Edited version of private advice

Authorisation Number: 1051943016747

Date of advice: 25 January 2022

Ruling

Subject: GST and out-of-court settlement

Question 1

Have you made a creditable acquisition pursuant to section 11-5 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) in relation to the payment made as an out-of-court settlement?

Answer

No.

Question 2

Are you entitled to an input tax credit pursuant to section 11-20 of the GST Act in relation to the payment made as an out-of-court settlement?

Answer

No.

This ruling applies for the following period:

25 January 20XX to 24 January 20XX

Relevant facts and circumstances

You are registered for GST.

You entered into an out-of-court settlement with another entity.

No formal written settlement agreement as such was entered into. However, you provided a copy of a letter (signed by the representatives of both parties) confirming the settlement which had been negotiated by the parties.

The settlement related to a dispute between the parties in relation to a lease previously entered into by them in respect of commercial premises. The dispute arose upon you vacating the property on expiry of the lease.

More specifically, the dispute was about whether you had complied with the make good obligations under the lease. The lessor contended that you had not complied and that as a result you were liable to pay the lessor a specified sum plus 10 per cent GST in make good expenses and other costs and charges.

The lessor provided you with a spreadsheet with details of their initial claims for end of lease costs, including rent and outgoings since the expiry of the lease and make good works.

You advised the lessor that you agreed that there was some damage and make good works required to the property which you were willing to pay for and the settlement sum agreed included consideration of those matters.

You further advised that you had paid all rent up until the lease expiry date and had vacated the premises on expiry of the lease. However, the lessor claimed that since there were outstanding make good works, the rental amounts were to continue.

You subsequently received legal advice confirming that rent was not payable after the lease expiry date.

The lessor did not charge or attempt to charge you any interest.

You initially made a lower settlement offer to the lessor. However, this was rejected.

After much negotiation between the parties, you offered the lessor a higher amount plus GST, to which the lessor provided a final counter offer of a specified amount (including GST) as full and final settlement of their claim.

You advised that it was only once you tabled the legal advice that you had received confirming that the lessor was not entitled to charge rent and outgoings after the lease expiry date that the lessor reduced its claim to the final settlement amount including GST.

You further advised that you agreed to the final settlement amount (including GST) on the basis that it was equivalent to a final figure that you had in mind plus GST. However, when you requested a tax invoice for the final settlement amount, the lessor advised that GST was not applicable to the transaction.

You have paid the lessor the final settlement amount less 1/11th of that amount. You are willing to pay the residual amount (equivalent to the GST) once the ATO has ruled on the two issues in your ruling request, which relate to whether or not GST applies to the transaction.

You advised that you carried out substantial repairs to the property both prior to and after the lease expiry date. You are unaware of whether the lessor has completed any residual make good works using the money you have paid to them to date.

You provided a copy of the lease for the property (which is located in Australia), together with a copy of the deed of renewal of the lease.

You advised that the lessor was at all relevant times carrying on an enterprise in Australia and was registered for GST.

You also provided copies of relevant correspondence between the parties and other relevant and related documents.

Apart from the signed settlement letter, there are no other agreements in existence settling out the terms of the settlement.

Relevant legislative provisions

A New Tax System (Goods and Services Tax) Act 1999

Section 9-5

Section 9-10

Section 9-15

Section 11-5

Section 11-15

Section 11-20

Detailed reasoning

Section 11-20 of the GST Act provides that you are entitled to the input tax credit for any creditable acquisition that you make.

You make a creditable acquisition under section 11-5 of the GST Act if:

(a)  you acquire anything solely or partly for a creditable purpose; and

(b)  the supply of the thing to you is a taxable supply; and

(c)   you provide, or are liable to provide, consideration for the supply; and

(d)  you are registered or required to be registered (for GST).

According to subsection 11-15(1) of the GST Act, you acquire a thing for a creditable purpose to the extent that you acquire it in carrying on your enterprise. However, under subsection 11-15(2) of the GST Act, you do not acquire the thing for a creditable purpose to the extent that:

(a)  the acquisition relates to making supplies that would be input taxed (for example, financial supplies and supplies of residential premises, although there are some exceptions); or

(b)  the acquisition is of a private or domestic nature.

