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Ruling

Subject: GST and security deposits

Question

Is the deposit received from the customer a security deposit for GST purposes?

Answer

Yes, the deposit received from the customer is a security deposit for GST purposes.

Relevant facts and circumstances

You are a manufacturer and distributor.

In many instances you are dealing with subcontractors or small business operators that you may have not have dealt with in the past or the project envisaged is significantly larger than anything they have ordered from you in the past and may not be able to justify a substantial increase in credit limit.

You have rigorous credit policies and processes and while you are keen to grow your business you are constantly reviewing credit worthiness of your existing and potential customers to minimize risk of bad debt write-offs and defaults by customers, particularly when customized product is involved.

Your customers may pay deposits which amount to up to 50% of the contract price. You maintain that because of the unique and highly customized nature of your products that you require a deposit as the products have a one-off application and if a default occurs you would not have a market for the product or the opportunity to on-sell, and would suffer a total loss on the product.

Given the cost of producing such unique and highly customized products is typically over 50% of the total sale price of the product, if default was to take place you would still incur a loss even after exercising your rights to the forfeited deposit.

You determine the amount or percentage of the deposit after taking into account the following:

§ whether or not this is a new customer

§ whether or not the customer is requiring a significant increase in credit limit

§ the uniqueness of the goods to be manufactured

§ unusual sizes or designs that render the product difficult or impossible to sell in the event of default

§ the use of special or unusual materials that could not be readily used on other jobs

§ the vulnerability of goods to loss in value

§ the industry or segment that the customer operates in or will be selling the good into - what is the strength of the ultimate customer, beyond the customer we are dealing with?

You have advised that if the customer fails to perform its obligations then the deposit will be forfeited. The customer understands that the goods are unique and highly customised, and a default will result in the loss of the deposit.

The terms and conditions of sale contain the following:

§ Once placed, no order may be cancelled by the customer except in writing and then only with your prior written consent, which you may withhold at your discretion and without being required to give a reason.

§ Quotations are subject to revision without notice. All prices quoted are exclusive of GST unless otherwise stated.

§ Title in the goods delivered remains with you until you have received payment in full of all money owing by the customer and if payment is not made by the due date you shall, without prejudice to any other remedies available to you, be entitled to retake possession of the goods and hold them until payment in full has been received or to resell the goods and to recover the deficiency on resale plus costs of repossession from the customer.

§ Payment for goods purchased from you must be on a cash with order basis, following which you will issue a tax invoice to the customer. However, if any approved account has been established with you, payment must be received by the last working day in the calendar month following the month in which you issue a tax invoice.

§ If the customer fails to pay the amount due to you on or before the due date, then you shall have the following rights in addition to any other rights you may have:

§ the customer shall indemnify you against all costs, losses and damages (including but not limited to legal costs on a solicitor/client basis, accounting costs and loss of profit) incurred or suffered by you as a result of such default end actions taken by you in respect of the same.

You advised that under the above terms and conditions there is no obligation to refund any deposit. If a deposit is received and the order cancelled by the customer you would in all probability pursue the customer for the balance of the agreed sale price plus GST. You are not aware of any instance where you had to refund a deposit or the order cancelled after receipt of a deposit and you consider this to be a remote possibility.

You provided a copy of an invoice for a deposit received. It sets out that the document is not a tax invoice and GST has not been included.

You provided a copy of Tax invoice showing the full value of the order, a deduction for the deposit previously paid and the GST on the total value of the order.

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 29-5.

A New Tax System (Goods and Services Tax) Act 1999 section 99-5.

A New Tax System (Goods and Services Tax) Act 1999 section 99-10.

A New Tax System (Goods and Services Tax) Act 1999 section 195-1.

Reasons for decision

Division 99 of A New Tax System (Goods and Services Tax) Act 1999 (GST Act) sets out special rules in relation to a deposit held as security for the performance of an obligation.

To fall within the provisions of Division 99 of the GST Act, the amount received by the supplier must be a 'deposit'.

The term 'deposit' is not defined in the GST Act. However, judicial decisions have indicated that the term 'deposit' has a particular meaning in a commercial context.

In Federal Commissioner of Taxation v. Reliance Carpet Co Pty Ltd (Reliance Carpet) [2008] HCA 22; (2008) 2008 ATC 20-028; (2008) 68 ATR 158 the High Court noted that the term 'deposit' had several aspects. These aspects include that a deposit: could be counted towards the payment of the purchase price; be brought into account in assessment of damages (however, the forfeiture of a security deposit is not a payment in the nature of damages or liquidated damages); be a token provided by the purchaser as 'an earnest to bind the bargain'; and provide a form of security for performance by the purchaser.

Goods and Services Tax Ruling GSTR 2006/2 discusses security deposits. This ruling has been amended in parts to reflect the decision made in the High Court decision in Reliance Carpet. Paragraph 20 of GSTR 2006/2 provides that for a payment to be considered a 'security deposit' for the purposes of Division 99 of the GST Act, it should have the following characteristics:

§ be held as a security for the performance of an obligation

§ the contract, conduct and intent of the parties to the contract must be consistent with the payment being a security deposit

§ be at risk of forfeiture upon failure to perform the obligation

§ be a reasonable amount.

Held as security

A security is held when it is paid to a person in the capacity of stakeholder. It is held for the benefit of the supplier to secure the recipient's obligations.

