25 May 2010

Full Federal Court rejects Commissioner's "economic substance" approach to GST administration

by Andrew Sommer

It is not open for the Commissioner to seek to "look through" legal realities so as to impose tax on what he perceives to be the "economic substance" of the transaction.

The Full Federal Court has rejected the Commissioner of Taxation's approach in seeking to impose GST on the basis of the "economic substance" of a transaction rather than its legal form (Commissioner of Taxation v Gloxinia Investments (Trustee) [2010] FCAFC 46).

The Court's ruling throws into question the whole of the Commissioner's logic in his public ruling, GSTR 2008/2 "development lease arrangements with government agencies" and a Decision Impact Statement setting out the future of that ruling would be expected in the near future.

Of broader significance may be some of the Court's statements about the importance of the legal substance of transactions in the identification of the GST consequences of transactions.

In Gloxinia, the Full Federal Court held that the Woollahra Municipal Council made a supply of residential premises to a developer, Gloxinia, following Gloxinia's completion of a development on land owned by the Council.

Was there a supply of new residential premises or not?

The Commissioner had sought to argue that there was no supply of the new residential premises to Gloxinia by the Council, which would mean Gloxinia's sale of the long-term leases to purchasers would be the first supply of new residential premises, and thereby liable to GST at that point.

Gloxinia contended that because the Council had made the first supply of the new residential premises to Gloxinia (which was a taxable supply), Gloxinia's subsequent sale of the long-term leases over those residential premises was an input taxed supply, and Gloxinia was not liable to remit GST on that supply.

GSTR 2008/2 and looking through certain legal transactions to the "economic substance"

GSTR 2008/2 represented an attempt by the Commissioner to look through certain legal transactions in an attempt to get to the "economic substance" of a transaction. In particular, the Commissioner concluded that:

  • there was no supply of works by the developer to the government authority on whose land the works were constructed; and
  • therefore, there was no supply of "residential premises" when the government authority granted a lease over the land at a time when the premises had been constructed on the authority's land. Even though the completion of those works was a necessary pre-condition to the lease being granted, the Commissioner's view was that the "true character" of the transaction was a lease "merely" of the land and "not land and the attached development works".

It was this logic that that led to the Commissioner arguing in Gloxinia that there was no supply by the Council to Gloxinia of the "residential premises".

Why there was a supply by the Council to Gloxinia

The Court stated:

"Especially in the written submissions, the Commissioner sought to elevate the 'social and economic reality' of the transaction over its strictly legal form and effect.

The Court cannot ignore the legal effect of the grant of the Strata Lot Leases by the Council.

Nothing in any of the cases referred to by the Commissioner … dictates that the Court should ignore the legal effect of the transactions involved, particularly the grant of the Strata Lot Lease."

This lead the Court quickly to the conclusion that the taxpayer must succeed, as there was no question that the residential premises were the subject of a long-term lease by the Council to Gloxinia.

Justice Dowsett's dissent

Justice Dowsett found in favour of the Commissioner. However, it is instructive to examine his reasons for doing so.

Rather than endorsing the Commissioner's "economic substance" approach, Justice Dowsett had a different view of the legal consequences of the transaction. He determined that on the facts of this particular case, the supply to Gloxinia was merely bare legal title to the Strata Lots at a time which Gloxinia already held all of the other rights in the Strata Lot. This did not amount to the supply of the "residential premises" by way of long-term lease.

What happens now to GSTR 2008/2?

The Commissioner is yet to announce his plans for a Decision Impact Statement in response to the Gloxinia decision.

What does this mean for future decisions by the Commissioner of Taxation?

The Court's approach in Gloxinia is a clear indication that there is a limit to the extent that terms like "practical business tax" will be useful in determining the GST impact of transactions.

While it is important to have regard to the operation of the tax in the real world of business, respect for the legal consequences of transactions validly entered into by commercial parties are equally part of that real world. It is not open for the Commissioner to seek to look through legal realities so as to impose tax on what he perceives to be the "economic substance" of the transaction.

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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 communication. Persons listed may not be admitted in all States and Territories.