From the facts given, your acquisition of anything supplied to you relating to the out-of-court settlement is for a creditable purpose as the acquisition pertains to your business which is registered for GST. As such, paragraphs 11-5(a) and 11-5(d) of the GST Act are satisfied.

However, in order to determine whether all of the requirements of section 11-5 of the GST have been met by you, it will also be necessary to consider whether there has been a supply of a thing to you which is a taxable supply (for which you have provided consideration in the form of the settlement payment). Whether there is a taxable supply will need to be determined from the perspective of the supplier.

Under section 9-5 of the GST Act, you (in this case, the supplier) 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 (essentially Australia); and

(d)        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.

For completeness we note that there do not appear to be any GST-free or input taxed supplies arising under the settlement in this case.

There is a discussion on the meaning of 'consideration' (in the context of a supply being made for consideration) at paragraphs 74 to 96 in Goods and Services Tax Ruling 2001/4 Goods and Services Tax: GST consequences of court orders and out-of-court settlements (GSTR 2001/4). In particular, paragraphs 75, 76, 91, 93 and 96 of the ruling state as follows:

75. Section 9-15 further 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. Thus, 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.

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

91. The references in the GST Act to 'supply for consideration and more commonly to 'consideration for a supply' underscore the close coupling between the supply and the consideration that is necessary before a payment will be consideration for a supply that will make the supply subject to GST.

93. In determining whether a payment satisfies the requirements of subsection 9-15(1), the test is whether there is a sufficient nexus between the supply and the payment made.

96. In determining whether a sufficient nexus exists between supply and consideration, regard needs to be had to the true character of the transaction. An arrangement between parties will be characterised not merely by the description which parties give to the arrangement, but by looking at all of the transactions entered into and the circumstances in which the transactions are made.

According to paragraph 13 of GSTR 2001/4, an out-of-court settlement will include any form of dispute resolution in which the terms of the resolution are agreed between the parties, rather than imposed by the court. We consider the settlement of the dispute between you and the lessor to be an out-of-court settlement for the purposes of GSTR 2001/4.

Paragraph 17 of GSTR 2001/4 provides that the GST consequences of an order or out-of-court settlement will depend on whether the payment made under an order or settlement constitutes consideration for a supply and, if so, whether the supply is in the nature of a taxable supply. As such it is necessary to determine whether your payment of the out-of-court settlement amount constitutes consideration for a taxable supply by the lessor to you.

Where the settlement amount is found not to be consideration for a taxable supply, then paragraphs 11-5(b) and 11-5(c) of the GST Act will not be satisfied and your acquisition will not be a creditable acquisition. For completeness it is noted that based on the facts in this case, any supply made by the lessor in relation to the out-of-court settlement would be connected with Australia and would be made in the course or furtherance of an enterprise carried on by the lessor (an entity that is registered for GST).

For there to be a 'supply for consideration' in relation to the out-of-court settlement, paragraph 21 of GSTR 2001/4 provides that the following three fundamental criteria must be met:

(i)    there must be a supply;

(ii)   there must be a payment; and

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

Essentially, a supply is something which passes from one entity to another. The supply may be one of particular goods, services or something else (paragraph 2 of GSTR 2001/4). The term is defined very broadly in subsection 9-10(1) of the GST Act as any form of supply whatsoever; whilst subsection 9-10(2) of the GST Act, without limiting subsection (1), includes a list of various types of supplies and the means by which such things can be passed.

Any of the types of supplies referred to in subsection 9-10(2) of the GST Act could be related to an out-of-court settlement. There could also be more than one supply that is related to a settlement. Further, the subject of the dispute may not be a supply at all (refer to paragraphs 42 and 43 of GSTR 2001/4).

GSTR 2001/4 explains at paragraph 44 that supplies that are related to an out-of-court settlement fall within the following three categories:

•         earlier supply

•         current supply

•         discontinuance supply.

However, the existence of a particular supply in relation to a given settlement will not necessarily mean a sufficient nexus exists between that supply and a payment made under the settlement.

