Can you make a supply merely by tolerating something?

In brief

In an important ruling, the High Court has decided that a purchaser of leased premises will make a supply of the leased premises when, after completion, the purchaser observes its express obligations under the lease. The decision provides much-needed certainty for vendors and purchasers of leased property. However, the implications of the reasoning behind the decision could be more far-reaching than originally thought, with the High Court continuing to take an extremely broad view of the core concept underpinning Australia's GST system as to when an entity makes a 'supply'. Partner Katrina Parkyn and Senior Associate Marc Johnston report on the practical aspects of the case.

The facts of the case

South Steyne Hotel Pty Ltd (South Steyne) acquired the Sebel Manly Beach Hotel Complex, strata titled the individual residential apartments, leased the apartments to a management company (for it to operate a serviced apartment business) and then sold three of the apartments to MBI Properties Pty Ltd (MBI) subject to the relevant leases.

Earlier litigation between the Commissioner and South Steyne¹ determined that the supply of the three apartments to MBI were GST-free supplies of going concerns. The Full Federal Court also found that, following MBI's acquisition of South Steyne's reversionary interests in the three apartments, MBI did not make input taxed supplies to the management company as, instead, there was just a continuation of the existing leases granted by South Steyne.

Before this decision, the Commissioner had taken the view that where an entity acquired a reversionary interest in a residential apartment using the going concern exemption the entity would have an 'increasing adjustment' after completion under Division 135². Division 135 provides for the recipient of a going concern to have an increasing adjustment if the recipient intends that some or all of the supplies that will be made through the enterprise that is acquired will be supplies that are neither taxable or GST-free supplies (such as input taxed supplies of residential accommodation).

The effect of this adjustment is to essentially unwind any GST saving obtained by applying going concern treatment. Where the premises will be used solely to make input taxed supplies, the amount of the increasing adjustment will equal 10 per cent of the purchase price. The South Steyne decision threw doubt on the Commissioner's position. The issue then became the subject of the MBI Properties case³.

The Full Federal Court decision

In MBI Properties, the judge at first instance agreed with the Commissioner. However, on appeal the Full Federal Court decided that the supply of the lease of residential premises happened when the lease was granted. There was no continuing supply beyond the grant, merely a continuation of the lease which was the subject of the supply. This meant that Division 135 did not apply and the Commissioner lost.

Uncertainty for commercial leasing 

Commentators made much of the Full Federal Court decision and its implications for the GST treatment of commercial leases following the sale of leased property. Among the main concerns were:

• whether a purchaser that acquires commercial property subject to a lease would make any taxable supplies to the tenant post-completion – if not, the purchaser would have no GST liability on rent it receives post-completion; and
• whether the vendor would remain liable for GST on rent received by the purchaser following completion – on the basis that the vendor made the initial taxable supply, albeit that Division 156 allows the vendor to 'spread' its GST liability over the lease term (to coincide with the receipt of rent).

Following the Full Federal Court decision, the Commissioner released an interim decision impact statement which attempted to manage these uncertainties by providing that:

• taxpayers could continue to lodge GST returns based on the Commissioner's previously published views in GST Determination GSTD 2012/2, which were that:
  • post-completion, a purchaser would make a taxable supply to the tenant by continuing to lease the property; and
  • the vendor would cease to have any GST liability in respect of the lease (since the vendor does not receive the rent); and
• taxpayers who lodged returns on the basis of the Commissioner's published views would be protected from having to pay any underpaid tax, penalty or interest if those views were determined to be incorrect.

This enabled a vendor of leased commercial premises to self-assess its net amount on the basis that it was not liable for GST on rent paid by the tenant to the purchaser of the property. Vendors and purchasers could therefore continue to account for GST post-completion as they always had and, provided that the tenant continued to pay GST to the purchaser, this seemed to work fine in practice.

The High Court decision

The High Court allowed the Commissioner's appeal and held that the Full Federal Court was wrong to conclude that MBI did not make any supplies as a result of it assuming South Steyne's rights and obligations to the tenant under the apartment leases. MBI therefore had an increasing adjustment under Division 135 because it intended to make input taxed supplies of residential accommodation to the tenant (paragraph 2).

