LECTURE 11 GST: SELECTED ISSUES

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1 LECTURE 11 GST: SELECTED ISSUES SALE OF A GOING CONCERN Introduction Where certain conditions are satisfied, the sale of a business as a going concern to a registered or requiredto-be registered acquirer will be GST free The main advantage offered by the legislation is that the buyer does not need to finance the GST component of the transaction. o If the transaction was taxable, the buyer would still be able to claim an ITC for the GST on the purchase price; therefore the advantage is mainly a cash flow advantage for the buyer. o However, there is still a real benefit because the GST free treatment will result in a reduced sale price and consequently the stamp duty (calculated on the GST inclusive price) will be lower. Conditions for GST-Free Treatment Conditions for the sale of a going concern to be GST free (S (1)): 1. The supply is for consideration AND 2. The recipient is registered or required to be registered AND 3. The supplier and the recipient have agreed in writing that the sale is of a going concern Agreement in Writing Requirement is designed to stop the purchaser from claiming an ITC when the vendor believes it is GST free. The agreement that the supply is of a going concern must be explicit and should be expressed in unequivocal terms. The Commissioner takes the view that the agreement must be made on or before the date on which the supply is made The going concern agreement does not have to be part of the contract of sale. o However, where different components of the sale are covered by different contracts, care must be taken to ensure that the agreement applies to all contracts Registration Requirement The requirement that the recipient must be registered or required to be registered must be satisfied on and from the date of the supply (GSTR 2002/5). If the seller is not registered, the sale of the business will not be subject to GST in any event. What is the Supply of a Going Concern? The supply of a going concern a supply where: (s (2)) o The supplier supplies to the recipient all the things that are necessary for the continued operation of an enterprise AND o The supplier carries on, or will carry on, the enterprise until the day of the supply (whether or not as part of a larger enterprise carried on by the supplier) Enterprise = It is possible to sell a going concern that consists of an enterprise which is part of a larger enterprise (s 9-20) Supply Must Be All Things Necessary Something is necessary to the business if the business cannot be operated without it o Conversely, if something that is not necessary for the continued operation of the business, it would be potentially taxed as a separate taxable supply. o What is necessary will vary according to the specific circumstances of the business. Enterprise Must be Carried on Until Day of Supply Under the arrangement, the seller must carry on business until the day of the supply to the purchaser. o This requirement will be satisfied even where some activities of the business are ceased for a short period to facilitate the sale (e.g. stock take or maintenance). The day of the supply is the date on which the recipient assumes effective control and possession of the enterprise even though the economic risk and benefit may be deemed by the contract to have passed at an earlier date (GSTR 2002/5)

2 GST Adjustments for Supplies of Going Concerns The recipient of a supply of a going concern will be liable for an increasing GST adjustment if he or she intends to make input taxed or private supplies through that enterprise (s 135-5). The adjustment is calculated as: 1/10 th x purchase price x proportion of non-creditable use The proportion of input taxed supplies is worked out on the basis of the prices of the input taxed supplies (or private supplies) compared to all supplies made by the enterprise. If the recipient changes its business purposes and the proportion of input taxed supplies (or private supplies) are different from those intended, an adjustment should be made under the rules set out in Div 129 (s ). o Division 129 provides that when there is a change in the intended use of a thing acquired and this change has an effect on the creditable purpose of the thing, a GST adjustment must be made. Sale of a Business Owned by a Company There are three ways that a business operated by a company can be disposed of: 1. Sale of the separate assets owned by the business 2. Sale of the business as a going concern 3. Sale of the shares in the company that owns the business o The supplier is not the company carrying on the business but the shareholder and consequently the going concern exemption is not relevant. Instead, the sale of shares is treated as a financial supply which is input taxed; i.e. no GST is payable but the seller will not be able to claim input tax credit for costs such as legal advice or accountant advice in relation to the sale. o The purchaser of the shares will inherit the operating company s tax and financial history; this will include the company s GST status and liabilities. It is important for the acquirer to check that the company has complied with its GST obligations and that has correctly categorised its supplies, monitored its thresholds and maintained an effective accounting system. The sale of the separate assets would probably be a taxable supply if the requirement of all things necessary is not satisfied. The sale of the business as a going concern will be GST free if the requirements in Subdiv 38J are satisfied. GST AND FINANCIAL SUPPLIES Introduction Supplies that are classed as financial supplies, including loans, share trading and life insurance and related transactions are input taxed (s 40-5). o This means that while the supply is not taxable, the supplier cannot obtain an ITC for the GST paid on the things acquired to make the supply. Not every supply made by a financial supply provider (e.g. a financial institution) is treated as a financial supply. For instance, general insurance, general leases and broking services are taxable supplies. Not every financial supply will be made by a financial institution. For example, retailers who provide credit to their customers are making financial supplies that will be potentially input taxed. Meaning of Financial Supply The definition of financial supply is provided in the GST regulations (Reg ) For a supply to be a financial supply, 1. There must be a provision, acquisition or disposal of an interest in specific items 2. The provision, acquisition or disposal must be for consideration 3. It must be in the course of an enterprise 4. It must be connected to Australia 5. The entity that provides, disposes or acquires the interest must be a financial supply provider 6. The financial provider is registered for GST or required to be registered for GST