Earlier supply

Where the subject matter of the dispute is an earlier transaction in which a supply was made involving the parties, that supply is referred to in GSTR 2001/4 as an 'earlier supply' (refer to paragraph 46 of the ruling).

The example given in the abovementioned ruling involves a dispute between a company and a retailer that was previously supplied toys. The dispute concerns payment for those toys. The dispute is resolved through an out-of-court settlement whereby the retailer pays all monies owed to the company for the toys.

Current supply

A 'current supply' is one that may be created by the terms of the settlement (refer to paragraph 48 of GSTR 2001/4).

The example given in the abovementioned ruling involves a dispute over a claim by one entity that another entity is using its trade name. Negotiations result in the former entity entering into an agreement with the latter entity that allows the latter entity to use the former entity's trade name in the future.

Discontinuance supply

Paragraphs 50 and 54 of GSTR 2001/4 provide that even where there is no earlier or current supply, the very wide range of things that can constitute a supply means that one or more new supplies will probably crystallise on an out-of-court settlement being reached. Such 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

However, whether a discontinuance supply will be a taxable supply will depend on the requirements of section 9-5 of the GST Act being met in relation to that supply (refer to paragraph 55 of GSTR 2001/4).

Whether there is a nexus between the supply and the consideration

Regarding the issue of nexus, GSTR 2001/4 relevantly provides as follows:

100. As discussed above, a sufficient nexus between a payment made under a court order or out-of-court settlement and a supply must exist to create the 'supply for consideration' relationship. Our views on where such a relationship exists are set out below.

Earlier supply

101. Where the only supply (other than a 'discontinuance' supply) in relation to a court order or out-of-court settlement is an earlier supply and a sufficient nexus exists between the payment made under that order or settlement and the earlier supply, the payment will be consideration for that supply.

Current supply

105. Where the only supply (other than a 'discontinuance' supply) in relation to a court order or out-of-court settlement is a current supply and a sufficient nexus exists between the payment and that supply, the payment will be consideration for the current supply.

Discontinuance supply

106. 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. In such a case, the payment under the settlement would be in respect of that claim and not have a sufficient nexus with the discontinuance supply.

107. 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 which does not give rise to additional payment in its own right. They are in the nature of a term or condition of the settlement, rather than being the subject of the settlement.

108. We do not consider that the inclusion of a 'no liability' clause in a settlement deed alters this position. 'No liability' clauses are commonly included in settlement agreements and we do not consider their inclusion to alter the substance of the original dispute, or the reason payment is made.

109. We consider that a payment made under a settlement deed may have a nexus with a discontinuance supply only if there is overwhelming evidence that the claim which is the subject of the dispute is so lacking in substance that the payment could only have been made for the discontinuance supply.

Regarding a dispute where a claim is made for damages, GSTR 2001/4 relevantly provides as follows:

Damages

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

Regarding the payment of costs on resolution of a dispute, GSTR 2001/4 relevantly provides as follows:

Costs

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 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.

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.

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.

How the above applies to the facts in this case

In this instance there is no earlier or current supply relating to the out-of-court settlement amount. We disagree with your contention that there is an earlier supply.

You contend that the settlement amount relates to an earlier supply because the settlement reached between the parties arose solely out of obligations arising under the lease and solely in respect of earlier supplies by way of the lease of real property. On this basis you consider there to be a clear nexus between the payment made under the settlement and those earlier supplies; with the payments being mainly in respect of rent and repairs which, so far as the lessor was concerned, were required to be made under the lease and thus it is unlikely that the settlement payment would be consideration for either a current supply or a discontinuance supply.

You further contend that we are not dealing with a 'pure' claim for damages unrelated to an earlier supply, but rather with a damages claim arising under the express terms of a lease and in respect of the earlier supply of the property by way of that lease.

For there to be an earlier supply, the subject matter of the dispute must be an earlier transaction in which a supply was made involving the parties. In this case, the subject matter of the dispute largely involves the lessor seeking payment from you due to the condition in which the property had been left when you vacated the building at the expiry of the lease (i.e., 'make good works' or damages). Additionally, there were claims made by the lessor to recover costs associated with the dispute, such as legal fees and administrative expenses.

