Edited version of private advice

Authorisation Number: 1051716166885

Date of advice: 10 July 2020

Ruling

Subject: Out-of-court settlement payment

Issue 1 - Income Tax

Question 1

Is a settlement payment to a supplier being a lump sum amount equal to what would otherwise be payable on a monthly basis over five years under an existing supply agreement an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Issue 2 - GST

Question 1

Is the lump sum payment a taxable supply under section 9-5 of A New Tax System (Goods and Services Tax) Act 1999 (the GST Act)?

Answer

Yes

This ruling applies for the following period:

1 July 2017 to 30 June 2018

The scheme commences on:

1 July 2017

Relevant facts and circumstances

You provide onsite diesel refuelling for clients.

You entered into an agreement with Entity A for the supply of diesel.

The agreement was for a fixed period with a further two options, each of a fixed period.

The agreement stipulated a minimum supply volume per annum at the commencement of the agreement with minimum volume increasing by a percentage amount annually thereafter.

The agreement between you and Entity A became uncompetitive as you were able to source supply from alternative suppliers at a lower price.

As the first fixed period was approaching an end, you verbally advised Entity A that the option for a further fixed year period would not be exercised. However, the agreement stipulated termination of the agreement must be advised in writing.

Entity A did not respond to the notification of the option not being exercised until a particular legal contractual date had passed and subsequently maintained that you had not validly terminated the arrangement.

Entity A claimed that as you did not advise them in writing of ending the agreement with them, the automatic renewal clauses were valid and applied.

Entity A lodged a claim against you for failure to purchase the minimum annual volume contained in the agreement. The initial sum claimed by Entity A was in excess of an amount being the minimum annual volume over the next two fixed periods. The claim assumed the two fixed periods would be exercised.

Through discussions, it was eventually reduced to an amount over one fixed period. You accepted this figure as a result of independent legal advice that there appeared a reasonable prospect that Entity A would succeed in enforcing the contractual terms of one fixed period.

Entity A gave a notice requiring you to pay the Low Volume Fee amount by a specific date.

You did not pay the Low Volume Fee to Entity A by the specific date.

Entity A lodged a claim in a Court against you for failure to purchase the minimum annual volume for each petroleum product for each volume period entitling Entity A to require you to pay the Low Volume Fee.

Entity A requested that you obtain a bank guarantee for an amount in favour of Entity A in respect of the performance of your obligations under the agreement.

In accordance with the agreement, you obtained a bank guarantee from your bank for an amount in favour of Entity A in respect of its performance of its obligations under the agreement for a specified period.

Entity A enforced a bank guarantee and made a demand for an amount to your bank for failure to maintain the minimum purchase agreements. The bank paid the amount to Entity A.

You alleged the enforcement of the full bank guarantee was unreasonable and far exceeded the loss to Entity A.

You demanded repayment of the amount from Entity A. Entity A did not repay this amount.

A supply of petroleum was not received by you as a result of this payment to Entity A.

An out-of-court settlement was finally reached. You agreed to allow Entity A to retain the bank guarantee amount already drawn and cease further legal action. Due to independent legal advice, there appeared a reasonable prospect that Entity A would succeed in enforcing the contractual terms for one option period.

As a result of the out-of-court agreement, it was agreed between the parties without any admission of liability to settle all claims and counterclaims for the amount already paid to Entity A. Both parties were released from their respective agreements.

The settlement was disclosed to your bank as well as your auditors.

The monies withdrawn were reported in the relevant financial report.

Your financial report was unqualified for the relevant income year.

You did not claim a tax deduction for the amount as a result of the out-of-court settlement payment.

Both entities are registered for GST.

The supply of diesel was wholly domestic.

Relevant legislative provisions

section 8-1 of the ITAA 1997

section 9-5 of the GST Act

section 9-15 of the GST Act

Reasons for decision

Issue 1 - income tax

Question 1

Summary

The settlement lump sum payment that you paid to Entity A represents the amount that would have been paid to your supplier under the agreement for low value supply over the second fixed period.

The amount arose because of an error in giving notice under the agreement. However it arose as part of the businesses normal operations and was incurred in producing assessable income. It is considered to be an operating expense.

As such the payment is an expense from carrying on a business that is not capital, domestic, or private in nature and which is an allowable deduction under section 8-1 of the ITAA 1997.

