Edited version of your written advice

Authorisation Number: 1051215905757

Date of advice: 20 April 2017

Ruling

Subject: GST and decreasing adjustment

Question 1

Are you entitled to a decreasing adjustment under section 78-10 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) for the Goodwill Payment paid to the Subcontractors as a result of the Settlement Agreement?

All further legislative references are to the GST Act unless specified otherwise.

Answer

No. You are not entitled to a decreasing adjustment under section 78-10 for the Goodwill Payment paid to the Subcontractors as a result of the Settlement Agreement

Question 2

Are you entitled to a decreasing adjustment under section 78-10 for the Settlement Payments paid to the Subcontractors as a result of the Settlement Agreement?

Answer

No. You are not entitled to a decreasing adjustment under section 78-10 for the Settlement Payments paid to the Subcontractors as a result of the Settlement Agreement

Relevant facts and circumstances

Background

● You provide general insurance products

● It is not contested that the requirements of subsection 78-10(2) are satisfied. That is:

● your supplies of general insurance policies are taxable supplies;

● the policyholders have either, no entitlement to an input tax credit for the premium paid in relation to the period during which the event giving rise to the claim happened, or an entitlement to such an input tax credit, but the amount of the input tax credit was less than the GST payable by the insurer for the taxable supply;

● you are registered for GST; and

● settlements under the insurance policies you provide do not relate to non-creditable insurance events.

Summary of relevant agreements

● Essentially, there are four parties involved in the transactions and payments at issue:

● You;

● Policyholders;

● Contractor; and

● Subcontractors.

The relationship between the parties is explained further below.

Contractual arrangement between you and policyholder

● You offer your customers a range of general insurance policies. One of these policies is household insurance, which is often combined with contents insurance.

● On payment of the relevant premium amount by the policyholder, there is a contractual arrangement (that is, an insurance policy) between that policyholder and you, under which you are obliged to settle any claim made, in accordance with the terms of the policy.

Contractual arrangement between you and Contractor

● Due to various reasons you determined that you required external assistance with the management of loss adjusting services and building management works.

● You therefore entered into a contractual agreement (Contractor Agreement) under which:

● Contractor would (on a non-exclusive basis) provide you with a combination of building management and loss adjusting services and, if required, contents management loss adjusting services (collectively, "the Services").

● In return for the provision of the Services, you would pay fees.

● Contractor was entitled to engage Subcontractors to assist with the work required.

● Contractor was entitled to submit its invoice to you for payment of the fees upon confirmation of the scope and the report estimate of repairs. Correspondingly, Contractor was obliged to make full and final payment to the Subcontractors.

● In performing the Services, Contractor was required to ensure that any Subcontractors involved in performing the Services:

● were adequately skilled and qualified; and

● performed the Services in such a manner as to promote the interests of you and your brand and to not cause embarrassment to you or bring your reputation into disrepute.

● All fees payable by you to Contractor under the Contractor Agreement have been paid and there are no outstanding fees. You have treated the fees paid to Contractor as consideration for creditable acquisitions under Division 11 for GST purposes.

Contractual arrangement between Contractor and Subcontractors

● In accordance with the Contractor Agreement, Contractor was required to engage, on its own behalf, any Subcontractors necessary to undertake some or all of the Services. Written contractual arrangements were entered into between Contractor and the Subcontractors. However, as you were not a party to those agreements, you are unable to provide any executed or proforma agreements.

● You did not engage any Subcontractors nor were any Subcontractors engaged on your behalf. Therefore, there is no contractual arrangement between you and Subcontractors in respect of the provision of the subcontracted services.

Voluntary administration of Contractor

● Pursuant to your obligations under the Contractor Agreement, and in good faith, you paid the fees that Contractor had progressively invoiced for.

● Contractor subsequently entered voluntary administration.

● During the voluntary administration process, it came to light that Contractor had not paid or passed on some of the fees to its Subcontractors, despite Subcontractors issuing invoices to Contractor for the work performed and Contractor's contractual and legal obligations under the Contractor Agreement and any agreement Contractor may have had with its Subcontractors.