3 Interest Interest is defined by Reg as any form of property. It includes: o A debt or right to credit o An interest conferred under a superannuation scheme o A mortgage over land or premises o o o A right under a contract of insurance A right to receive a payment under a derivative A right to future property Provision, acquisition or disposal A provision includes the allotment, creation, grant or issue of an interest (Reg ). An acquisition includes acceptance and receipt of the interest (Reg ). A disposal includes assigning, cancelling, redeeming, transferring or surrendering the interest (Reg ). An Acquisition-Supply includes the acquisition of financial interests. Consideration The term consideration has the same meaning as s In the course of an enterprise... This means that an occasional share trade by a private individual is not a financial supply Connected with Australia A mortgage over land or goods situated in Australia will be connected to Australia. The supply will be connected to Australia if it is made through a business located in Australia. Financial Supply Provider The terminology covers the entity that is the owner of the interest immediately before its supply, or the entity that creates or acquires the interest (Reg ). o For example in a situation where shares are sold, both the seller and the acquirer are financial supply providers. o However where shares are sold through an agent, the agent is only a financial supply facilitator (Reg ). Specific Items of Financial Supplies The most common types of financial supplies include: Services provided to bank account holders (e.g cash collection, ATM, supply of EFTPOS card ) Loans, debt and credit arrangements, including supply of credit cards Mortgages and charges Interests in a regulated superannuation fund Life insurance Provision of guarantees and indemnities ( except warranty of goods) Hire purchase only where the credit component is charged separately from the goods Currency transactions Issuing of securities (shares, bonds etc ) Forward contracts and other derivatives Incidental Financial Supplies Supplies incidental to financial supplies are treated as financial supplies (Reg ). Incidental supplies are supplies that are made as the same time as the main financial supply, but with no separate consideration, and the supplier and recipient are the same as for the main financial supply o For a supply to be an incidental supply, it must be normal practice for it to be supplied with the main financial supply Things that are NOT Financial Supplies Reg provides a lengthy list of things that are not financial supplies including: o Ancillary services eg debt collection, forms non-standard cheque books and agency services (brokerage) o Professional services such as Provision of advice or facilitation services (e.g. access to a payment system such as an EFTPOS system supplied to a business).

