation for the cost of repairs

(c) part was compensation for loss of income resulting from the goods not working

(d) part was reimbursement of the other party's legal costs relating to the dispute, and

(e) part was interest.

As part of the settlement agreement, the other party returned the defective goods to you.

Relevant legislative provisions

A New Tax System (Goods and Services Tax) Act 1999 section 9-5

A New Tax System (Goods and Services Tax) Act 1999 section 9-40

A New Tax System (Goods and Services Tax) Act 1999 section 11-5

A New Tax System (Goods and Services Tax) Act 1999 section 11-20

A New Tax System (Goods and Services Tax) Act 1999 paragraph 19-10(1)(a)

A New Tax System (Goods and Services Tax) Act 1999 paragraph 19-10(1)(b)

A New Tax System (Goods and Services Tax) Act 1999 paragraph 19-10(2)(a)

A New Tax System (Goods and Services Tax) Act 1999 section 19-40

A New Tax System (Goods and Services Tax) Act 1999 section 19-55

Reasons for decision

Summary

You are not entitled to an input tax credit where you paid the out-of-court-settlement payment, because the payment is not consideration for any supply made by the other party or any other entity to you.

In accordance with section 19-40 of A New Tax System (Goods and Services Tax) Act 1999 (GST Act), you have a decreasing adjustment because:

· the return of the goods was an adjustment event

· you had a GST liability on your supply of the goods, which was attributed to an earlier tax period, and

· as a result of the adjustment event, the GST liability you had no longer correctly reflects the amount of GST on the supply (the corrected GST amount).

In accordance with section 19-55 of the GST Act, if the corrected GST amount relating to a supply you make is less than the previously attributed GST amount, you have a decreasing adjustment equal to the difference between the previously attributed GST amount and the corrected GST amount.

The decreasing adjustment in your case is equal to the GST liability you originally had, because the cancellation of the supply reverses the entire GST liability you originally had.

Detailed reasoning

You are entitled to input tax credits on your creditable acquisitions.

You make a creditable acquisition where you satisfy the requirements of section 11-5 of the GST Act, which states:

You make a creditable acquisition if:

(a) you acquire anything solely or partly for a *creditable purpose; and

(b) the supply of the thing to you is a *taxable supply; and

(c) you provide, or are liable to provide, *consideration for the supply; and

(d) you are *registered or *required to be registered.

(*Denotes a term defined in section 195-1 of the GST Act)

GST is payable on taxable supplies.

You make a taxable supply where you satisfy the requirements of section 9-5 of the GST Act, which states:

You make a taxable supply if:

(a) you make the supply for *consideration; and

(b) the supply is made in the course or furtherance of an *enterprise that

(c) you *carry on; and

(d) the supply is *connected with Australia; and

(e) you are *registered, or *required to be registered.

However, the supply is not a *taxable supply to the extent that it is *GST-free

or *input taxed.

In order to determine whether you are entitled to an input tax credit, we need to determine whether the payment you made was consideration for a supply made by the other party to you.

Goods and Services Tax Ruling GSTR 2001/4 discusses the GST implications of out-of-court settlements.

Damages payments

Paragraphs 71 to 73 of GSTR 2001/4 discuss damages paid as part of an out-of-court-settlement. They state:

71. Disputes often arise over incidents that do not relate to a supply. Examples of such cases are claims for damages arising out of property damage, negligence causing loss of profits, wrongful use of trade name, breach of copyright, termination or breach of contract or personal injury.

72. When such a dispute arises, the aggrieved party will often assert its right to an appropriate remedy. Depending on the facts of each dispute a number of remedies may be pursued by the aggrieved party in order to ensure adequate compensation. Some of these remedies may be mutually exclusive but it is still open to the aggrieved party to plead them as separate heads of claim until such time as the matter is resolved by a court or through negotiation.

73. 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.

In your case, there was a dispute between you and the other party relating to defective goods you supplied to the other party. An out-of-court settlement was reached. Part of the out-of-court settlement was payment of damages for repair costs and loss of income resulting from the goods not working. The damages and loss in themselves do not constitute supplies. Therefore, the out-of-court settlement payment you made was not consideration for a supply made by the other party to you to the extent that it was to compensate for those damages and that loss.

Refund of purchase price of defective goods

To some extent, the payment you made was a refund of the purchase price of the defective goods. To the extent that the payment was a refund of the purchase price of the defective goods the payment is not consideration for a supply made by the other party to you.

Reimbursement of legal costs

Paragraphs 145 to 148 of GSTR 2001/4 deal with reimbursement of legal costs relating to a dispute. They state:

145. When a dispute is finalised, either by a court giving judgment or through negotiation of a settlement, the unsuccessful party in the action may be required to pay the costs or part of the costs that have been incurred by the successful party in bringing or defending the claim. These costs, referred to as party costs, could include barrister's fees, solicitor's costs, fees for various expert reports and court costs.

146. In any legal action the parties concerned are required to pay their legal advisers the solicitor client costs incurred and the supply of these legal services will attract GST and be GST inclusive sums to the extent that they are not GST-free. Both parties to a dispute, as recipients of a supply of legal representation respectively, may be entitled to an input tax credit for a creditable or partly creditable acquisition of these services.