In reaching its decision, the High Court made a number of potentially far-reaching comments relating to the scope of the GST rules, including that:

• there is a supply whenever one entity provides something of value to another entity (paragraph 34) and a supplier does not always need to take some action to make a supply;
• the 'something' that is provided can be anything and it can be provided by any means, including by the supplier refraining from acting or by means of the supplier tolerating some act or situation (paragraph 34); and
• when a supplier enters into, and performs, an executory contract there will in general be at least two supplies (paragraph 35) – a supply which is made at the time of entering into the contract and a further supply which is made at the time of contractual performance 'even if contractual performance involves nothing more than the supplier observing a contractual obligation to refrain from taking some action or to tolerate some situation during a contractually defined period' (paragraph 35).

The High Court concluded that these observations apply as much to a lease as to any other executory contract. Consequently, there is a supply on entering into a lease and a 'further supply which occurs progressively throughout the term of the lease' by 'the lessor observing and continuing to observe the express or implied covenant of quiet enjoyment under the lease' (paragraph 36).

Relevant to MBI, the High Court also held that there was an input taxed supply of residential premises by way of lease both at the time of grant and as a result of MBI observing its express obligation under the lease to provide the tenant with use and occupation of the leased premises (paragraph 40). That is, both supplies had the character of being a supply of residential premises as opposed to, for example, a supply of residential premises at the time of grant and a supply of something else (not residential premises) during the term. In particular, the High Court noted that (paragraph 38):

there is no warrant in the text or policy of the GST Act for reading the reference in the special rule in s 40-35 to a supply of 'residential premises' that is a supply 'by way of lease' as referring to the supply which occurs at the time of entering into the lease but not as referring to the further supply which occurs by means of the lessor observing and continuing to observe the express or implied covenant of quiet enjoyment under the lease. The reference encompasses both, and both are therefore input taxed.

 

MBI had a fallback argument that the High Court also rejected. MBI argued that the Division 135 adjustment formula required the existence of a 'price' for the intended input taxed supply that it would make to the tenant but that there was no such price as all of the rent remained consideration for the initial grant of an apartment lease by South Steyne to the tenant. The High Court held that the rental payments could not be treated exclusively as consideration for the supply made at the time a lease was granted (paragraphs 2 and 42) and that there was no need to establish an exclusive connection between a particular payment and a particular supply to avoid double taxation (as that outcome is avoided by the operation of the attribution rules in Division 29).

It is not entirely clear from the High Court's reasoning why Division 29 has this effect as it seems equally plausible that Division 29 could be the cause of double taxation by requiring both an incoming and outgoing lessor to remit GST in the GST period that the rent is received. This is because regardless of the entity to which the tenant actually pays rent, that rent remains consideration for both the grant of the lease and the toleration supply that the High Court has identified (paragraph 45). At a practical level, however, it is reasonable to expect that the Commissioner will continue to administer the GST Act in accordance with his existing views⁴ such that there should be no risk of double taxation. 

The practical implications

The High Court decision confirms that the purchaser of a reversionary interest will, post-completion, make a supply by way of lease to the tenant. The basis for such a supply is that the purchaser will tolerate and continue to observe the covenant of quiet enjoyment under the lease. This resolves much of the uncertainty that lessors and lessees faced as a result of the Full Federal Court decision. 

Taxpayers who are less likely to be happy with the decision, including MBI Properties, are those that have acquired residential premises on a GST-free basis using the going concern exemption. As a consequence of the High Court decision, if a taxpayer acquires leased residential premises using the going concern exemption, solely for the purpose of supplying residential accommodation, the taxpayer will have an increasing adjustment equal to 10 per cent of the purchase price.

Perhaps more importantly, the decision raises the question of when a 'toleration' supply will trigger a GST liability. There is no doubt that an entity can make a supply when it 'enters' into an obligation to tolerate some act or situation⁵. However, traditional thinking had been that in order to 'make' a supply an entity had to do something and there can be no supply where no action is taken (such as when a judgment debt is released upon payment by a judgment debtor to its judgment creditor⁶ or when a land owner's interest in land is extinguished as a result of the land vesting in a government entity after that interest in land has been compulsorily resumed). It could be suggested that the High Court's reasoning ignores the verb 'make' in the definition of taxable supply and is tantamount to saying that an entity can make a supply by doing nothing other than choosing to not infringe some prior obligation the entity has assumed or imposed upon itself. If correct, this has the potential to radically increase the situations in which taxable supplies may arise.

