Australia: The twisted conundrum of commercial residential property and GST

Last Updated: 11 February 2013
Article by Scott McGill

Where something simple ends up being way too complex – MBI Properties Pty Ltd v Commissioner of Taxation

Over the last few years we have had a series of decisions flowing out of the development and sale of units in what is now known as the Sebel Residences in Manly that have left developers, advisers and the Australian Taxation Office alike in a confused and uncertain position.

The wagging tail of these protracted proceedings - MBI Properties Pty Ltd v Commissioner of Taxation {2013} FCA 56 ('MBI') - was handed down Wednesday 6 February 2013, less than a week after it was heard. The cases that went before it on separate but related issues initially before Stone J in the Federal Court and ultimately before the Full Court in South Steyne Hotel Pty Ltd v Federal Commissioner of Taxation (2009) 180 FCR 409 ('South Steyne') are perhaps better known. MBI Properties Pty Ltd is a related party to South Steyne Hotel Pty Ltd.

As purchaser, MBI Properties has been punished harshly on the acquisition of what are otherwise residential investment units, with an extra 10% of the purchase price payable to the ATO as a GST adjustment event 1.

It should have been simpler, but perhaps the saga is not yet over as there are at least 12 other impacted parties, who were arm's length and unrelated to the vendor. Most of which have proceedings on foot to also argue with the ATO. As unrelated parties they are able to argue different grounds, but more on that later.

A quick and simple overview

Leaving aside some of the complexities, let's start with a relatively simple and common development example – old multi story hotel, looking to refurbish and sell off the individual rooms to investors and have those investors place the units back in a pool for an experienced operator to offer hotel style accommodation. Common areas, hotel facilities such as reception/concierge, restaurants, gym pool etc and some hotel room service to be provided. Good idea, should be a success.

Every development however incurs costs, and embedded in those costs is generally 10% GST. Developers will typically want to claim back that GST to manage costs and cash flow through construction/refurbishment. Under GST legislation, they are entitled to do so as long as what they finally produce & supply is taxable and subject to GST. Simple.

This is however where it starts to get complex, as residential property is not ordinarily subject to GST unless it is "new" or is considered to be "commercial residential premises" and accordingly taxable. Dealings in residential property other than in those circumstances is input taxed meaning no GST is payable on the income you receive, and no credits are available on relevant costs.

At the time that the South Steyne developments commenced there was some doubt amongst advisers and many robust discussions with the ATO as to whether such investment units were commercial residential premises or not. The definition 2 includes a "hotel" or something that is similar to a hotel. It should be noted however that the ATO has maintained its view that investment units on their own cannot be a "hotel" or something similar. This was based largely on a policy driver that mum and dad investors should not be burdened with the complexity of GST compliance on investment properties.

Access to GST credits not an issue for developers where they sold the units, as they would be considered "new" and would ordinarily be subject to GST, albeit at a concessional level under the margin scheme. However the arrangements in South Steyne end up being quite a bit more complicated than this, with all the units being divided into strata lots and then leased individually to the hotel operator before sale. When sold to investors they were sold with that lease in place and already in the pool for management by the operator.

As the advisers considered the investment units may be commercial residential it was considered that there would be a cash flow and also perhaps a Stamp Duty saving by selling the units as a GST free going concern 3. This made the vendor happy as they would be able to charge the market selling price and not have to take a chunk out of the proceeds to send to the ATO as GST. The downside was however to the purchaser with two possible outcomes:

  • The purchaser would be obligated to charge and collect GST on the lease income they subsequently received from the hotel operator, and if they later sold the unit it would be subject to GST (if not also sold as a GST free going concern).
  • Alternately if the investment units were not properly commercial residential and accordingly input taxed, then the adjustment event provisions of the often overlooked Division 135 of the GST Act would kick in to give the purchaser a GST liability equivalent to 10% of the purchase price.