4 Reduced Input Tax Credits As financial supplies are input taxed, the supplier cannot normally claim input tax credits for acquisitions related to those supplies. o However, a reduced input tax credit (RITC) is available for certain types of services (reduced credit acquisitions) acquired by financial supply providers (s70-5). The percentage of the input tax credit for reduced credit acquisitions is 75 % (Reg ). The list of reduced credit acquisitions (RITC eligible services) is provided by Reg Each type of financial business (credit unions, mortgage finance, etc) has its own list of RITC eligible services. Financial Acquisition Threshold (De Minimis test) Another exception to the general rule that you do not acquire a thing for a creditable purpose if you are making an input taxed supplies is provided by s 11-15(4). Under this provision, an acquisition is not treated as relating to input taxed supplies if: o The acquisition relates to financial supplies, and o The entity that makes the acquisition does not exceed the financial acquisition threshold. It is designed to ensure that entities making financial supplies that are not part of their principal activities are not denied an input tax credit. Calculating the Threshold The Financial Acquisition Threshold (FAT) test has two components a current year component (s189-5): and a future year component ( s ); both components must be satisfied. o The current year component requires the entity to calculate the financial acquisitions made or likely to be made during the current month and the previous 11 months. The entity must then work out the input tax credits that would normally apply to these acquisitions. o In a similar way, the projected year component requires the entity to calculate the financial acquisitions and the amount of input tax credits that it is likely to make during the current month and the next 11 months. If the total of the credits available under both test is less than either: 1. $50,000, or 2. 10% of the total input tax credits the entity is entitled to, then, all input tax credits can be claimed. If either threshold is breached, then none of the credits can be claimed Meaning of Financial Acquisition An acquisition that relates to the making of a financial supply. Must be used or intended to be used for the making of a financial supply Acquisitions exclude importations and those that relate to borrowing It is necessary to allocate overheads to financial acquisitions to the extent that they relate to financial supplies. (s and Div 189) Interaction of Financial Acquisitions Threshold and RITC When calculating the amount of input tax credit for the purpose of the threshold, the ATO requires that 100 % of the input tax credit on reduced credit acquisitions ( i.e acquisitions which can benefit from the RITC) count towards the financial acquisition threshold (GSTR 2003/9). o If the total amount breaches the financial acquisition threshold, any GST that is claimable as an RITC can be reclaimed at 75% of the GST incurred. Accounting Issues: Attribution of GST Where a finance service provider makes input taxed supplies as well as taxable supplies and GST free supplies, it is necessary to attribute the GST that has been incurred between the different categories of supplies. While it is often possible to trace direct acquisitions that relate specific supplies, the problem comes when determining which portion of overhead relates to GST free, taxable or input taxed supplies.

5 GST incurred GST on acquisitions relating to GST Free and taxable supplies GST on overhead expenses GST on acquisitions relating to input taxed supplies Apportion Creditable GST Non-creditable GST Is the total more than the Financial acquisition threshold? No All GST is creditable Yes GST is not creditable GST AND SALE OF REAL PROPERTY Overview of the GST Rules on the Sale of Real Property Summary of GST Rules on Sales of Real Property The rules applying to the different types of sales of real property are as follows: Type of premises Example GST treatment New residential premises New house Taxable supply Commercial residential premises Hotel Taxable supply Other residential premises Existing house Input taxed supply Non-residential premises Office building Taxable supply Part of a going concern Part a business; e.g. hotel GST free Farm land Sale to intending farmer GST free Vacant land by registered supplier Private sale Taxable supply Not taxable

6 Meaning of Real Property The definition s in the GST Act defines real property as including: o An interest in or right over land o A personal right to be granted such rights (e.g. options) o A licence to occupy the land or any contractual right exercisable in relation to the land, for example a restrictive covenant. Meaning of Residential Premises According to s195-1, residential premises means land or a building, o Occupied as residence or for residential accommodation o Intended to be occupied and capable to be occupied as a residence or for residential accommodation Sale of New Residential Premises The sale of new residential premises is treated as follows: o If the premises were used for residential accommodation before 2 December 1998, the sale will be input taxed o In other cases, the sale will be subject to GST (s 40-65). Note that GST will only be payable if the seller is carrying on an enterprise and is registered or required to be registered. Meaning of New Residential Premises S defines new residential premises as: o Residential premises that have not previously been sold as residential premises, or have not been subject to a long term lease. o Residential premises that have been created by substantial renovations, i.e. involving the removal or replacement of all the building. This can apply even though the renovations do not involve replacing or removing external walls, roof or stair cases. o Residential premises that have been built to replace demolished premises on the same land, or which contain a building that has been built for that purpose. If the land on which a building that has previously been sold as residential premises is increased in size, the original house and land package would not be new. Similarly if the land is subdivided, so that the building now occupies a smaller block, that does not make those premises new. Meaning of Substantial Renovations The renovations need to affect the building as a whole. o Building is not treated as substantially renovated if there are radical changes to only one or two rooms o However there would be substantial renovations, if the fibro external walls were replaced by brick; some internal walls were removed; flooring throughout the house was replaced; the existing kitchen was removed and a new extended kitchen was installed (GSTR 20003/3). Replacing Demolished Premises The word 'demolish' is not defined in the GST Act, and therefore takes its ordinary meaning. The general meaning of the word is to throw or pull down (a building etc); reduce to ruins; to put an end to ; destroy ; ruin utterly (GSTR 2003/2, para 85). o In the context of the GST legislation, demolish means the pulling down or removal of a building. However, premises can be demolished without removal of all of the building, for example, where some of the existing foundations are retained. Similarly, the demolition of premises, apart from the facade, and construction of residential premises behind the facade, would create new residential premises. New residential premises do not include residential premises that have been used for rental purposes for a period of at least five years since they were built, substantially renovated or replaced. Sale of Strata Units Individual units in a strata title block are residential premises. However when several units are under the control of one management, the premises as a whole may be commercial residential premises, the sale of which is not input taxed (GSTR 2000/20).

