Edited version of your written advice

Authorisation Number: 1051192153533

Date of advice: 24 February 2017

Ruling

Subject: Out-of-court settlement

Question 1

Are you entitled to claim GST credits in relation to a payment you made to settle court ordered costs?

Answer

No. You cannot claim GST credits in relation to the settlement of court ordered costs. This is because the payment under the settlement arrangement is not a payment for a supply made by the successful party to you and therefore it is not a taxable supply and it does not include GST.

Question 2

Are you entitled to claim a deduction in relation to a payment you made to settle court ordered costs?

Answer

No. You cannot claim the settlement costs as they are not sufficiently connected to your income earning activities as per section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Relevant facts and circumstances

You are registered for GST.

You were the plaintiff in proceedings in court relating to a business.

You issued a tax invoice to the business.

The court dismissed your causes of action and ordered you pay costs for the defendants.

The court found that the subject matter of the proceedings related to your exit from the business.

You paid an amount under an agreement to settle the costs so as to avoid further escalation of legal costs.

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 9-10.

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Question 1

GST registered entities can claim credits for GST included in the price they pay for things that they use in their enterprise or business. GST is only charged on taxable supplies.

Section 9-5 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) provides that 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 you carry on; and

(c) the supply is connected with the indirect tax zone; 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.

The term ‘supply’ is defined in section 9-10 of the GST Act. A supply can be 'any form of supply whatsoever' and includes a supply of goods or services. However, the payment of court ordered costs or costs negotiated in a settlement by an unsuccessful party to a successful party does not constitute a supply under section 9-10 of the GST Act. There is no supply made between the parties and the payment merely compensates the successful party for costs or losses incurred in the dispute. As there is no supply, a taxable supply has not occurred and therefore there are no GST consequences.

Goods and Services Tax Ruling GSTR 2001/4 Goods and Services Tax: GST consequences of court orders and out-of-court settlements outlines our view on the matter. Paragraphs 145 to 149 of GSTR 2001/4 provide:

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 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^F70 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.

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. It does not matter that the payment of the costs order or settled amount is made by an entity other than the unsuccessful party.

Paragraphs 153 to 155 of GSTR 2001/4 provide an example to illustrate the difference between a party’s own legal expenses and negotiated costs in a settlement:

Example - Registered entity

153. ABC Co, a registered transport company, sues for compensation for damages arising out of breach of a contract it has with a major retailer. Prior to any court proceedings being issued, a settlement is reached whereby the retailer agrees to pay the estimate of damages and a percentage of the costs incurred by ABC Co in bringing the action, for example, for the recovery of dishonoured cheque fees, costs of issuing a letter of demand, or court filing fees etc.

154. ABC Co is able to claim an input tax credit for the GST included in the fees charged by its legal representatives. The actual cost to ABC Co is a GST exclusive amount.^73A

155. As with a court ordered award of costs, the payment of costs to ABC Co under the settlement arrangements is not a payment for a supply made by ABC Co. It is a payment akin to damages and there is no GST liability for ABC Co arising from the receipt of the payment.

Conclusion

A payment under a settlement arrangement may relate to a specified or identifiable amount in relation to professional legal costs. For example, the professional legal costs of a successful party may include barrister’s or solicitor’s fees (which may have included GST). Those costs are in the nature of the types of costs referred to as party costs that are discussed in paragraph 145 of GSTR 2001/4 above.

Although the barrister’s and solicitor’s fees may be consideration for taxable supplies made by the respective barrister or solicitor to a defendant, from the perspective of an unsuccessful party, those supplies were not made to the unsuccessful party and that party did not provide the consideration.

As the unsuccessful party who negotiated a settlement of the court ordered costs awarded against you, the payment you made under the settlement is akin to damages. There is no supply made by the successful party to you and no GST is payable. You are therefore not entitled to claim GST credits in relation to the costs negotiated under the settlement.

For GST purposes, it is not relevant that the matters considered in the court proceedings included invoices you issued to the defendant. This does not affect the outcome of the decision.

Question 2

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature.

For settlement costs to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of the taxpayer's assessable income. Also, in determining whether a deduction for settlement costs is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the costs follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the costs incurred in gaining the advantage will also be of a capital nature.

Legal costs are generally deductible if they arise out of the day to day income earning activities of the taxpayer and the legal action has more than a peripheral connection to the taxpayer's income producing activities. It therefore follows that, if the action goes beyond the normal business related duties, then there may be doubt about the nexus with income earning activities and the character of the associated expense changes from income earning to being of a private, domestic or capital nature.

In your case, the settlement costs did not arise as a consequence of you conducting your day to day workings or income earning activities. You paid a settlement amount to the other party for legal costs they incurred plus interest. The subject matter of the court proceedings was the dispute between yourself and the other party regarding your exit from the business. The court proceedings did not relate to your day to day income earning activities. Consequently, the expenses are not incurred in gaining or producing assessable income and are capital in nature.

Given regard to the full circumstances, it is considered that the costs incurred in relation to the court proceedings and orders are capital in nature and not sufficiently related to the gaining or producing of assessable income. Accordingly no deduction is allowable under section 8-1 of the ITAA 1997 for the costs negotiated under the settlement.