This was made clear in the materials provided by the vendor and their agents, and caused concern amongst potential purchasers, who in reality were just looking for an investment unit.

To alleviate this concern and protect the purchasers from this adjustment event a clause was inserted in the purchase contract that essentially provided that if the investment units were not commercial residential and subject to GST on the lease fee received, then the terms of the contract would be varied. Clause 47.6.6 is referred to at length in the South Steyne judgements.

That contract variation would result in the sale at the agreed purchase price not being treated as a GST free going concern, but rather as a taxable supply with the margin scheme applying - and for the "absence of doubt" the GST liability on this would be payable by the vendor and not charged on to the purchaser.

Great result, vendor gets to try the more complex approach to save money and the purchaser is protected from a difficult and costly outcome if the vendor is incorrect. All good?

Where did it go wrong?

The facts of the South Steyne case are complex, but relevant to the MBI case the ultimate judgment of the Full Court held in 2009 that:

  • The premises in question were not commercial residential premises in either the hands of the vendor or the purchaser/s of the units. Accordingly the lease from unit owner to Mirvac was not subject to GST and was an input taxed supply.
  • The supply of the hotel room by the operator to a guest was however a taxable supply of commercial residential premises.
  • No "supply" however was made under the lease to Mirvac by the purchaser as acquirer of the lease reversion.
  • The terms of the contract that sought to make the sale of the premises a taxable supply under the margin scheme - with the GST liability staying with South Steyne as vendor - were not effective and the sale remained a GST free going concern.

This was perhaps an acceptable result to the vendor entity, however a potentially disastrous result to MBI and other purchasers as the intended protection under the contract agreed to by both parties fails.

The reasons for this continue to confuse me. With respect I consider this to be not only at odds with policy intent (and the arguments of the ATO) but also the catalyst for the extraordinary outcomes we are now seeing argued. With respect I consider for other (arm's length) purchasers, proper assessment of the surrounding circumstances, intentions of the parties and the terms of the contract, another court would find differently. This will be argued as these cases now come to bear.

After some time of both the ATO and advisers trying to digest the full impact of the South Steyne decision and what was actually meant by purchasers not making any further lease supplies on the acquisition of a reversion, the ATO ultimately raised GST assessments against impacted purchasers for 10% of the contract purchase price under Division 135.

These have been disputed and the first to see the light of day was MBI Properties Pty Ltd. Whilst I consider that the better answer is and will ultimately be held for other purchasers that the contract operates as intended, MBI is unable to run that argument and was constrained to the narrow arguments regarding the operation of Division 135.

Going concerns, Division 135 & the MBI case

The ability to treat the sale of something as a GST free going concern is a practical concession, and all things being equal a revenue neutral provision to the ATO. Where you meet certain conditions, GST is waived on the sale price on the assumption that whatever GST would have been charged would be available as a credit to the purchaser, so essentially revenue neutral from the ATO view. In most cases the contract value will be lower and there are worthwhile Stamp Duty savings in that.

The protection to abuse of these provisions is Division 135, which in simple terms seeks to recover GST from the purchaser if they would have otherwise not been entitled to claim the GST if charged on the purchase - but for it being a GST free going concern. Entirely logical, but unfortunately somewhat problematic in practice.

Division 135 prescribes that you have an adjustment event equal to 10% of the purchase price where you have acquired something as a GST free going concern and "you intend" that some or all of the supplies "made through the enterprise to which the supply relates" will not be taxable or GST free. In other words you will make input taxed supplies. The supply of residential premises under lease is input taxed and carries no GST liability so this would appear to invoke Division 135 for the purchasers of the investment units? It is perhaps not that simple.

Division 135 requires that there be "supplies made" and the decision of the Full Court in South Steyne, clearly held that the purchaser made no further supply under the lease to Mirvac. The key MBI argument is that with no further supply, the provisions of Division 135 could not be invoked.