● To this end, you wanted to ensure that policyholders continued to receive a high level of service, while recognising that your relationships with the Subcontractors was critical. More broadly, you wanted to ensure that your reputation as one of the most trusted brands

● Of paramount concern to you was the potential disruption to claim settlements caused by the Contractor voluntary administration and the potential for, as an example, Subcontractors to cease buildings works or, Subcontractors to undo works already performed. In this regard, you note that, under the relevant State laws, a Subcontractor who performs services over a certain value is, upon failure to be paid by Contractor, legally entitled to ask the home owner (in practically all cases, the policyholder) for full payment. If the policyholder fails to pay, then the Subcontractor would have the right to remove materials from the property used for the works as they have not been paid for. Therefore, payment by you made directly to the Subcontractors avoided the situation where the Subcontractors would be forced to pursue payment from policyholders and/or un-do the works provided.

● Accordingly, you hosted a meeting with all Subcontractors who had completed works, or were partway through completing works, in respect of an insurance policy claim and who were owed, or likely to be owed, money by Contractor. During this meeting, you:

● instructed the Subcontractors who had already been authorised to commence work by Contractor to continue the works and to issue their invoices to Contractor in accordance with the existing contractual arrangement;

● provided assurances to Subcontractors with outstanding invoices to Contractor that you would make arrangements to ensure the outstanding amounts were paid; and

● provided an assurance that any continuing or future work to be performed by a Subcontractor to complete work they had already been instructed to undertake under a contract with Contractor would be paid for.

● At this stage in the process, you had not formalised how you intended to honour your commitments made to Subcontractors.

● Contractor subsequently entered into liquidation.

"Goodwill Payments" and "Settlement Payments"

● Through your legal and accounting advisors, you have investigated various options to give effect to the desire to settle the existing insurance claims which involved works by the Subcontractors. You advise that it was considered not possible to make a direct payment to Subcontractors as this may have been subject to a clawback during the voluntary administration or liquidation process in order to pay other debts owed by Contractor which had priority (for example, employee entitlements). Thus, as a means to an end, a mechanism was developed whereby under agreements with each of the respective Subcontractors ("Settlement Agreements"):

● an affected Subcontractor would assign to you all of the Subcontractor's rights, title and interest in the debt owed to it by Contractor; and

● you would pay to the Subcontractor an amount equivalent to the debt which Contractor owes, or will owe following completion of the works instructed by Contractor (that is, there is no discount). This amount being the consideration for the assignment of the Subcontractor's rights, title and interest in the debts owed by Contractor is referred to as the 'Purchase Price' in the Settlement Agreements.

● Neither Contractor nor the Administrator were parties to any Settlement Agreement since the debt owed by Contractor remains unaffected. You have advised that the payments by you to Subcontractors under the Settlement Agreement fall within two categories:

Goodwill Payments

● These payments were for works completed by Subcontractors that were invoiced by the Subcontractors to Contractor. You have already been invoiced for, and paid, Contractor for these amounts under the Contractor Agreement. However, Contractor had failed to pass on these amounts to the Subcontractors. In an economic sense, these Goodwill Payments represent a double payment for the same works by you (once to Contractor under the Contractor Agreement and once to Subcontractors under the Settlement Agreement).

Settlement Payments

● These amounts were for works that were approved by Contractor, but not yet completed and invoiced to Contractor by the Subcontractors, as at the time Contractor went into voluntary administration. Thus, you have not paid Contractor any amount in respect of these claims.

● The terms of the Settlement Agreements do not distinguish the Purchase Price between a Goodwill Payment and Settlement Payment.

Other relevant points

● For your reporting purposes, the amounts paid to the Subcontractors under the Settlement Agreements were processed against the individual policyholders' claims. Furthermore, the payments as ex-gratia payments in your financial statements.

● You have advised that it is highly unlikely that you will recover any amounts from Contractor. However, regardless of whether you recover an amount from Contractor, the Subcontractors are entitled to keep all monies paid to them by you.

● Given that the policies are in respect of household insurance, it is expected that all policies relate to policyholders who have either no input tax credit entitlement or only a partial input tax credit entitlement.

Relevant legislative provisions

A New Tax System (Goods and Services Tax) Act 1999 (GST Act) - Section 78-10

Reasons for decision

Question 1

Are you entitled to a decreasing adjustment under section 78-10 for the Goodwill Payment paid to the Subcontractors as a result of the Settlement Agreement?

Decreasing adjustment under section 78-10

Subsections 78-10(1) and 78-10(2) provide that:

(1) An insurer has a decreasing adjustment if, in settlement of a claim under an insurance policy, the insurer:

(a) makes a payment of money; or

(b) makes a supply; or

(c) makes both a payment of money and a supply.

