Edited version of your private ruling

Authorisation Number: 1012608172372

Ruling

Subject: GST and out-of-court settlements

Question 1

How much GST is payable under section 9-40 of the A New Tax System (Goods and Services Tax) Act 1999 on the settlement payment received?

Answer

The GST payable on the settlement payment received is calculated with reference to the elements of the settlement.

Relevant facts and circumstances

The entity entered into a Deed with another entity to provide loan introduction and management services.

The services provided by the entity to the second entity were taxable supplies and the second entity provided recipient created tax invoices in relation to these services.

From a specified date the entity ceased originating new loans for the second entity however the entity continued to receive management fees in relation to existing loans funded by the second entity.

A dispute arose between the entities in regard to the services provided by the entity and the amounts paid by the second entity. The dispute involved:

A Dispute Analysis report prepared for the entity provides a summary of the estimation of the value forgone by the entity.

The parties entered into a deed of release and settlement and termination of the Deed (Settlement Deed) to resolve the dispute. Under the Settlement Deed, the second entity agreed to pay an amount to the entity.

A consequence of the Settlement Deed is that the Deed was terminated.

The Settlement Deed also released both parties from further legal action.

Relevant legislative provisions

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

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

Reasons for decision

Section 9-40 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) provides that you are liable to pay the GST on any taxable supply that you make. Section 9-5 of the GST Act provides that one of the requirements for a taxable supply is that 'you make the supply for consideration'.

GSTR 2001/4 explains that a supply related to an out-of-court settlement may have occurred prior to the settlement (which may have been the subject of the dispute), or it may be created by the terms of the settlement itself. There may be more than one supply that is related to a settlement. It further explains that supplies made by parties in an out-of-court settlement may be described as:

• Earlier supplies - where the subject of the dispute is an earlier transaction in which a supply was made involving the parties, that supply is referred to in this ruling as an 'earlier supply';

• Current supplies - where a new supply is created by the terms of the settlement agreement;

• Discontinuance supplies - Generally, the terms of a settlement will ensure no further legal action in relation to that dispute, provided that the terms of the settlement are complied with.

The terms of the settlement in conjunction with any prior agreements will determine whether or not either party has made supplies and whether there is a sufficient connection between a settlement amount and the supply for the payment to be consideration for a supply. As explained from paragraph 115 of GSTR 2001/4, where a settlement payment relates to different parts of a settlement agreement, it will need to be separated into the separate elements:

115. Where payment made under a court order or out-of-court settlement has a sufficient nexus with more than one supply, with one or more supplies being taxable and one or more being GST-free or input taxed, the payment will be for each of the relevant parts. This will also be the case where the payment is partly for an item of damages which is not a supply.

…

117. In the case of an out-of-court settlement, where the terms of the settlement include a dissection and itemisation of the payment into the heads of claim, that itemisation will be accepted as representing the amounts of these relevant parts to the extent that it is made on a reasonable basis.

118. Where no dissection is made, even though the payment has a sufficient nexus with more than one supply, or to a supply and an item of damages which is not a supply, the payment should be apportioned into amounts representing these relevant parts in order that the correct GST consequences result.

119. The apportionment should be determined by the parties on a reasonable basis. Where a payment is apportioned in a manner that cannot be justified in terms of reasonableness, the general anti-avoidance provisions of the GST Act may have application.

There are several elements to the Settlement Deed which must be considered. They are:

• the underpayment of management fees and other entitlements to the entity under the Deed;

• costs incurred by the entity;

• economic loss (diminution) suffered by the entity;

• termination of the Deed;

• interest on underpayments or overpayments;

• discontinuance of the claims

• apportionment of the settlement payment

Management fees

Under the terms of the Deed, the entity was required to 'introduce' prospective borrowers and 'manage' previously settled loans. For all settled loans that the entity managed, a management fee calculated under the Deed was payable, provided the loan was not in default.

The management fees are consideration for an earlier supply of services by the entity.

The main matter of the dispute is the earlier supplies and more specifically, the amount of consideration paid by the second entity for the acquisition of those earlier supplies. Therefore, the payment made under the Settlement Deed has a direct relationship to these earlier supplies.

A specified amount of the settlement payment directly relates to the underpayment of the management fees and is consideration for the taxable supply of management services provided by the entity.

Costs Incurred by the entity

As explained at paragraphs 148 - 149 of GSTR 2001/4, a settlement payment made in relation to costs incurred by a party is not consideration for a supply:

148. … 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 ….

149. Accordingly, the payment of court ordered costs or costs negotiated in a settlement in the circumstances described will not be consideration for an earlier or current supply….

Therefore, the part of the settlement payment which relates to costs incurred by the entity is not consideration for any supply made by the entity.

Economic Loss

As explained at paragraph 73 of GSTR 2001/4, economic loss claimed to be suffered by the entity is not a supply:

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…

A significant part of the claim made by the entity is that it has suffered economic loss as a result of the alleged actions by the second entity and/or alleged breaches of the Deed. The Dispute Analysis has attempted to value the total economic loss incurred by the entity.

The Dispute Analysis states that the entity has incurred 'marginal administration costs'. It is understood that these are additional costs for internal administration that the entity would not have otherwise incurred. As such, these administration costs are damages in nature.