An unusual and perhaps unintended outcome with much broader implication. In an extraordinary judgment Griffiths J seeks to address this by interpreting Division 135 as not requiring the referable supplies as being made by "you" as the purchaser. He indicates that the original supply by the vendor is the relevant supply, and as that was not taxable, Division 135 is invoked.

Although this perhaps addresses the perceived immediate mischief in MBI, with respect it is perhaps not the better technical answer. There is some serious question as to whether a provision that refers to "you" having an adjustment event, where "you" are the recipient of a supply that is a GST free going concern, and "you" intend will not be making taxable or GST free supplies does not firmly imply that "you" would be making those supplies.

This is further supported by the wording of Division 11 in respect of creditable purpose 4. Division 135 is specifically in place to address the mischief that Division 11 would otherwise deal with, but for there being a GST free going concern and in doing so focusses on "you" and "your" enterprise:

"You acquire a thing for a creditable purpose to the extent that you acquire it in *carrying on your *enterprise."

It seems to me unlikely that Division 135 was intended to have a different function regarding a third parties enterprise.

That being said, if his honour is correct, and the referable supply or supplies relevant to Division 135 do not have to be made by "you", then it may be validly argued that the most relevant referable supply and enterprise is that which is made, using the subject property, by the operator to the guest/s. Griffiths J supports this connection in paragraph 37 of the judgement by referring to a "strong and inextricable connection with the serviced apartment business" run by Mirvac.

That enterprise is clearly making taxable supplies, which if accepted as the most relevant enterprise, would prevent the operation of Division 135.

Where to from here?

It remains to be seen whether MBI has the appetite to appeal this decision and continue the fight. This is an expensive exercise and MBI was required to meet the Commissioner's costs in this action.

The appeal has some merit, however even if MBI were to be successful, it opens another can of worms, leaves the legislation wanting as to its intended function and would no doubt result in the ATO and Treasury seeking amendments to correct the anomaly.

The better answer lies in the twisted wreckage before it by revisiting the decision that the mutually agreed contractual provisions of the purchase contract did not work. It is a matter of record that the South Steyne decision was made without sufficient evidence and/or submissions on the issue – and by implication lead to two of the Full Court Judges indicating they could not understand the purpose of the provision, holding that the primary contractual position stood. It is also a matter of record that Stone J in the first instance decision and Edmonds J in the Full Court found differently.

With respect it is suggested that on full assessment of all the circumstances and the intention of the parties that a Court would properly find that the sale of the units to the purchasers was indeed a taxable supply under the margin scheme, leaving a GST liability with the vendor as argued by the Commissioner in the first instance, leaving no Division 135 liability for purchasers and put some certainty back into the property industry.

This will provide the "right" answer, reflecting the policy intention, dilute the anomalies that have fallen out of South Steyne in regard to leases and put simple investors back into the correct position. South Steyne Hotel Pty Ltd has a liability – but this is at a lower level than that imposed on the purchasers and in any case intended by the parties. It will not escape any one's attention however that the ATO is now outside the four year time limit to recover any such GST.


1 Division 135 – A New Tax System (Goods & Services Tax) 1999 ('GST Act')

2 Section 195 commercial residential premises – GST Act

3 Section 38-325 – GST Act

4 Section 11-15 (1) – GST Act

This publication is issued by Moore Stephens Australia Pty Limited ACN 062 181 846 (Moore Stephens Australia) exclusively for the general information of clients and staff of Moore Stephens Australia and the clients and staff of all affiliated independent accounting firms (and their related service entities) licensed to operate under the name Moore Stephens within Australia (Australian Member). The material contained in this publication is in the nature of general comment and information only and is not advice. The material should not be relied upon. Moore Stephens Australia, any Australian Member, any related entity of those persons, or any of their officers employees or representatives, will not be liable for any loss or damage arising out of or in connection with the material contained in this publication. Copyright © 2011 Moore Stephens Australia Pty Limited. All rights reserved.

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