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Focus: Tax – May 2008

The 'Reliance Carpet' decision: GST and forfeited deposits

In brief: The High Court has handed down its first decision involving the interpretation of a substantive GST issue: whether GST was payable on the forfeiture of a deposit paid under a land sale contract. The decision is likely to create uncertainty for both the Commissioner of Taxation and taxpayers, including where a forfeited deposit has been retained if the underlying transaction would not have generated a GST liability. Partners Michael Perez (view CV) and Ross Stitt (view CV) and Senior Associate Marc Johnston examine the decision.

How does it affect you?

  • The High Court's decision in Commissioner of Taxation v Reliance Carpet Co Pty Limited is the first High Court case dealing with the interpretation of a substantive GST issue.
  • The decision means that GST is payable on a deposit forfeited under a contract where the supply that would have occurred had the contract proceeded would have been subject to GST.
  • Uncertainty has been created by the High Court's decision in a number of areas, including where a forfeited deposit is retained but the underlying supply would not have resulted in a GST liability had it occurred.

Facts and issue

The main facts relevant to this case (Commissioner of Taxation v Reliance Carpet Co Pty Limited [2008] HCA 22) are as follows:

  • Reliance Carpet executed an agreement for the sale of land and a 10 per cent deposit was paid; however, the purchaser failed to pay the balance of the purchase price by the due date.
  • The taxpayer issued a rescission notice to the purchaser requiring that this default be remedied; however, the purchaser failed to do so.
  • The contract was terminated, the deposit was forfeited and the Commissioner of Taxation (the Commissioner) assessed GST on the forfeited deposit.
  • Reliance Carpet objected. The objection was disallowed and the Administrative Appeals Tribunal (the AAT) affirmed the Commissioner's decision.
  • Reliance Carpet appealed to the Full Federal Court, which held that no GST was payable upon forfeiture on the basis that the forfeited deposit was not consideration for any supply.

The operation of Division 99 of the A New Tax System (Goods and Services Tax) Act 1999 (Cth) (the GST Act) was of fundamental importance to the outcome. Division 99 of the GST Act ensures that the ordinary GST attribution rules do not apply to a deposit until it is either forfeited or applied as part of the consideration for a supply.

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Decision

The High Court commenced by reiterating the often lamented misuse of the term 'rescission'. In this case, the contract was not rescinded, but rather was terminated by one party for breach by the other. The court reiterated that the GST in Australia is not a tax on consumption but on a particular form of transaction, that is, a supply. This could be contrasted with the position in the member states of the European Community, where the High Court saw the value added tax (VAT) as a general tax on the consumption of goods and services.

The High Court held that the Full Federal Court 'fell into error' by upholding Reliance Carpet's objection, noting that the fact that the contract did not proceed to completion did not prevent there being a supply when the contract was entered into.

The significance of a deposit paid under a contract was explained by the High Court given its relevance to the GST treatment. The deposit would need to be brought into account in any assessment of damages if an action was pursued by Reliance Carpet against the purchaser for its breach of contract. The High Court pointed out that 'whilst the contract remained executory and was on foot but uncompleted by the purchaser, the deposit provided to the taxpayer a form of security for that performance by the purchaser'.

Although a forfeited deposit has various characteristics, that 'does not mean that the taxpayer may fix upon such one or more of these characteristics as it selects to demonstrate that there was no taxable supply'. It was sufficient for the Commissioner's case that one of those characteristics was that it 'operated as a security for the performance of the obligation of the purchaser to complete the Contract and was liable to forfeiture on that failure'. It is notable that the High Court did not comment upon the nexus requirement that a supply must be 'for' consideration before it can be a taxable supply and instead contented itself with the fact that the deposit was 'in connection with' a supply by Reliance Carpet.

The High Court held that no assistance could be derived from the treatment of deposits in New Zealand and Canada because their tax systems lacked 'any sufficiently close analogue to Division 99'. The recent European Court of Justice decision regarding deposits forfeited upon cancellation of hotel reservations was also considered not to be directly relevant. That was because some of the characteristics of a forfeited deposit that were emphasised by the European Court of Justice in determining that no VAT was payable, most notably that the deposit constituted fixed compensation, did not reflect the common law in Australia.

The High Court had no trouble in establishing a sufficient connection between the payment of the deposit and a supply by Reliance Carpet because 'the payment of the deposit obliged the parties to enter into the mutual legal relations with the executory obligations and rights laid out in the Contract'.

Unlike the Full Federal Court, the High Court agreed with the AAT that Reliance Carpet made a supply to the purchaser by entering into the contract for the sale of the land. This was a supply in terms of section 9-10(2)(g) of the GST Act – the entry into an obligation to do something, ie transfer the land on settlement. The High Court also saw the transaction as satisfying the definition of supply in s9-10(2)(d) – a grant of contractual rights in relation to land.

