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Ruling

Subject: GST and out-of-court settlements

Question

Should GST be remitted to the ATO on a payment received as a result of an out-of-court settlement?

Answer

No, GST is not payable on settlement amounts as a result of an out-of-court settlement.

Relevant facts and circumstances

Entity A suffered significant damage during the floods in December 2010.

Entity A had been advised by its insurance broker that it was covered for flood damage. However when a claim was made to the insurance provider, the claim was rejected on the grounds that the cover was insufficient.

Entity A sought legal representation and commenced litigation against the insurance broker. Entity A obtained independent valuation for the flood damage it had suffered.

Prior to the commencement of the court proceedings, an out-of-court settlement was reached and an agreement was entered into with the insurance broker whereby the insurance broker paid Entity A a settlement sum based on the independent quotations Entity A had obtained in relation to the damage it had suffered.

As a result of the settlement agreement, Entity A discontinued all further action against the insurance broker.

Relevant legislative provisions

A New Tax System (Goods and Services Tax) Act 1999 Section 7-1 (1)

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

A New Tax System (Goods and Services Tax) Act 1999 Section 9-10

Reasons for decision

Under subsection 7-1(1) of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act), GST is payable on taxable supplies.

Under section 9-5 of the GST Act:

You make a taxable supply if:

(a) you make the supply for consideration;

(b) the supply is made in the course or furtherance of an enterprise that you carry on;

(c) the supply is connected with Australia; and

(d) 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.

Goods and Services Tax Ruling 2001/4 Goods and Services Tax: GST consequences of court orders and out-of-court settlements (GSTR 2001/4) provides guidance on the GST consequences resulting from court orders and out-of-court settlements. Paragraph 21 of GSTR 2001/4 relevantly states:

21. A 'supply for consideration' is the first step towards there being a taxable supply. However, for there to be a supply for consideration, three fundamental criteria must be met:

· there must be a supply …

· there must be a payment … and

· there must be a sufficient nexus between the supply and the payment for it to be a supply for consideration…

Supply is defined by section 9-10 of the GST Act as:

(1) any form of supply, whatsoever.

(2) Without limiting subsection (1), supply includes any of these:

…

(g) an entry into, or release from, an obligation:

(i) to do anything; or

(ii) to refrain from an act

…

The definition of supply is broad and with respect to an out-of-court settlement could include any of the supplies referred to in subsection 9-10(2) of the GST Act.

Paragraphs 46, 48 and 51 of GSTR 2001/4 states that supplies related to out- of-court settlements are characterised according to the following categories:

* an earlier supply - where the subject of the dispute is an earlier transaction in which a supply was made involving the parties; or

* a current supply - a new supply created by the terms of settlement; or

* a discontinuance supply - where the terms of settlement, in finalising a dispute, will ensure no further legal action in relation to that dispute, provided that the terms of the settlement are complied with. This often takes the form of a plaintiff releasing a defendant from some (or all) of the existing claims and from further claims and obligations in relation to the dispute.

Entity A and the insurance broker agreed to settle the dispute in relation to the insurance broker failing to arrange appropriate insurance for Entity A.

Under the terms of the settlement, Entity A agreed to accept the payment in full and final satisfaction of its claim and on the facts of this case, there are no supplies which would come within the scope of a current supply or earlier supply. Therefore of relevance in this case is a discontinuance supply.

Discontinuance supply

Paragraph 54 of GSTR 2001/4 characterises a discontinuance supply as:

(i) surrendering a right to pursue further legal action

[paragraph 9-10(2) (e) of the GST Act]; or

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

[paragraph 9-10(2) (g)]; or

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

[paragraph 9-10(2) (g)]

Entity A took action against the insurance broker for failing to arrange appropriate insurance to cover it for a flood event. An out-of-court settlement was reached whereby the insurance broker agreed to pay Entity A a settlement sum. As per the terms of the settlement, Entity A agreed to discontinue any legal proceedings and to give up its legal right to pursue present and future claims, actions and causes of action against the insurance broker relating to the dispute.

In this instance, there is no earlier supply or current supply relating to the payment the insurance broker makes to Entity A. Rather the dispute was finalised when Entity A surrendered its rights and entered into obligations to abide by the terms of the settlement. Therefore, the only supply arising from the settlement of the dispute is in the nature of a discontinuance supply.

For a supply to be a taxable supply, the supply must be made for consideration.

In GSTR 2001/4, the Commissioner states that the subject of the dispute may not give rise to a supply at all. Paragraphs 71-73 of GSTR 2001/4 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.

Paragraphs 106 and 107 of GSTR 2001/4 relevantly state:

Discontinuance supply

106. Where the only supply in relation to an out-of-court settlement is a 'discontinuance' supply, it will typically be because the subject of the dispute is a damages claim. In such a case, the payment under the settlement would be in respect of that claim and not have a sufficient nexus with the discontinuance supply.

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.

The Commissioner's further view on damages is relevantly stated in paragraphs 110 and 111 of GSTR 2001/4.

Damages

110. With a dispute over a damages claim, the subject of the dispute does not constitute a supply made by the aggrieved party. If a payment made under a court order is wholly in respect of such a claim, the payment will not be consideration for a supply.

111. If a payment is made under an out-of-court settlement to resolve a damages claim and there is no earlier or current supply, the payment will be treated as payment of the damages claim and will not be consideration for a supply at all, regardless of whether there is an identifiable discontinuance supply under the settlement.

The dispute arose in relation to the insurance broker failing to arrange appropriate insurance to cover Entity A for a flood event. The dispute was settled by the parties under the terms of the settlement where a settlement sum was paid by the insurance broker to Entity A.

For a supply to be a taxable supply and therefore subject to GST, the conditions under section 9-5 of The GST Act must be met. The payment of the settlement amount from the insurance broker was not consideration provided to Entity A for a supply of goods or services by Entity A. Rather, it was a payment of damages to compensate Entity A for the lack of insurance cover as arranged by the insurance broker. That is, there was no supply from Entity A and no consideration from the insurance broker to Entity A as a result of the out-of-court settlement. The payment of the settlement sum is regarded as payment of a damages claim and is not considered to be consideration for a taxable supply.

The requirement of a supplier making a supply for consideration under paragraph 9-5(a) of the GST Act is not satisfied.

Therefore the payment by the insurance broker to Entity A of the settlement sum is not subject to GST.