Detailed reasoning

Subsection 8-1(1) of the ITAA 1997 allows a deduction for any loss or outgoing to the extent that (a) it is incurred in gaining or producing assessable income or (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

However, subsection 8-1(2) of the ITAA 1997 provides that a loss or outgoing is not deductible to the extent that it is capital or of a capital nature; of a private or domestic nature; incurred in relation to gaining or producing exempt income or non-assessable non-exempt income; or a provision of the ITAA 1997 prevents its deduction.

Incurred in producing assessable income

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, when 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.

Settlement 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.

However, where the expenditure is devoted towards a structural rather than operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v FC of T (1938) 61 CLR 337; 5 ATD 87).

Paragraphs 66-68 of Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues provides:

66. The classic test for determining whether expenditure is of a capital or revenue nature which is explained in the judgment of Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CRL 337; (1938) 5 ATD 23; (1938) 1 AITR 403 (Sun Newspaper):

His Honour said at 363:

There are, I think, three matters to be considered,(a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

67. The character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure as it says the most about the essential character of the expenditure itself. This was emphasised in the decision of the High Court in G.P. International Pipecoaters v Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATC 4413; (1990) 21 ATR1.

68. If expenditure produces some asset or advantage of a lasting character for the benefit of the business it will be considered to be capital expenditure. As stated in Sun Newspaper at 355 per Latham J, an enduring benefit does not require that the taxpayer obtain an actual asset, it may be a benefit which endures, in the way that fixed capital endures. Menzies J in John Fairfax & Sons Pty Ltd v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 11 ATD 510; (1959) 7 AITR 346 concluded that a capital expense can also result in the reduction of capital. In Foley Brothers Pty Ltd v. FC of T (1965) 13 ATD 562; (1965) 9 AITR 635, outgoings incurred for the purpose of altering the organisation or structure of the profit-yielding subject (including its demise) were considered to be of a capital nature.

In your case the out-of-court settlement payment that you paid to your supplier represents the amount that you would have to pay to your supplier under the agreement for low value supply over the next fixed period. Your normal business operations caused you to incur this amount under your existing agreement. Had a decision been made not to purchase from your supplier over the next fixed period this amount would have accordingly been an operating expense and deductible.

While the amount arose because of an error in giving notice under the agreement, it still arose as part of the business's normal operations.

Entity A enforced a bank guarantee and made a demand to your bank under the agreement of which the bank paid the amount to Entity A. This payment arose as a result of a dispute between Entity A and yourself regarding the failure to acquire the minimum volume supply of petroleum and whether a valid exercise of an option to extend the agreement period was valid.

It was after this date that the out-of-court settlement payment which you agreed to was taken to be the amount already paid to Entity A. This agreement was part of your continuing business operations to cease the contract with Entity A and any obligation to Entity A, and continue to source diesel for your business with more favourable suppliers.

The Commissioner has given regard to the full circumstances. It is considered that the expense incurred in relation to the out-of-court payments are related to the gaining or producing of your assessable income because:

• the obligation to pay the low value supply fee arose out of your normal business operations,
• the decision to cease the contract of supply with Entity A arose out of your normal business operations to source the best price, and
• had a decision been made not to purchase fuel over the next option period this amount would have accordingly been an operating expense and deductible.

The Commissioner does not believe the payment represents a capital amount because it lacks the following features:

• the amount is not in relation to a part of the businesses structure and does not secure any type of enduring benefit that goes toward the business structure
• it was not a payment to cancel or terminate the contract, it was the amount that was required as the low volume fee that was due and payable under the agreement. This amount could have been payable had the business continued to operate and not purchase the required amount; it would have given the same outcome as is currently the case whereby the business wanted to cease the agreement and failed to give the required written notice.
• the taxpayer has not ceased business from the requirement to pay the amount such that it had substantial importance to the business
• the low volume fee appears to be aimed at ensuring there is an incentive for a certain volume of fuel ordered, and as such it is involved primarily with sales and profit yielding rather then the structure of the business itself.

As such the Commissioner believes that the payment is not capital, private or domestic in nature. The payment does not relate to exempt income.

Conclusion

Accordingly a deduction is allowable under section 8-1 of the ITAA 1997 for the payment of the out-of-court settlement as it has been incurred in producing ordinary income of the business. It is considered to be an operating expense.

