Edited version of private advice

Authorisation Number: 1051925785952

Date of advice: 24 January 2022

Ruling

Subject: Deductions - rectification costs

Question 1

Are you entitled to a deduction for rectification costs you incurred?

Answer

Yes

Question 2

Is there a GST component to the rectification cost?

Answer

No

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You carry on a business as a builder.

You were contracted on XX XXX XX to construct a house for a client.

On XX XXX XX you poured the concrete slab.

The client claimed the slab was defective and took you to court to seek rectification costs.

The client was successful and you were ordered to pay $XXXX in rectification costs.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

A New Tax System (Goods and services Tax) Act 1999 section 9-5

A New Tax System (Goods and services Tax) Act 1999 section 9-40

Reasons for decision

Question 1

Summary

You are entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the value of rectification costs incurred in laying a slab for a client, as the expense is incidental and relevant to your earning of assessable income and are not capital in nature.

Detailed reasoning

Section 8-1 of the ITAA 1997 provides that you can deduct from your assessable income any loss or outgoing that you incur in gaining or producing your assessable income. However, you cannot deduct a loss or outgoing under this provision to the extent that it is capital, private or domestic in nature, or incurred in earning exempt income. For a deduction for rectification costs to be allowed, the expenses must be incidental and relevant to the production of a taxpayer's assessable income and have arisen as a consequence of the taxpayer's income earning activities.

You incurred the rectification costs in your capacity as a builder. The requirement for you to pay these costs arose out of laying a concrete slab when constructing a house for a client for the purposes of producing assessable income. Therefore, it is accepted that there is a connection between your rectification costs and your income. As a general principle, it also follows that the treatment of a damages payment, such as rectification costs, will follow the taxation treatment of legal expenses incurred in relation to the particular matter.

In your circumstances, there is a relevant connection between your earning of assessable income and the rectification costs. Also, the expenditure did not produce any enduring benefit and consequently is not capital in nature. Therefore, you are entitled to a deduction under section 8-1 of the ITAA 1997 for the rectification costs incurred as a result of the slab being found defective.

Additional information

Any insurance proceeds received in relation to this incident would be included in your assessable income as an assessable recoupment under section 20-20 of the ITAA 1997.

Question 2

Summary

No, the rectification costs paid by you as per the Court order is not consideration for a taxable supply made.

Detailed reasoning

Section 9-40 of the GST Act provides that you must pay the GST on any taxable supply that you make.

Section 9-5 of the GST Act states:

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 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.

All the criteria in section 9-5 of the GST Act must be met for there to be a taxable supply.

'Supply' is defined in section 9-10 of the GST Act. The GST consequences of an out-of-court settlement will depend on whether the payment made under a settlement constitutes consideration for a supply and, if so, whether the supply is a taxable supply.

Goods and Services Tax Ruling GSTR 2001/4 Goods and Services Tax: GST consequences of court orders and out-of-court settlements deals with the GST consequences of court orders and out-of-court settlements and discusses the meaning of supply.

Paragraph 21 of GSTR 2001/4 provides, for there to be a supply for consideration, three fundamental criteria must be met:

(i)            there must be a supply

(ii)           there must be a payment and

(iii)          there must be a sufficient nexus between the supply and the payment for it to be a supply for consideration.

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

         •            earlier supply

         •            current supply

         •            discontinuance supply

An earlier supply is a supply that occurred before the dispute arose, and which is the subject of the dispute. A current supply is one that may be created by the terms of the court order or out-of-court settlement.

A discontinuance supply may be characterised as:

         •            surrendering a right to pursue further legal action

         •            entering into an obligation to refrain from further legal action

         •            releasing another party from further obligations in relation to the dispute.

However, whether any of these supplies would be a taxable supply would then depend on the requirements of section 9-5 of the GST Act being met in relation to that supply.

Rectification costs

Based on the facts provided, the Court awarded that you pay $XXXX to the home-owner due to the concrete slab being defective.

Paragraphs 73,110 and 111 of GSTR 2001/4 state:

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.

110. With a dispute over a damages claim, the subject of the dispute does not constitute a supply. 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.

It is therefore concluded that the rectification costs is not a supply for GST purposes and therefore the amounts paid are not consideration for a taxable supply. As such, they do not attract GST.