Damian O'Connor, Special Counsel
If you build a residential property and rent it out, you cannot claim input tax credits on the cost of the construction. This is because residential rent is input taxed, ie GST is not payable on the rent received but no input tax credits are allowed for the costs of building the rental property.
If you build and sell a new residential property, the sale will be subject to GST and you will be entitled to claim input tax credits.
The GST treatment where you build to sell and then rent is much more complicated than you might expect.
Commissioner's original view
The Tax Commissioner's original view was that while you don't have to pay GST on rent received, you do have to pay back all the input tax credits claimed on the construction costs. These amounts have to be paid back because (the Commissioner said) the purpose that you held the property was now 100% non-creditable (ie residential rent), not 100% taxable (sale) for which the property was held when input tax credits were claimed.
When the property was eventually sold (a GST taxable supply) some input tax credits could be claimed, apportioned over the non-creditable use (rent) and the taxable activity (the sale).
Sale time apportionment could work on the basis that no input tax credits are allowed for the proportion that the rental income (or the notional market rental if this was higher) represents of the total proceeds (the sale price plus the rent). For example, if the sale price was $1 million and the rent received was $75,000, 7.5% of the input tax credits would be denied with the balance claimable in the Business Activity Statement (BAS) period that the sale was made (effectively recovering most of the ITC's previously claimed and then repaid to the ATO).
The Australian Taxation Office (ATO) reasoning seemed to be that you can only have a 100% sale purpose or a 100% rental purpose, you can't have both at the same time. According to the Commissioner, once you start to rent the property the sale intention disappears and with it your entitlement to claim input tax credits at that time.
Whatever the reasoning, this was a wholly unsatisfactory outcome for developers. All the input tax credits claimed would need to be repaid to the ATO as an adjustment to GST net amounts, only to have most of the money returned when the property was sold.
The Commissioner's changing perspective
On 19 August 2008, the Commissioner issued an ATO Interpretative Decision setting out his new view of how these transactions should be treated for GST purposes.
Importantly, the Interpretative Decision accepted that a property could be used for different purposes at the same time, ie rental (which does not give an entitlement to ITCs), and sale (which does give an ITC entitlement).
Once the Commissioner had reached this conclusion, it follows that a change in purpose from 'sale only' would not trigger a requirement to pay back all the ITCs that had been originally claimed. So far, so good.
In order to satisfy the ATO that there is a concurrent sale purpose, the Interpretative Decision identified some factors the Commissioner might take into account – including listing with agents at somewhere around market price.
Once concurrent purposes are established (to the Commissioner's satisfaction), the next question is how to apportion ITC entitlements on a fair and reasonable basis, in accordance with the GST adjustment rules.
Broadly, these adjustment rules require the initial intended purpose (ie sale) and the actual application (some sale activities, some rental activities) to be compared at the end of each "adjustment period".
The complicated question under the new interpretation is just how much ITCs should be paid back to the ATO at that time, given that the property hasn't yet been sold, you don't know what the sale price is or how long it will be rented for.
In a simple case apportionment can work by reference to factors such as the proportion of taxable and non-taxable income a particular asset generates, floor area, time used for the respective activities etc.
The ATO current preferred approach is called the "output based indirect method", basically using an estimate of the sale price as the basis for working out the proportion of the ITCs that relate to taxable supplies and which can therefore be claimed.
The ATO view (as updated in a draft ruling issued in December 2008), is that the percentage entitlement to ITCs worked out using the output indirect method may need to be further apportioned on a time basis in some cases, such as where the sales purpose ceases and rental then commences.
Where does that leave us?
The ATO position is still unsettled as the current ruling is a draft. The preferred ATO position will involve working through the complicated adjustment period rules, as well as ensuring that there is sufficient evidence of taxable purpose (ie marketing for sale) over time, to satisfy the Commissioner that any apportionment of input tax credits is fair and reasonable.
We understand that the ATO target date for finalising the draft ruling is 17 June 2009. In the meantime, the ATO's revised view is certainly a step in the right direction and provides some guidance on the evidence that the Commissioner may seek when he reviews the GST treatment of these transactions.
It is worth keeping in mind that the correct treatment of GST adjustments is being targeted as part of the ATO 2009 Compliance Program. The ATO have even published a 'Voluntary Disclosure Statement – Property' if you have the urge to disclose any GST adjustments that you think have not been properly accounted for.
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