Issue 2 - GST

Question 1

Summary

The payment is consideration for a taxable supply under section 9-5 of the GST Act.

Detailed reasoning

GST registered entities can claim input tax credits for the creditable acquisitions they make. GST is only charged on taxable supplies. An entity is liable for GST on any taxable supplies that they make.

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

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

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

The term 'supply' is defined in section 9-10 of the GST Act.

Subsection 9-10(1) of the GST Act defines supply as 'any form of supply whatsoever'.

Subsection 9-10(2) of the GST Act states in part:

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

...

(a)   a creation, grant, transfer, assignment or surrender of any right

(b)   a financial supply

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

(i)     to do anything,

(ii)    to refrain from an act, or

(iii)  to tolerate an act or situation

...

Consideration is defined in subsection 9-15(1) of the GST Act to include any payment, act or forbearance in connection with, in response to or for the inducement of a supply of anything.

The supplies in the current out-of-court settlement

Goods and Services Tax Ruling Goods and services tax: GST consequences of court orders and out-of-court settlements (GSTR 2001/4) deals with the GST consequences of court orders and out-of-court settlements and discusses the meaning of supply. According to GSTR 2001/4, a supply related to an out-of-court settlement may have occurred prior to the settlement or it may be created by the terms of the settlement itself. There may be more than one supply that is related to a settlement and in addition, the subject of the dispute may not be a supply at all.

In particular, GSTR 2001/4 explains that supplies related to out-of-court settlements fall into three types. These are:

- earlier supply

- current supply

- discontinuance supply.

Earlier supplies are supplies made prior to the out-of-court settlement and where both the supplier and the recipient have some dispute regarding the supplies.

Current supplies are supplies created by the terms of the out-of-court settlement.

A discontinuance supply is, according to paragraph 54 of GSTR 2001/4:

           (i)     surrendering a right to pursue further legal action [paragraph 9-10(2)(e) of the GST;

         (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)].

In finalising a dispute, a settlement will generally ensure there is no further legal action in relation to that dispute. Such a settlement could be the plaintiff releasing a defendant from some (or all) of the existing claims and from further claims and obligations in relation to the dispute. Therefore a discontinuance supply could arise.

In the current case, there is an earlier supply pursuant to the agreement which is the subject matter of the dispute between you and the supplier. Therefore this earlier supply is said to be related to the out-of-court settlement.

In addition, the out-of-court agreement provides Entity A and yourself respectively release each other from the existing claims or allegations where the terms of the out-of-court agreement are complied with. Furthermore, you both acknowledge and confirm the agreement was terminated by a specific date and no longer binding on either party. Also, under out-of-court agreement you will pay a settlement sum to Entity A with no admission of liability.

These terms of the out-of-court agreement have created a discontinuance supply in accordance to paragraph 54 of the GSTR 2001/4 which is discussed above.

Supply for consideration

Section 9-15 of the GST Act provides that a payment will be consideration for a supply if the payment is 'in connection with' a supply and 'in response to' or 'for the inducement' of a supply. There must be a sufficient nexus between a particular supply and a particular payment, which is provided for that supply, for there to be a supply for consideration.

There are two elements to the definition of consideration. The first is the payment by one entity to another and the second is the nexus that must be established between the payment and a supply.

In the present case, you have paid a settlement payment. The payment was paid pursuant to the terms of the out-of-court agreement which settled the dispute arose from the earlier supply under the agreement, the terms of the out-of-court agreement also created a discontinuance supply. As such the payment can be said to have a connection with both of these two supplies.

It is unclear from the terms of the out-of-court agreement as to the dissection or itemisation of the settlement lump sum payment. Therefore the extent to which the settlement lump sum relates to each supply is unknown.

Consistent with our finding that the settlement lump sum payment that you paid to your supplier represents the amount that you would have to pay to your supplier under the agreement for low value supply over the next option period, it is our view that the settlement lump sum payment has a sufficient nexus between the earlier supply under the agreement. As such, we consider that the settlement lump sum is consideration for the earlier supply.

Conclusion

The earlier supply made by the supplier would be a taxable supply as requirements in section 9-5 of the GST Act are satisfied thus the settlement lump sum is consideration for a taxable supply.

It is worth to point out that in the present case, whether the settlement lump sum relates to the earlier supply or the discontinuance supply does not change the GST outcome because both supplies will be taxable supplies.