June 2008

Two important GST developments - application to forfeited deposits & new integrity measure for the margin scheme

GST can apply to forfeited deposits

The High Court has decided in Reliance Carpet Co Pty Ltd v Commissioner of Taxation [2008] HCA 22 that GST can apply to a forfeited deposit.  This overturns the earlier decision of the Full Federal Court.  The immediate impact of this decision is that the GST registered vendors that make sales as a part of their enterprise will now lose 1/11th of the deposit as GST.  This will have particular implications in property sales, but will also apply to other supplies.  It will affect past transactions where there has been forfeiture.

The decision

In the Reliance case, a purchaser exercised an option and paid a deposit to Reliance (as vendor) and the parties signed a contract for sale of land.  The purchaser defaulted, the contract was rescinded and the deposit forfeited.  The Commissioner assessed Reliance to GST in respect of the tax period in which the deposit was forfeited to it.

In a unanimous ruling, the High Court has held that forfeited deposits are essentially payment for a taxable supply of 'interim obligations'.  It found that in signing the sale contract Reliance made a supply in that it agreed to maintain the property and pay rates, taxes and insurance premiums until the deal was finalised.

Upon forfeiture the deposit was treated as consideration for a supply of those interim obligations.  Had the sale settled, there would have been a supply of the land.

The Court found that Division 99 of the GST Act provides in effect a timing rule.  Under that Division a deposit held as security for the performance of an obligation is not treated as consideration for a supply, unless the deposit:

(a) is forfeited because of a failure to perform the obligation; or
(b) is applied as all or part of the consideration for a supply.

When one of those things occurs a taxable supply can occur because the requirement of consideration is satisfied.

Will GST apply to all forfeited deposits?

GST will apply only to a forfeited deposit if:

  • the vendor is GST registered (or required to be registered), and
  • the vendor entered the contract as a part of an enterprise that it carries on.

Therefore, GST will not apply for example to forfeited deposits that may have been paid under a contract for the sale of a private owner-occupied home (as the contract will not be entered by the vendor as a part of an enterprise).

Importantly however it does appear that a supply of 'interim obligations' in exchange for a deposit may be subject to GST even if the larger or overall supply may be GST-free.  For example if a property is sold by a business under the going concern exemption but the contract is terminated and the deposit forfeited, the vendor may be liable to GST on the deposit even if the sale of land would have been GST-free had it completed.

What should vendors do?

Vendors should consider whether contracts should include a GST clause that allows the vendor to recover GST if it makes a taxable supply to the purchaser.  This will allow the vendor to recover an additonal amount from the purchaser.  In practice however recovery may be difficult, as forfeiture often occurs because the purchaser has inadequate funds.

Alternatively the vendor could increase the deposit amount to 11% (including GST).  There is a risk that deposits that exceed 10% may be viewed as either a penalty or an instalment payment.  In that case the court can find the deposit to be not reasonable and not subject to forfeiture, or GST liability can be inadvertently accelerated.  The Commissioner's view is that for a deposit that exceeds 10% in a land purchase contract to be accepted as a security deposit to which Division 99 applies, suppliers must be able to show that they are at a higher risk of significant losses in the event of default.

2008/2009 Budget announcement and GST margin scheme

The Government says that it will introduce an 'integrity' measure in respect of the interaction between the margin scheme with the GST-free going concern and the GST-free farmland provisions.  This replaces a previously announced measure.  This interaction is best illustrated using the following illustrative taxable sales:

Year 20X2 Mr A sold land to Mr B for $550,000.

Year 20X4 Mr B sold the land to Mr C under the GST going concern provision for a consideration of $660,000.  No GST was payable as the sale was a sale of a going concern.

Year 20X8 Mr C sold the land to Mr D for a consideration of $1,100,000.  As Mr C had previously acquired the land under a GST-free transaction, he was eligible to utilise the margin scheme.  The GST payable on the sale was 1/11th of the margin.  The margin was $440,000 (being the difference between the sale price of $1,100,000 and Mr C's original cost of acquisition of $660,000).  The GST payable was $40,000 (1/11th of the margin).

In the example, the new measure may require that when Mr C sells the land to Mr D, the margin will be the difference between $1,100,000 and the cost of Mr B's acquisition ($550,000).  Thus, GST payable under the "new margin scheme" is $50,000.  The additional $10,000 represents the GST on the "value added" by Mr B when he sold the land to Mr C.

Given the general nature of the budget announcement, it is not possible to outline its actual operation until further details are released.  For taxpayers who may be affected by the proposed changes, it will be prudent to stay updated as to the proposed changes and to plan accordingly.