Paragraph 31 of GSTR 2006/2 states:

31. In analysing contracts, the courts have commonly described a deposit as an 'earnest' that is paid 'to bind the bargain'. A payment made as an earnest has been said to be 'a portion of something, given or done in advance as a pledge of the remainder'. This can be distinguished from paying the first instalment of the total price in a purchase contract, which is to be paid over a period of time, that is, an initial instalment payment, or a part payment.

Performance of an obligation

A security deposit is held to secure, or to act as a guarantee for the performance of the recipient's obligations under a contract. The nature of the obligations is usually dependent upon the intentions of the parties, as evidenced by the terms and conditions (express or implied) of a contract and the conduct of the parties.

Forfeiture

A security deposit must be at genuine risk of forfeiture. It is a fundamental requirement that the parties to a contract clearly understand at its commencement either through an express term, or by implication, that the deposit may be forfeited if the recipient fails to perform the secured contractual obligation. There must be a mutual intention by the contracting parties to make the deposit subject to forfeiture. If such an intention is not present, the deposit is not a security deposit.

Reasonable

The question of what is a reasonable amount for a security deposit under a purchase contract is considered in paragraphs 67-79 of GSTR 2006/2. Paragraph 72 of GSTR 2006/2 states:

72. What constitutes a reasonable amount for a deposit under a purchase contract depends upon the degree of risk to the supplier upon a breach or termination of contract by the recipient. If the supplier seeks a large security deposit, then that supplier needs to demonstrate that special circumstances exist.

The view of the Commissioner as stated in paragraph 77 of GSTR 2006/2 is that for a deposit of greater than 10% in a purchase contract to be accepted as a security deposit to which Division 99 applies, suppliers must be able to show that they are at higher risk of significant losses in the event of default.

Paragraph 78 of GSTR 2006/2 list some factors that may be taken into account in determining the reasonableness of an amount paid as a security deposit for a purchase contract:

§ duration of the contract and the time over which payment is to occur, as this may increase the risk of loss or devaluation or adverse conditions during that period

§ uniqueness of the goods or the process involved in the supply, including:

o unusual designs or sizes that render a complete product very difficult to sell in the event of default

o the use of special materials that could not be used on other jobs and

o the purchase of highly specialized equipment which could only be used in the performance of the contract at risk

§ the vulnerability of the goods to loss in value, or

§ other extraordinary conditions of the contract.

Paragraphs 83 and 84 of GSTR 2006/2 provide an example for special circumstances where a deposit is reasonable:

83. Xena is a specialist dressmaker from whom Alice has ordered her wedding dress. The material Alice has chosen is expensive and the design and colour of the dress is unusual. If Alice cancels her order for the wedding dress, Xena would find it difficult to find another buyer for the dress. As a consequence, Xena faces a significantly higher risk in the event of a default.

84. A sizeable deposit, approximately equal to one third of the total price of the dress, is paid by Alice when she places the order. This deposit is forfeited if Alice does not collect the dress. This deposit reflects the higher risk if the contract is not completed. In the special circumstances, the deposit is reasonable and is a security deposit.

Paragraph 37 of GSTR 2006/2 goes on to state that a deposit must be a deposit in more than name only. The paragraph states:

37. The fact that a certain payment is labelled a 'deposit' does not make it a security deposit at law. Whether a particular payment is a security deposit is a question of fact, determined by looking at the terms of the contract, and the intention of the parties to the contract.

Hence, the conduct, intent and contract between the parties must support that the payment is a security deposit.

In your case, your payment terms are 'cash on order' basis and the deposit received is accompanied by an order. You advised that the deposit is taken to secure the customer's obligation to complete the contract. Under the terms and conditions of the contract once an order is place, it may not be cancelled by the customer except in writing and then only with your prior written consent, which you may withhold at your discretion and without being required to give a reason.

You advised that under the terms and conditions there is no obligation to refund any deposit. Due to the uniqueness and highly customised nature of the products it is your mutual understanding that the amount is at risk of forfeiture in event of default by the customer.

You require a deposit of up to 50% of the sale price. You stated that this percentage is dependent on a number of factors including the uniqueness of the goods to be manufactured, the unusual sizes or designs and the use of special or unusual materials that could not be readily used on other jobs. You also advised that the cost of production is typically 60-70% of the total sale price. You further advised that if default was to take place, you will not have a market for the product or the opportunity to on-sell and you would still suffer a loss even after exercising your rights to the forfeited deposit. We consider that the amount calculated as a deposit is reasonable under the circumstances.

On the information provided, the amount you receive from the customer meets the characteristics of a security deposit for the purposes of Division 99 of the GST Act.

Attribution of the GST payable

Subsection 99-5(1) of the GST Act provides that if an amount is paid as a security deposit, it is not treated as consideration for a supply until it is either:

§ forfeited because of a failure to perform the secured obligation or

§ applied as all or part of the consideration for the supply.

Subsection 99-10(1) of the GST Act provides that the GST on a taxable supply for which the consideration is a security deposit is attributable to the tax period in which the security deposit is forfeited or applied as all or part of the consideration for a supply.

As the amount you receive from your customer is a security deposit, the GST payable on the taxable supply is attributable to the tax period in which the security deposit is forfeited or applied as part of the consideration for the supply.