The rental/leasing of the premises by the lessor to you (being the earlier transaction in which a supply was made involving the parties), is not the subject matter of the dispute between the parties. Thus, there is no earlier supply related to the out-of-court settlement.

The facts in this case show that all rent up until the expiry date of the lease had been paid by you before the dispute arose. In addition, even though the lessor did initially seek to claim rent from you covering a period after the lease expiry date, the correspondence between the parties indicates that the lessor did not pursue this further after you provided them with a copy of the legal advice that you had obtained on the matter.

Thus, there is also no other earlier transaction involving a supply between the parties (such as rental of the premises post the lease expiry date) that could be the subject matter of the dispute.

We also note that the example in GSTR 2001/4 regarding an 'earlier supply' involved a previous supply transaction (the supply of toys by the company to the retailer). The subject matter of the dispute was the failure of the retailer to pay the company for the toys that had previously been supplied (i.e., the dispute was about the previous supply of the toys - that was the earlier transaction between the parties in which a supply was made and which was the subject matter of the dispute). In your case, the dispute does not, for example, involve you failing to pay the rent on the lease (which is the previous supply transaction between the parties); instead, the subject matter of the dispute is in the main about damages to the property after you had vacated it (i.e., the dispute is not about the past leasing transaction between the parties which was a supply).

You have not contended that there is a current supply.

As to whether there is a discontinuance supply, the facts provided show that the out-of-court settlement meets the description of a discontinuance supply. The parties have agreed to discontinue any further action with respect to any current and future claims by agreeing that the settlement amount was the full and final settlement of the dispute and any and all claims which the parties have in respect of the prior lease of the premises.

Having already determined that there is no earlier supply or current supply, we now need to determine if the only remaining supply, a discontinuance supply, is a taxable supply. In order to do this, it is necessary to consider the terms of the settlement to establish whether there is a nexus between the payment of the settlement amount and the discontinuance supply.

Although we do not have the final breakup of the final settlement amount, the correspondence and other documentation that you provided strongly indicate that the dispute is mainly about damages; and to a lesser degree about the recovery of dispute related costs. The claim for rent post the lease expiry date that appears in the spreadsheet from the lessor regarding their initial claim does not appear to feature in the final settlement amount.

As previously discussed, 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. In such a case, the payment under the settlement would be in respect of that claim and not have a sufficient nexus with the discontinuance supply.

•         a payment made under a settlement deed may have a nexus with a discontinuance supply only if there is overwhelming evidence that the claim which is the subject of the dispute is so lacking in substance that the payment could only have been made for the discontinuance supply.

•         paying compensation for costs or losses incurred in a dispute will be treated in the same manner as damages.

We do not consider the claim for damages and the claim for the recovery of dispute related costs, which is the subject of the dispute, to be so lacking in substance that the settlement payment could only have been made for the abovementioned discontinuance supply. You acknowledge that there was some damage and make good works required to the property and that the settlement sum included consideration of those matters.

Therefore, there is no nexus between the discontinuance supply and the settlement amount. Hence, your payment of the settlement amount to the lessor will not constitute consideration for the discontinuance supply, or indeed for any other supply.

Since the out-of-court settlement amount does not constitute consideration for a supply, the requirements in paragraphs 11-5(b) and 11-5(c) of the GST Act are therefore not satisfied.

Accordingly, as all of the requirements in section 11-5 of the GST Act will not be satisfied, you are not considered to have made a creditable acquisition and you will not be entitled to claim an input tax credit for the payment of the settlement amount.

Further information

As we do not consider you to have made a creditable acquisition, the supplier would not be required to issue you with a tax invoice. Further, we would not envisage using the Commissioner's discretion to treat another document as a tax invoice.

Under the GST law, a supplier is only required to issue a tax invoice to the recipient for a taxable supply. As you have not made a creditable acquisition, the Commissioner would generally not exercise his discretion to treat another document as a tax invoice, should you make such a request.

Where a supply is not a taxable supply, the supplier should still issue an invoice (as opposed to a tax invoice) to the recipient for record keeping purposes. Further information on tax invoices is available in Goods and Services Tax Ruling 2013/1 Goods and Services Tax: tax invoices (GSTR 2013/1) which is available on our website at www.ato.gov.au