Division 99, by ensuring that the deposit was only treated as consideration if it was forfeited or applied as consideration, had the consequence that the supply by Reliance Carpet occurred before the deposit was treated as consideration. However, this lack of temporal coincidence did not matter because Division 99 ensured that the GST was attributable to the tax period when forfeiture occurred. In other words, the forfeiture of the deposit caused the supply of entering into the contract to become a taxable supply by allowing the deposit to be treated as consideration for that supply at the time of forfeiture.

The High Court did not consider it to be a problem that there can be two supplies where a contract proceeds to completion. This was on the basis that, until this happens, the deposit is not treated as consideration for any supply. In other words, there is no taxable supply until completion when the deposit is applied as part of the consideration and, as a consequence, there is only one taxable supply.

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Comments

The High Court did not make any general observations on the nature of GST, other than to say that it is not a tax on consumption but a tax on supplies. Similarly, it did not take the opportunity to provide any general guidance on the interpretation of GST. Perhaps the High Court's willingness to undertake what the Full Federal Court saw as a 'juristic dissection' of the sale contract and, in particular, to countenance multiple supplies, can be interpreted as an implicit rejection of any kind of commercial or substance approach to the interpretation of GST. It was certainly not an application of what is sometimes referred to as the 'practical business tax' approach to interpreting GST (see the comments made in Sterling Guardian Pty Ltd v FCT (2005) 60 ATR 502 and Saga Holidays Limited v Commissioner of Taxation (2006) 64 ATR 602).

Unfortunately, the High Court did not deal with one of the main concerns raised in the Full Federal Court: namely, the possibility that the approach accepted by the High Court results in GST being payable on the termination of a contract where the supply that would have occurred had the contract proceeded would not have been subject to GST. Section 9-30 of the GST Act is one possible solution to this difficulty. It provides that the supply of a right to receive a supply that would be GST-free or input taxed is itself GST-free or input taxed. The High Court characterised the supply by Reliance Carpet on entering into the sale contract as encompassing the grant to the purchaser of the 'right to require in due course conveyance of the land to it upon completion of the sale'. It is not clear, however, whether it would expect s9-30 to apply in this type of situation.

Although Chief Justice Gleeson touched upon this issue during the hearing when dealing with Reliance Carpet's submission that absurd or anomalous results could arise if its position was not accepted, the High Court decision is conspicuously silent on this point. During the hearing, Chief Justice Gleeson seemed to agree with submissions made on behalf of the Commissioner that s9-30(2)(b) of the GST Act could apply to ensure there was no GST on the forfeiture of a deposit with respect to a contract dealing with an input taxed supply of residential premises. However, the decision leaves us none the wiser as to the High Court's view on whether this section prevents a GST liability from arising in that situation.

It remains to be seen how far the Commissioner will take this decision and whether it will have wide-ranging consequences or be confined to its facts. Taxpayers may be forced to revisit any transaction where they retained a forfeited deposit, even if the underlying supply would have otherwise not generated a GST liability. The main practical problem taxpayers will then face is trying to recover an additional amount from the party in breach under any GST gross-up clause in the agreement between them (always assuming the GST clause was drafted in a way that it survives termination).

Ultimately, it may be that a prudent supplier will simply require a deposit that is calculated on a GST inclusive basis (ie 11 per cent of the GST exclusive consideration for a proposed supply).

An unfortunate consequence of the decision is that, although there might only be one taxable supply in these circumstances because of the operation of Division 99, it is contrary to the conventional thinking that an arrangement should not be unbundled into a number of separate supplies if, in reality, there is just a single supply from an economic point of view. In some circumstances, the effect of the High Court's decision may be that, where Division 99 does not apply, the consideration received for a supply may relate in part to the initial grant of rights rather than to the core or underlying supply that is the actual subject matter of the arrangement. It might also provide scope for parties to artificially unbundle transactions in ways that might alter the GST outcome.

The decision of the High Court may encourage the use of liquidated damages clauses (ie the parties could agree that an amount equal to the deposit is to be paid as liquidated damages if the vendor terminates the contract as a result of the purchaser's breach with the possible effect of no GST being payable). The contracting parties could then agree to refund the deposit in all situations, rather than forfeiting it upon breach, but in a breach scenario the refund would be made by way of offset. This may or may not be effective from a GST perspective but, in any event, it may not be a desirable outcome because the right to sue for damages could be lost in certain circumstances.

Significantly, the High Court rejected Reliance Carpet's argument that there was not a sufficient nexus between the forfeited deposit and any supply because the various contractual rights and obligations were exchanged regardless of whether or not the deposit was paid. It appears from the High Court decision that the requirement for there to be a nexus between a supply and consideration can be satisfied where the consideration is 'in connection with' the supply. This can be contrasted with the more onerous test suggested by the requirement in s9-5(a), that a supply must be made 'for' consideration. It will be interesting to see how the Federal Court approaches the next case where GST nexus issues are raised.

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