(2) However, this section only applies if:

(a) the supply of the insurance policy by the insurer was solely or partly a taxable supply; and

(b) either:

(i) there was no entitlement to an input tax credit for the premium paid in relation to the period during which the event giving rise to the claim happened; or

(ii) there was an entitlement to such an input tax credit, but the amount of the input tax credit was less than the GST payable by the insurer for the taxable supply; and

(c) the insurer settles the claim for a creditable purpose; and

(d) the insurer is registered, or required to be registered; and

(e) the settlement does not relate solely to one or more non-creditable insurance events.

In this case, it is not contested that the requirements of subsection 78-10(2) are satisfied.

When considering eligibility of claims under either Division 11 or Division 78, paragraphs 28 to 30 of Goods and Services Tax Ruling GSTR 2006/10 Goods and services tax: insurance settlements and entitlement to input tax credits (GSTR 2006/10) provide that:

28. If an insurer pays a supplier for providing goods, services or anything else to another entity in settling a claim under an insurance policy, then the insurer may be entitled to an input tax credit under Division 11 or, alternatively, a decreasing adjustment under Division 78.

29. When the insurer settles a claim and is entitled to an input tax credit under section 11-20, there is no entitlement to a decreasing adjustment under section 78-10. However, if the insurer has no entitlement to an input tax credit, a decreasing adjustment may be available.

30. It has been argued that an insurer may be eligible to both an input tax credit and a decreasing adjustment when settling a claim. Division 78 reflects the legislative purpose to give insurers decreasing adjustments on settlements to ensure that GST is only levied on the margin between insurance premiums and settlements. Consistent with that intention, the Commissioner considers that there is no entitlement to a decreasing adjustment where an insurance settlement gives rise to an input tax credit for the insurer.

With regard to claims eligible under Division 78, paragraph 33 of GSTR 2006/10 provides that:

33. If an insurer settles an insurance claim by way of payment of money to the insured or a third party, or reimburses the insured or a third party for costs incurred, or to be incurred, then the insurer may be entitled to a decreasing adjustment.

Importantly, the opening words to subsection 78-10(1) provide that a decreasing adjustment arises if the payment of money or supply or both payment of money and supply are made in settlement of a claim under an insurance policy.

Paragraphs 10 to 20 of Goods and Services Tax Determination GSTD 2011/1 Goods and services tax: is an ex gratia payment by an insurer in response to a claim under an insurance policy a payment made 'in settlement of a claim'? (GSTD 2011/1) discusses the meaning of the phrases 'a claim under an insurance policy' and 'in settlement of a claim' in the context of ex gratia payments. Those paragraphs are not reproduced in full here. However, those paragraphs provide that the phrase 'a claim under an insurance policy' means exercising a right, under a contract or statute, to remedy against loss, damage, injury or risk; and can also mean asserting, making a demand to, and a right, under a contract or statute, to such remedy. Those paragraphs also provide that an ex gratia payment, in the insurance context, may be made in settlement of a claim where the insurer is released from all liability in relation to the claim.

In this case, it is not contested that, an entitlement to input tax credits under Division 11 will not arise for you in relation to the Subcontractor services as you are not the recipient of such services. Furthermore, it is not contested that an entitlement to input tax credits under Division 11 will not arise for you in relation to your acquisition of the right, title and interest in debts from the Subcontractors as such acquisitions will not be creditable acquisitions where they are input taxed financial supplies to you (that is, they are not taxable supplies to you).

In this case, the Purchase Price that you provide to the Subcontractors (regardless of whether they are referred to as Goodwill or Settlement Payments for the purposes of this private ruling) is consideration for the assignment of the Subcontractor's rights, title and interest in the debts owed by Contractor. The Purchase Price is also not a third party payment by you to Subcontractors as consideration for the subcontracted services.

We agree with your opinion that for the Goodwill Payments to be seen as payments 'in settlement of a claim', there must be a reasonable connection or nexus between the payments made by you and the settlement of the policyholder's claims. However, based on the construct of the arrangement via an acquisition of rights, title and interest in the debts (as evidenced by the terms to the Settlement Agreement), we are of the view that the nexus between the payment of the Purchase Price and the settlement of the claim under an insurance policy is one that is remote and that the payment of the Purchase Price would, rather, have a more relevant association or nexus to the immediate acquisition of rights, title and interest in the debts as opposed to the settlement of the policyholders' claims despite the consequence of facilitating the completion of any unfinished subcontracted works that may be achieved through the acquisition of the debts.