7 Where a block of flats that has previously been sold as residential premises is strata titled, that doesn t make the newly- created strata new. o However, if substantial renovations are necessary to subdivide the block into flats, the new flats will treated as new premises Similarly, if the block of flat is under company title and the company that built the flats and strata titled them sells them, the sale is treated as a sale of new premises. Margin Scheme Overview Where the supply of real property is a taxable supply, special rules known as the margin scheme for calculating GST may apply (s 75-5) Normally GST would be calculated as 10 % of the value of each sale or (1/11 th of the GST inclusive price). Taxpayers who adopt the margin scheme may calculate the GST as 1/11 th of the margin between the selling price and the purchase cost of the property. There are two situations where a seller may elect to apply the margin scheme (eligible supplies): o If the property was held at 1 July 2000, the margin scheme allows the seller to calculate GST only on the increase in value since that date. o If the property was acquired after 30 June 2000 from another seller who used the margin scheme, the margin scheme allows the seller to calculate GST on the margin between the selling price and the price paid for the property. This also applies where the property was acquired under a GST-free, input taxed or non-taxable sale (for instance from an unregistered vendor). o The downside of the margin scheme is that the acquirer of the property cannot claim any input tax credit on the acquisition (s 75-20). The margin scheme will typically be applied by property dealers and developers who sell new residential units, land or house and land packages to private owners. As the purchasers would not be able to claim an ITC in any event, they will not be affected by the ineligibility to claim an ITC. The margin scheme cannot apply to subsequent sales of residential premises as these supplies would be input taxed. Ineligible Supplies The margin scheme can only apply to a supply of a real property which is a taxable supply. The following property supplies are ineligible to use the margin scheme: 1. Second and subsequent sale of residential property ( input taxed) 2. Short term and long term leases on residential properties (input taxed) 3. Farm land supplied for farming (GST free) 4. Certain supplies of sub-divided farm land ( GST free) 5. Land supplied as part of a going concern (GST free) o In addition, a supply of real property will be ineligible if the property has been acquired through a taxable supply in respect of which the GST liability was worked without applying the margin scheme. In other words, an eligible transaction is a taxable supply where the property was acquired either: o Through a transaction where the margin scheme applied o From an unregistered party ( e.g. a private seller) ( non taxable supply) o GST free under the going concern or the farmland provisions o Without consideration from a registered associate ( non taxable supply)

