Australia: GST and the incoming lessor – you might have overpaid

Key Points:

You should consider whether you have overpaid GST and if so, take action to protect your ability to claim refunds of GST.

A property with a sitting tenant is sold. If you thought this was a continuing supply under the GST Act, think again. The Full Federal Court's decision in MBI Properties Pty Limited v Commissioner of Taxation [2013] FCAFC 112 confirms that the supply made under a lease is a one-off supply made upon the grant of the lease – meaning that some taxpayers might be entitled to a refund.

Starting at the beginning: the South Steyne GST case

The dispute at the heart of MBI had its genesis in the South Steyne litigation which dealt with the question of whether the purchaser of land subject to an existing lease makes a supply to the continuing tenant under that lease.

Imagine A owns a residential unit and leases it to B. In doing so, A makes a supply to B, amounting to the grant of all the rights under that lease.

A then sells its interest in the property ("the reversion") to C, subject to B's continuing rights as a tenant of that property. B continues in possession of the property, notwithstanding the sale to C. Indeed, the only thing that changes is that, after the sale, B will pay rent to C.

In South Steyne, the Full Federal Court said there was no supply made by C to B under the continuing lease. This came as a surprise, as it had been assumed that C, as the incoming lessor, would make a supply to the continuing tenant in consideration for the rent being paid by that tenant.

What South Steyne didn't answer: an incoming lessor's liability for GST

Because the supply under the lease in South Steyne was an input taxed supply on which no GST was payable, the Court did not need to consider whether the incoming lessor would be liable for GST in connection with the rent paid by the continuing tenant. Ordinarily, however, the lessor of residential premises making an input taxed supply would be denied input tax credits for acquisitions relating to the making of that input taxed supply. If the incoming lessor is not making an input taxed supply, the question arises as to whether there is any denial of credits.

Unsurprisingly, the Commissioner of Taxation's Decision Impact Statement on South Steyne stated his view that:

• the incoming lessor is liable for any GST payable on supplies made for the period of the lease after the date the purchaser acquires the reversionary interest; and
• the incoming lessor would be denied input tax credits for acquisitions relating to the making of input taxed supplies (or supplies that "would be" input taxed if they were supplies at all) under a continuing lease.

Enter Division 135

A number of provisions in the GST law enable a supply to be made "GST-free", including the supply of a going concern and supplies of farmland for farming purposes. By treating these supplies as GST-free, the recipient of the supply is not required to claim input tax credits – because no GST is payable. But these concessions were intended to provide cash flow relief to purchasers, rather than a full relief against the liability for GST.

Where the recipient of the supply would not have been entitled to a full input tax credit, there may be revenue leakage where the sale to that recipient was made as a GST-free supply of a going concern or a GST-free sale of farm land.

Division 135 is intended to claw back that benefit from that recipient. The mechanisms by which it attempts to do so are complex and potentially unsatisfactory – but that is a matter for another time.

MBI becomes an incoming lessor – and liable for GST?

MBI bought three apartments in the hotel complex that had been the subject of the South Steyne litigation. Before the sale, the vendor granted a lease to MML. The apartments were sold to MBI subject to that continuing lease as GST-free supplies of going concerns. Following South Steyne, the lease of the apartments to MML was an input taxed supply. As the purchaser of the reversionary interest, MBI would have an increasing adjustment (essentially a liability for GST) under Division 135 if it were making an input taxed supply to MML (under the continuing lease).

If, however, MBI was not making an input taxed supply, then no increasing adjustment could arise.

Justice Griffiths held that MBI had an increasing adjustment on the basis that under Division 135 it did not matter whether the input taxed supply was made by the purchaser of the reversion or someone else. It was sufficient if the supplies that "will be" made through the purchased enterprise would have been input taxed.

There's no increasing adjustment – so there's no GST liability

The Full Federal Court unanimously overturned Justice Griffiths' decision, making it abundantly clear that there is no supply made by the purchaser of the reversion to the continuing tenant.

As stated by Justice Edmonds:

"The lease is the subject of the supply, not the "supply"; the "supply" is the grant of the lease: see s 9-10(2)(d) of the GST Act. The act of the grant does not continue for the term of the lease; the "supply" is complete on the lease coming into existence. The "supply" constituted by the grant of the lease did not continue beyond the grant; the fact that the lease continued was solely a function of the terms of the grant, not a continuing supply by the grantor

...

"In my view, the primary judge erred in concluding that, following the sale of the reversion from South Steyne to MBI, there was a continuing supply by South Steyne to MML; there was no continuing supply, merely a continuation of the lease, the subject of the supply made by South Steyne to MML by the grant."

Finally, there could be no increasing adjustment for MBI because "MBI makes no supplies, input taxed or otherwise, in leasing the units to MML. In other words, it makes no supplies in carrying on its enterprise which could be regarded as being made "through" its enterprise."

What does this mean for incoming lessors?

Notwithstanding the decision in South Steyne, it had been assumed that the incoming lessor would be making some supply to a continuing tenant. The Full Federal Court has now unequivocally contradicted the position adopted by the Commissioner following South Steyne and cast doubt over:

• the liability of an incoming lessor to pay GST on supplies made to a continuing tenant in premises that would ordinarily be the subject of a taxable supply (such as commercial premises, warehouses, shopping centres); and
• the denial of input tax credits for acquisitions relating to the leasing of premises to continuing tenants in premises that would ordinarily be the subject of input taxed supplies.

As always, there is the prospect of the Commissioner seeking leave to appeal the decision of the Full Federal Court to the High Court. Given the wide ramifications of the decision, such an appeal would be likely.

The seriousness of the decision for the administration of GST and the integrity of the tax base also makes it possible that the Government will seek to make retrospective amendments to the GST law, making it clear that a supply by way of lease is a "continuing supply", not just by the original grantor of the lease but any subsequent lessor.

Nonetheless, you should consider whether you have overpaid GST and if so, take action to protect your ability to claim refunds of GST.

You might also be interested in...

• Leasing residential premises – so common but so unbearably complicated

Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.