The part of the settlement payment which relates to economic loss or damages is not consideration for any supply made by the entity and is not subject to GST.

Termination of the Deed

Provided that no default event has occurred, the Deed provides that the entity will continue to receive fees for as long as the entity manages a settled loan. However the Deed can be terminated by the second entity , in which case compensation based on the 'market value of the management rights for the relevant settled loan' is payable to the entity.

Under the Settlement Deed, the Deed is terminated and all rights and obligations of both parties (with some exceptions) are terminated. That is, the entity is not entitled to be compensated for the market value of the management rights.

It is reasonable to suggest that part of the settlement payment made under the Settlement Deed relates to the termination of the Deed. This is because the Deed had value in the hands of the entity prior to its termination.

However, the part of the settlement payment which relates to the termination of the Deed will only be subject to GST if it is consideration for a supply that MAS makes. Section 9-10 of the GST Act defines 'supply' as 'any supply whatsoever' and includes:

• a supply of goods;

• a supply of services;

• a provision of advice or information;

• …

• an entry into, or release from, an obligation:

• to do anything; or

• to refrain from an act; or

• to tolerate an act or situation;

The termination of the Deed may be a supply by the entity of the release from the obligations imposed under the Deed. GSTR 2009/3 discusses the GST consequences of paying cancellation fees upon the termination of a contract and, at paragraph 52, states:

52. … the parties to the contract may enter into another contract under which one party (usually the supplier) upon payment of a cancellation fee agrees to release the other party (usually the customer) from performing the latter's obligations under the original contract.

Paragraphs 64 - 65 of GSTR 2009/3 state the Commissioner's view that an amount paid when a contract is terminated may be consideration for a supply even though it is described as 'damages':

64. … The fact that an amount paid in relation to a cancelled arrangement might be described as 'damages', a 'penalty' or 'compensation' does not mean that the amount is not thereby consideration for a supply. An amount can have both the character of damages, a penalty or compensation and also be consideration in connection with a supply.

65. Regardless of whether an amount paid or payable is damages as properly understood (whether it is paid or payable under a liquidated or agreed damages clause or otherwise), the fundamental question to be answered in an Australian GST context is whether the amount is consideration for a supply. The classification of an amount as consideration for a supply or as damages is to be made in accordance with Goods and Services Tax Ruling GSTR 2001/4 Goods and services tax: GST consequences of court orders and out-of-court settlements.

By entering into the Settlement Deed, the entity has agreed to the termination of the Deed and the release of the second entity to any and all of its obligations under it. Had the parties chosen, the Deed could have continued or been terminated under the relevant clause of the Deed. Had the Deed been terminated by operation of the termination clause within the Deed, the second entity would have been required to make a compensation payment to the entity upon termination of the Deed. That compensation payment would have been consideration for either the earlier supplies by the entity (of introducing the borrower to second entity) or consideration for the current supply of the release from future obligations (to continue paying the management fees for as long as the loan continues). The compensation payment is consideration for either of these supplies which would have been taxable supplies under section 9-5 of the GST Act.

The part of the settlement payment which relates to the termination of the Deed is not a payment of damages but is consideration for a taxable supply made by the entity and is subject to GST.

Interest

GSTD 2003/1 discusses the GST consequences arising from a court order which includes an interest component. GSTD 2003/1, which is based on the principles outlined in GSTR 2001/4 explains that pre and post-judgement interest is not consideration for an earlier supply. Therefore, any part of the settlement payment which relates to interest is not consideration for a supply and is not subject to GST.

Discontinuance

The Settlement Deed contains clauses which release both parties from any further legal action (with some minor exceptions). As explained at paragraph 54 of GSTR 2001/4, this may be a supply:

54. We consider that these conditions of settlement can create supplies for GST purposes. The supplies may be characterised as:

(i) surrendering a right to pursue further legal action ; or

(ii) entering into an obligation to refrain from further legal action ; or

(iii) releasing another party from further obligations in relation to the dispute .

However, GSTR 2001/4 concludes that there will generally not be consideration for any discontinuance supply and, at paragraph 107, states:

107. 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.

…

109. We consider that a payment made under a settlement deed may have a nexus with a discontinuance supply 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.

There is no part of the settlement payment directly which relates to any discontinuance supply made by the entity.

Apportionment

As mentioned above, paragraph 118 of GSTR 2001/4 explains that the settlement payment must be apportioned into amounts representing the relevant parts of the settlement in order to determine the GST consequences of the settlement. As discussed above, the Settlement Deed results in payment being provided for the following:

• earlier taxable supply of introduction services ;

• costs incurred by the entity;

• economic loss suffered by the entity;

• supply made by the entity as a consequence of the termination of the Deed; and

• interest components.

An apportionment methodology that is fair and reasonable will attempt to evaluate the elements of the settlement and allocated portions of the settlement payment to those elements in a manner that recognises the value relative to the other elements.

It is not appropriate to use an apportionment methodology which allocates the settlement amount based on the claim made by the entity. This is because the claim is not accepted by the second entity as being correct and therefore, the settlement is not based on that claim. Furthermore, as the proposed apportionment methodology does not assign any amount to the termination of the Deed, it is not fair and reasonable.

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