8 Eligibility for the Margin Scheme Is the transsaction a taxable supply? NO- Ineligible Was the property acquired through a taxable supply without the margin scheme? NO- Eligible YES- Ineligible Operation of the Margin Scheme Where the margin scheme applies, there is no requirement to issue a tax invoice as no ITC can be claimed (s 75-30). For all supplies made under contracts that have been entered into on or after 29 June 2005, the decision to apply the margin scheme must be agreed in writing by both parties ( s75-5 (1A)). There is usually little benefit in using the margin scheme where the purchaser is a registered GST payer entitled to a full input tax credit. o However, where the purchaser is not a registered GST payer (e.g a private individual) or a person making input taxed supplies, there may be benefits in using the margin scheme so as to reduce the amount of GST on the purchase. Whether the margin scheme is applied or not will sometimes be determined by stamp duty considerations. As stamp duty will apply to the GST inclusive consideration for a sale of real property, the application of the margin scheme to reduce the amount of the GST payable may produce significant stamp duty benefits also. However, the parties will need to weigh the benefits of the stamp duty saved against the detriment of the unrecoverable GST if the margin scheme were applied, before deciding whether or not to use the margin scheme. How to Calculate the Margin The margin is the amount by which the consideration for the supply exceeds the cost of acquisition of the property (S 75-10) For a property held on 1 July 2000, the cost of the property is the value as at 1 July If the taxpayer was not registered or required to be registered at 1 July 2000, the cost is the value of the property at the time the taxpayer becomes registered or required to be registered (s 75-10(3)). For a property acquired on or after 1 July 2000, the cost is the consideration paid for the acquisition of the property. The costs of acquisition does not include any consideration for improvements, construction or development costs of building work, additional costs such as solicitors fees and stamp duty ( s75-14). If the sale is part of a subdivision, the cost is calculated on a pro-rata basis (s75-15). This apportionment can be done on the basis of any reasonable method (GSTR 2006/8): o Area o Expected selling price o Number of lots Margin Scheme: Special Rules Special rules apply to a supply of a freehold interest, stratum unit or long-term lease made on or after 17 March 2005 where the relevant interest, etc was acquired: o in an intra-group transaction o from a joint venture operator of a GST joint venture o by inheritance o from an associate o under a transaction under which the full consideration has not been paid If a property is transferred within a GST group, the margin scheme cannot apply to the subsequent supply of the property unless the group member who first acquired the property from outside the group would have been

9 able to apply the margin scheme to a supply outside the group ( s 75-5) (supplies within a GST group are not taxable under Division 48). The margin on a supply outside the group is the difference between the selling price and the consideration paid for that property by the first acquirer (s75-11). o The same rules apply to supplies made between joint venture participants. Where a property is inherited, the deceased and the beneficiary are treated as one entity for the purpose of the margin scheme rules (s 75-11). In this situation, the margin is the difference between the selling price and the consideration paid by the deceased for the property. o If the deceased acquired the property before 1 July 2000, and was not registered for GST, the cost of acquisition is the value of the property on the later of the date that the property was inherited, and the date the beneficiary became registered for GST. o If the deceased acquired the property before 1 July 2000 and was registered for GST, the cost of acquisition is the value on the later of 1 July 2000 and the date when the deceased became registered. When the property is acquired from an associate, the margin will be the amount by which the selling price exceeds the market value of the property at the time of the acquisition (s75-11). If the property is supplied to an associate, the margin is calculated as if the selling price was the GST inclusive market value of the property ( s 75-12). Where the full price under the contract has not been paid, the margin will only reflect the amount paid ( s75-12). o However if further payment are made (for the acquisition of the property), a decreasing adjustment will result( s 75-27). New Rules from December The deficiency in the wording of the margin scheme provisions allowed ineligible supplies to become reeligible for supply under the margin scheme as a result of interposing certain GST free supplies (e.g. supply of a going concern or farmland) or non-taxable supplies (supply to an associate). As a result, a supply that was ineligible for the margin scheme continues to be ineligible after it is supplied as part of a GST free sale of a going concern or farmland or supplied to a registered associate for no consideration. o However when an eligible supply was supplied as part of a GST free sale of a going concern or farmland or supplied to a registered associate for no consideration and then re-supplied to another party, this resupply will still be eligible for the margin scheme.