Notwithstanding the above, we are of the view that from a policy perspective, 'payments of money' under Division 78 are required to be made to the insured or a 'third party' that is an entity that the insured has a liability to in respect of the insured event or incident which has given rise to the insurance claim. That is, the third party is an 'injured' third party to whom the insured has a liability which could have arisen from damage caused by the insured. This is supported by paragraph 8 of GSTR 2006/10 (which is not reproduced here) as well as clause 6.60 of the Revised Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 8) 2000 which provides that:

Settlements to injured third parties

6.60 Items 28 and 29 amend section 78-65 to clarify that it applies, as for section 78-70, to the situation where the insured has a liability to a third party. This could be because of damage caused by the insured to the third party, and the settlement from the insurer is made to enable that liability to be discharged.

We note your contention that any requirement for a payment to have been made to a third party is satisfied given the legislative framework relating to building works the relevant State which allows for a Subcontractor to have rights against a home owner. However, our view is that the existence of such rights does not necessarily result in a liability that the insured has to a Subcontractor. Accordingly, Subcontractors in this case would not be regarded as a third party in this context as Subcontractors are not 'injured third parties and are not owed a liability by the insured.

Furthermore, from a policy perspective, we note that GST on general insurance operates by applying GST to the insurer's value added which is essentially the difference between the amount of premiums collected and the amount of payouts made.

Division 78 has, since its original inception, been refined by introducing the 'decreasing adjustment mechanism' (DAM) to achieve greater administrative simplicity while retaining the same fundamental concepts underlying the original legislation and end result. This is achieved by eliminating the insurer's entitlement to input tax credits and the insured's liability to remit GST. Relevantly, for the DAM to operate as intended section 78-65 (amongst other provisions) was inserted to ensure that the making of any payment (or supply) by an insurer to a third party entity is not treated as consideration for a supply to the insurer by the entity in respect of a settlement. Specifically, section 78-65 provides that:

Payments etc. to third parties by insurers

(1) The making of any payment by an insurer to an entity is not treated as *consideration for a supply to the insurer by the entity, to the extent that:

(a) the payment is made in settlement of a claim under an *insurance policy under which the entity is not insured; and

(b) the payment is to discharge a liability owed to that entity by the entity insured.

(2) The making of any supply by an insurer to an entity:

(a) is not to be treated as a *taxable supply by the insurer; and

(b) is not to be treated as *consideration for a supply to the insurer by the entity, or any other entity;

to the extent that:

(c) the supply is made in settlement of a claim under an *insurance policy under which the entity is not insured; and

(d) the supply is to discharge a liability owed to that entity by the entity insured.

(3) This section has effect despite section 9-5 (which is about what are taxable supplies) and section 9-15 (which is about consideration).

Asterisked terms are defined at section 195-1.

As such, notwithstanding the above reasons concerning the third party being an injured third party, 'our view is that it would be contrary to the intended operation of Division 78 for a decreasing adjustment to arise under the Division if the payment of money in question, being the Purchase Price in this case, is in fact consideration for a supply, being the rights, title and interest in the debts. In this respect, it is also noted that section 78-10 does not apply to the making of 'acquisitions' by an insurer in settlement of a claim under an insurance policy and therefore an acquisition of debts by you cannot satisfy the requirements of section 78-10.

Notwithstanding the above, should it be arguable that the Goodwill Payments (which represent a double payment for the same set of works) are made in settlement of a claim under an insurance policy, our view is that a decreasing adjustment will not arise under Division 78 given your treatment of fees paid to Contractor as consideration for creditable acquisitions under Division 11 for GST purposes. The ATO's view on claims eligible under Division 11 or Division 78 is provided at paragraph 30 of GSTR 2006/10 as cited above.

In light of the above reasons, we are of the view that a decreasing adjustment will not arise for you under section 78-10 for the Goodwill Payments paid to the Subcontractors as a result of the Settlement Agreement.

Question 2

Are you entitled to a decreasing adjustment under section 78-10 for the Settlement Payments paid to the Subcontractors as a result of the Settlement Agreement?

In light of the reasons provided at Question 1 (with the exclusion of those pertaining specifically to Goodwill Payments only), we are of the view that a decreasing adjustment will not arise for you under section 78-10 for the Settlement Payments paid to the Subcontractors as a result of the Settlement Agreement.