147. For the purposes of this Ruling, we are concerned with the subsequent stage when the successful party is able to recover costs wholly or partly through a court order for costs or by negotiation of an amount in a settlement.

148. As we have seen for a supply to be a taxable supply the conditions under section 9-5 of the GST Act must be met. In the instance of the payment of costs under the court order or settlement there is no supply for consideration from the successful party to the unsuccessful party. This is essentially paying compensation for costs or losses incurred in the dispute and will be treated in the same manner as damages under paragraphs 110 and 111.

Your reimbursement of the other party's legal costs is not consideration for any supply made by the other party to you. The associated legal services were supplied to the other party; not you. This reimbursement is essentially payment of compensation for costs incurred by the other party in the dispute and is treated in the same manner as damages.

Payment of interest

Your payment of interest to the other party is not consideration for any supply it made to you. This payment is essentially payment of compensation for costs incurred by the other party.

In summary, none of the payment you made to the other party is consideration for a supply it or any other entity made to you. Hence, you did not acquire anything in return for the payment; and no taxable supply was made to you in return for the payment. Therefore, you have not satisfied the requirements of paragraphs 9-5(a), 9-5(b) or 9-5(c) of the GST Act. Hence, you have not made a creditable acquisition. Therefore, you are not entitled to an input tax credit where you paid the settlement amount.

Adjustment events

Paragraph 129 of GSTR 2001/4 provides that an out-of-court settlement could involve an adjustment event that triggers an adjustment.

An adjustment event could result in a decreasing adjustment that alters the GST liability on a supply.

Section 19-40 of the GST Act provides that you have an adjustment for a supply for which you are liable to pay GST if:

in relation to the supply, one or more adjustment events occur during a tax period, and

GST on the supply was attributable to an earlier tax period, and

as a result of those adjustment events, the previously attributed GST amount for the supply no longer correctly reflects the amount of GST (if any) on the supply (the corrected GST amount).

In accordance with paragraph 19-10(1)(a) of the GST Act, an adjustment event includes any event which has the effect of cancelling a supply.

In accordance with paragraph 19-10(2)(a) of the GST Act, the return to a supplier of a thing supplied is an adjustment event (whether or not the return involves a change of ownership of the thing).

Paragraph 16 of Goods and Service Tax Ruling GSTR 2000/19 discusses cancellation of a supply. It states

16. The cancellation of a supply or an acquisition is an adjustment event. Generally, the return of a thing, or a part of it, to a supplier is an adjustment event (whether or not the return involves a change of ownership). If, on the facts, the return does not have the effect of cancelling the supply, it will not be an adjustment event. For example, the return of a thing for repair or maintenance is not an adjustment event. In the case of exchange of goods, where the exchange does not result in a cancellation of the supply or a change in the consideration, it will not be an adjustment event. This will depend on the facts and the contractual arrangements between the parties.

Paragraph 17 of GSTR 2000/19 gives an example of a return of goods that amounts to an adjustment event. It states:

17. Acorp Pty Ltd supplies goods to Bcorp Pty Ltd and issues an invoice. Subsequently, Bcorp returns some defective goods and seeks a refund. On the agreement between the parties the return and associated refund cancels the supply to the extent of the returned goods. This is an adjustment event.

In your case, the other party returned defective goods to you and sought a refund. The return of the goods to you is an adjustment event under paragraph 19-10(1)(a) of the GST Act because it involves returning to a supplier a thing supplied, and the return and associated refund cancels the supply.

As a result of the adjustment event, the GST liability you originally had no longer correctly reflects the amount of GST on the supply (the corrected GST amount) because GST is payable on supplies, but your supply was cancelled.

In accordance with section 19-40 of the GST Act, you have a decreasing adjustment because:

· the return of the goods was an adjustment event

· you had a GST liability on your supply of the goods, which was attributed to an earlier tax period, and

· as a result of the adjustment event, the GST liability you had no longer correctly reflects the amount of GST on the supply (the corrected GST amount).

In accordance with section 19-55 of the GST Act, if the corrected GST amount relating to a supply you make is less than the previously attributed GST amount, you have a decreasing adjustment equal to the difference between the previously attributed GST amount and the corrected GST amount.

The decreasing adjustment in your case is equal to the GST liability you originally had, because the cancellation of the supply reverses the entire GST liability you originally had.

You will need to issue an adjustment note to Sain in order to make your decreasing adjustment.

Goods and Services Tax Ruling GSTR 2000/1 sets out requirements for preparing adjustment notes. This can be found on the ATO website, www.ato.gov.au or on an internet search engine.

You will report the decreasing adjustment at label 1B of the first activity statement that you lodge after you issue the adjustment note (in accordance with section 29-20 of the GST Act).

Where a supplier has a decreasing adjustment relating to a supply it made, the purchaser may have a corresponding increasing adjustment if it is registered for GST and its purchase of the thing supplied was a business expense. Such an increasing adjustment would effectively reverse the input tax credit (or part thereof) claimed by the purchaser. An increasing adjustment is reported at label 1A of an activity statement.

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