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Ruling

Subject: GST and out-of-court settlements

Question

Are you entitled to claim input tax credits in respect of the payment of an amount in an out-of-court settlement.

Answer

No, you are not entitled to claim input tax credits in respect of the payment of an amount in an out-of-court settlement.

Relevant facts and circumstances

You operate a consultancy and you are registered for goods and services tax (GST).

You were previously employed by another consultancy operating a similar enterprise.

You signed an employment contract which included the following provision:

· upon termination of employment you were bound by 'non competition' provisions in the contract which included a restraint period and a restraint area.

You left your previous employment and established your own consultancy.

Prior to the end of the restraint period, a number of clients of your previous employer transferred their custom to your consultancy.

Your previous employer, as plaintiff, commenced an action for damages against you arising from breach of contract as it maintained that it had suffered loss and damage.

You and the plaintiff participated in mediation and reached a settlement. The relevant terms of the settlement included the payment of a specific sum of money and the filing of a notice of discontinuance of the action.

You and the plaintiff entered into the agreement and subsequently fulfilled the terms of the settlement.

You paid the settlement sum to the plaintiff but it has not issued an invoice to you.

You made a number of contentions.

GST was not mentioned in any of the Court documents provided to the ATO.

The plaintiff is registered for GST.

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 11-5

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

Reasons for decision

Summary

You did not make a creditable acquisition when you paid a sum of money to the plaintiff in accordance with the terms of settlement in an out-of-court order.

Consequently, you are not entitled to claim input tax credits in respect of that payment.

Detailed reasoning

Under section 11-20 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) you are entitled to claim input tax credits for any creditable acquisition you make.

Section 11-5 of the GST Act provides that you make a creditable acquisition if:

· you acquire anything solely or partly for a creditable purpose

· the supply of the thing to you is a taxable supply

· you provide, or are liable to provide, consideration for the supply, and

· you are registered, or required to be registered for GST.

To be entitled to claim input tax credits all of the above requirements must be satisfied.

Of relevance to this case is the requirement that the supply to the recipient must be a taxable supply.

A supply may be a taxable supply if it meets the requirements of a taxable supply as set out in section 9-5 of the GST Act which provides that you make a taxable supply if:

· you make the supply for consideration

· the supply is made in the course or furtherance of an enterprise that you carry on

· the supply is connected with Australia, and

· you are registered or required to be registered for GST.

However, the supply is not a taxable supply to the extent that it is GST-free or input taxed.

The first requirement to be satisfied in relation to a taxable supply is that there is a supply for consideration.

In this case a sum was paid in accordance with the terms of settlement agreed upon in an out-of-court settlement. You paid a sum of money to the plaintiff under the terms of settlement. Therefore, we need to determine whether this payment represents consideration for a supply made to you.

Goods and Services Tax Ruling GSTR 2001/4 provides guidance on determining the GST consequences of court orders and out-of-court settlements.

It provides an analysis of the concept of supply and consideration, and the nexus that must exist between a payment and a supply in order for there to be a 'supply for consideration'.

GSTR 2001/4 explains that supplies related to out-of-court settlements fall within one of three categories. These categories are:

· an earlier supply

· a current supply, and

· a discontinuance supply

There is also the possibility that the subject of a dispute is not a supply at all.

Paragraph 46 of GSTR 2001/4 states that an earlier supply is a supply between the parties that occurred before the dispute arose and in paragraph 47 it provides an example of a supply of widgets for which the vendor had not been paid.

You contend that the current situation is similar to and being required to pay for it. This analogy, if valid would characterise the supply as an earlier supply.

However, an analysis of the facts suggests that this analogy is not valid and that it is not an example of an earlier supply. Therefore, the payment is not related to an earlier supply.

A current supply is a new supply that is created by the terms of the settlement. An example of a current supply is provided in paragraph 49 of GSTR 2001/4. Here the defendant was using a trademark belonging to the plaintiff without permission. An agreement was reached to enable the defendant to use the trademark in the future provided that he paid for the right to do so.

In the above example, the plaintiff continues to own the trademark and the goodwill associated with it. However, in the current situation there is no current supply.

The third category is the supply related to discontinuance of action. Generally, the terms of settlement in finalising a dispute will ensure no further legal action in relation to that dispute. As in this instance, this involves you and the plaintiff releasing one another from the existing claims and from further claims and obligations in relation to the dispute.

Paragraph 54 of GSTR 2001/4 states that the Commissioner considers that these conditions of settlement can create supplies for GST purposes. These supplies may be characterised as:

· surrendering a right to pursue further legal action

· entering into an obligation to refrain from further legal action, or

· releasing another party from further obligations in relation to the dispute

In this instance, the parties to the dispute signed an agreement which would amount to a discontinuance supply. However, whether this is a taxable supply would depend upon whether the requirements of section 9-5 of the GST act are satisfied.

The amount you paid to the plaintiffs was agreed through mediation.

Paragraph 106 of GSTR 2001/4 provides that 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.

Following on from this, paragraphs 107 and 109 of GSTR 2001/4 explain that 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. This means that the supply is in the nature of a term of the settlement rather than the subject of it.

Accordingly, the payment of the sum agreed under the terms of the settlement would be in respect of the damages claim and it would not have a sufficient nexus with the discontinuance supply.

This means that the discontinuance supply will not be a taxable supply in these circumstances. GSTR 2001/4 provides further support for this view when it addresses the subject of damages at paragraphs 110 and 111.

The latter paragraph states that a payment made under an out-of-court settlement in respect of a claim for damages, and in the absence of either an earlier or current supply, will be treated as payment for the damages alone. It will not be regarded as consideration for a discontinuance supply.

In this instance there is a discontinuance supply which arises out of the fulfilment of the terms of the out-of-court settlement and it exists for the purpose of bringing finality to the dispute. There are no other supplies.

With no value ascribed to it, the discontinuance supply will not satisfy the requirements of a taxable supply as set out in section 9-5 of the GST Act. Therefore, the provisions for a creditable acquisition in section 11-5 of the GST will also not be met.

Accordingly, you did not make a creditable acquisition under section 11-5 of the GST Act and, as such, you are not entitled to claim input tax credits in respect of the payment made pursuant to the terms of settlement.