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11 TUTORIAL QUESTIONS QUESTION1: Vic is the financial controller for Rainwright Limited (Rainwright), an irrigation equipment manufacturer. You are working in the business tax services department of a leading accounting firm. In March 2010, Vic approaches you for some advice on GST. He provides the following information: Rainwright is registered for GST purposes and has been since the commencement of GST on 1 July It had to register because, in addition to its manufacturing business, it carried on a self-storage business and had an annual turnover in excess of the $75,000 GST threshold. Before the year ending 30 June 2010, Rainwright intends selling one of its warehouses to XYZ Limited (XYZ). Rainwright has owned the warehouse since 1996 when it was purchased for $1.7 million. Vic recalls that Rainwright had the warehouse valued as at 1 July 2000 following a suggestion from Rainwright s former accountant. The value assigned was $2 million. Rainwright anticipates selling the warehouse for $2.8 million. Vic anticipates legal fees of $15,000 including GST in relation to the sale of the warehouse. Following the sale to XYZ, Rainwright intends leasing back the warehouse for $140,000 per annum including GST (i.e. the warehouse will be leased back to Rainwright). Vic has asked for a meeting in relation to the GST implications of the planned activities REQUIRED: a) Does Rainwright need to charge GST on the sale of the warehouse to XYZ? Disposal of property is generally subject to GST (not residential except where property is new or substantially renovated). o Therefore, as a commercial property it is necessary to charge GST b) If your answer to (a) was yes, how much? Be sure to canvass all options that may be available to Rainwright when calculating the amount of GST. Rainwright has two options on how much GST to charge: the standard option or the margin scheme. If it uses the standard method, GST will $254,545 (ie $ x 1/11) If it uses the margin scheme, Rainwright only needs to charge GST on the margin - $72,727 (ie ( ) x 1/11) o Where margin scheme is used you cannot claim ITC. c) Is XYZ entitled to claim an input tax credit on the acquisition of the warehouse for any GST that Rainwright charges? (This is critical to negotiations over sale value.) Assume that XYZ is registered for GST. If Rainwright uses the standard method to calculate GST, XYZ will be entitled to an input tax credit If the sale proceeds under the margin scheme, XYZ will not have an entitlement to an input tax credit d) Is Rainwright entitled to input tax credits on the legal fees? Rainwright will be entitled to input tax credits in relation to the legal fees of $1,364. e) Is Rainwright entitled to input tax credits on the future lease payments to XYZ? Rainwright will be entitled to input tax credits in relation to future lease payments of $12,728 per annum

12 QUESTION 2 Claire Developments Pty Ltd is registered for GST purposes. A building project involves Claire acquiring land from Urban Property Pty Ltd. The contract of purchase states that the price is $330,000 (inclusive of GST calculated under the margin scheme). Claire demolished an existing building on the land and constructed 10 units. Construction costs were $5.5 million (inclusive of GST). Clair sold one of the units for $440,000 (GST inclusive). Discuss the GST implications of Claire s activities. The units were new residential premises As Claire is registered, the supply of the units are taxable supplies. Claire will not be entitled to an ITC in respect of the acquisition of the land. In order to calculate the relevant margin under the margin scheme, Claire will need to apportion the land acquisition cost of $330,000 among all the units (section 75-15). The company will be entitled to claim ITC on the GST included in the construction costs, the ITC would total $500,000. Using the formula under subsection 75-10(2), GST under the margin scheme will be: Margin= Consideration for supply Consideration for acquisition = $440,000 - $33,000 (1/10th of $330,000) = $407,000 GST = margin x 1/11th = $407,000 x 1/11th = $37,000 Multiple Choice Questions Question 1 Which of the following will not be input taxed? Answer The leasing of a retail outlet to a tenant on a two-year lease. Question 2 Real property Investments (RPI) buys an existing residential property from a private seller who is not registered for GST. RPI renovates the building and subdivides the buildings into five residential apartments which are sold to owneroccupiers and private investors. RPI is registered for GST and claimed an ITC on the costs of the renovations. Which of the following statements regarding the sale of the residential apartments is correct? Answer The margin scheme may be applied to the sale as no GST applied to the acquisition of the building Question 3 Westco Ltd is a financial institution making both input taxed and taxable supplies. For the previous 12 months period, its input tax supplies were $15 million and its taxable supplies were $7.7 million (including GST). Westco recently refurbished its main office. The cost of refurbishment was $38,500 (Including GST). What is the amount of input tax credit (rounded to the nearest dollar) that Westco can claim on the refurbishment cost? Answer $1,187 - The ITCs need to be apportioned 7.7/(15+7.7) * * 1/11 Question 4 Which of the following is not a feature of input taxed supplies? Answer The entity making the input taxed supply will be liable to GST.