Common sense suggests that the idea of a toleration supply will need to be limited in some way, perhaps simply to executory contracts or where it can be demonstrated that an entity actually took some action and entered into an obligation to tolerate an act or situation. Otherwise, difficult questions could arise whenever an entity receives consideration that has some connection with the entity 'refraining from acting, or by means of the [entity] tolerating some act or situation'.

Such an outcome is at odds with the existing GST treatment of other types of transactions that involve an entity becoming subject to some existing liability. For instance, the Commissioner currently accepts that there is no supply when a purchaser acquires the assets of a business and becomes responsible for paying various employee entitlements (under the relevant statutory regimes governing such entitlements)⁷.The High Court's decision that a supply may be based on tolerating a set of circumstances opens the door to a broader range of passive supplies and is likely to have been a surprise to the Commissioner. If the Commissioner maintains his present position, a purchaser will not be treated as making a form of supply merely by virtue of the purchaser 'tolerating' an assumption of liability.

Another example of where there should not be a toleration supply is when a government entity compulsorily acquires land. Most legislative regimes give a land owner the right to object against a proposed compulsory acquisition. The land owner should not be treated as making a taxable supply in return for the compensation that it receives as a result of the compulsory  acquisition merely because it refrains from exercising its objection rights and tolerates the compulsory acquisition. The land owner is merely a passive participant and, as the owner takes no action to cause the land to be vested in the government entity, should not be treated as making any form of toleration supply for which the compensation is consideration. This is a proposition that that the Commissioner currently accepts⁸ and will hopefully continue to accept notwithstanding the High Court's decision.

It is unfortunate that the High Court has decided to unbundle or dissect what is, in reality, one supply of a lease – the lessor grants the lessee a right to exclusive possession of the leased premises for the term of the lease in return for rent. The High Court's proposition that the grant of a lease, and for that matter the entry into any executory contract, results in the supplier making two supplies may have unintended consequences from a GST attribution perspective. For instance, the Commissioner may need to revisit his ruling regarding the attribution of GST in respect of supplies and acquisitions made on a progressive or periodic basis (GST Ruling GSTR 2000/35).

The ordinary attribution rules for a non-cash basis taxpayer operate so that all of the GST in relation to a supply of property, where the consideration is payable by instalments, is payable as soon as the first instalment is invoiced or paid (ie, all the GST is payable upfront based upon the total of the instalments rather than being payable periodically as and when each instalment is received – see Division 29 GST Act). As a contract for the sale of such property is executory until both parties have performed all of their obligations under it (ie, the supplier transfers title in the property to the recipient and the recipient pays the final instalment), it could now be argued that the special attribution rules in Division 156 GST Act apply to postpone the supplier's GST liability until the time when each instalment is paid. This would be on the basis that the supplier is making a supply on a progressive or periodic basis, as and when it complies with and observes its obligations under the contract, in return for consideration that is payable progressively or periodically.  

While the High Court's decision is clearly a sensible outcome, the same outcome could have been achieved by simply focusing on the supply that MBI Properties actually made, which was it assuming the contractual obligation to continue leasing the apartments to the tenant (paragraph 40).

As the High Court recognised (paragraph 27), a lease has a dual character and is both an interest in land (ie, an executed demise) and an executory contract. When leased premises are assigned it is ordinary commercial practice for the purchaser to assume, by some contractual means, responsibility for all of the obligations imposed on the lessor by the executory contract. This assumption of liability is the relevant supply that the purchaser makes to the tenant and should have been sufficient to resolve the appeal in the Commissioner's favour (ie, it is a supply that the purchaser makes for GST purposes because the purchaser imposes an obligation upon itself). The GST attribution rules in Division 156 would then ensure that the rent is attributed to the correct GST periods and without risk of double taxation.