01 Apr 2015

Be informed - and inform - to avoid goods and services tax liability on insurance settlements

by Mark Waller, Danielle Davison

The insured must inform the insurer strictly in accordance with the timeframe prescribed by the GST Act ‒ or be exposed to potentially unforeseen and adverse tax implications.

Most businesses will need to make a claim under a property or liability insurance policy at some point. In making and settling a claim under such a policy, however, they may not be aware of the risk that the settlement amount might attract goods and services tax (GST). If the settlement is significant, this could have serious financial implications for the insured entity.

Anyone responsible for managing risk in an organisation needs to be aware of this risk to avoid the potentially disastrous result of having to pay GST on an insurance settlement — an amount which is typically not recoverable from the insurer.

What is the risk?

Standard claim forms generally include a question asking the insured (the premium payer for the purposes of this article) to disclose its input tax credit (ITC) status. Such disclosure by the insured is usually enough to avoid GST liability — but only if it is properly made and made at the right time. There are important requirements under the GST legislation in respect of how and when the disclosure must be made to avoid the risk of attracting GST on an insurance settlement.

Picture this scenario:

  • Your company arranges insurance for a construction project through its insurance broker.
  • The project insurance includes a professional indemnity (PI) policy which provides cover for the costs of rectifying a defect in the project works caused by a design error — the limit for claims made under the PI policy is $10 million in the aggregate.
  • When arranging the insurance, you complete a proposal which discloses that the company is entitled to a 100% ITC.
  • After your insurance broker submits the proposal to the PI insurer, the company pays the premium for the PI policy in the amount of $550,000, which includes $50,000 for GST to be remitted to the Australian Taxation Office (ATO) by the PI insurer. The company subsequently claims a full ITC in respect of the premium.
  • During the course of construction of the project a design defect is identified and the company incurs $10 million in rectifying the design defect.
  • The company makes a claim under the PI policy to recover the rectification costs. The claim is made by letter and submission to the insurer and no “claim form” is required by the PI insurer. The insurer accepts the claim and pays the company the full policy limit of $10 million.
  • The company is subsequently audited by the ATO and the ATO issues a revised assessment requiring the company to remit $909,090.90 GST to ATO (being 1/11th of the settlement sum) on the basis that the settlement of the claim under the PI policy was a taxable supply as the company did not inform the PI insurer of its ITC status since the last premium was paid [1]  for the PI policy and before the claim was made under the policy.

Is the company liable to remit the GST?

The legal position

The GST treatment of insurance settlements is governed by a specific set of provisions in Div 78 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act). Section 78-45 provides that the payment of money or a supply (or both) by an insurer in settlement of a claim under an insurance policy [2] is not treated as consideration for a supply by the entity insured or by any other entity entitled to an ITC for the premium paid for the policy. The effect is that GST is not payable by the insured on the settlement amount; that is, the settlement does not amount to a taxable supply by the insured to the insurer.

However, s 78-50 of the GST Act provides an exception to this general rule. The exception operates where the insured is entitled to an ITC for the premium it paid [3] and either:

(a) did not inform the insurer at or before the time a claim was first made under the insurance policy and since the last payment of a premium of its entitlement to an ITC for the premium it paid; or

(b) in informing the insurer of its ITC entitlement, understated its extent.

In these circumstances, the whole or part of the settlement payment is expressly treated as consideration for a taxable supply, and the insured will be liable to remit GST (1/11th of the total value of the settlement) to the ATO. If the insured fails to remit the GST as required, the Commissioner of Taxation may commence enforcement proceedings against it seeking recovery of the unpaid sum, together with penalties and interest (see Divs 2, 3 and 4 of A New Tax System (Goods and Services Tax Administration) Act 1999).

When does the requirement to inform apply?

Section 78-50(1)(c)(i) requires the insured to inform the insurer of its ITC entitlement “since the last payment of a premium for the insurance policy and at or before the time a claim was first made under the insurance policy”.

It is clear from the text of s 78-50 that the insured does not have to inform the insurer every time a claim is made under a policy. If a number of claims are made pursuant to the one policy, the insured is only required to give the information once: at or before the time “a claim” — any claim — was “first made” under the policy.

Strictly speaking, in order to comply with the provision, the insured must first pay the premium. Once the premium is paid, the insured must then notify the insurer of its ITC status. Again, this must occur at or before the time it first makes a claim under the policy. In the scenario above, the advice to the PI insurer in the proposal regarding the insured's ITC status occurred before the premium was paid. It follows that, on a literal reading of the section, this disclosure to the PI insurer does not satisfy the timing requirements of s 78-50 and, assuming the PI insurer was not subsequently informed of the insured's ITC status before or at the time the claim was made, the amount of any claim settlement under the PI policy may be treated as a taxable supply attracting GST.

The insured will be “out of time” to notify the insurer of its ITC status when the insurer accepts any claim, or pays any claim, or settles any claim. In those circumstances, the insured will not have complied with s 78-50 and will thus be liable to remit as GST 1/11th of the total value of any settlement to the ATO.

So when is a claim considered to have been “first made”? While the answer depends on the facts of each case, the ATO has provided guidance on this point. For example, if the insured is required under the relevant policy to submit a claim form to the insurer, the claim is not made until that form has been filled out and submitted. If, however, a claim may be accepted without a claim form (for example, by telephone), the claim is made when the telephone claim is made.

The reference to “since the last payment of a premium”, although not expressly stated, implies that the premium paid is that in connection with the policy pursuant to which the relevant claim is made.

What level of disclosure is required?

Section 78-50 provides that the insured need only “inform” the insurer of its entitlement to an ITC for the premium paid, and the extent of that entitlement. The GST Act does not expressly provide how the insured must “inform” the insurer of such an entitlement.

To ensure the requirement to inform is met, prudence dictates that the insured should give notice of its ITC entitlement in writing. Again, this must occur at or before the time a claim is first made under the policy and since the last payment of a premium. Such evidence may be critical later in the event an allegation is made that the information required under s 78-50 was not given properly.

If information about the insured's ITC entitlement is given orally, the person giving that information should keep a careful written record of that fact setting out all relevant particulars (including the date and time that the information was given, by whom and to whom it was given) and immediately confirm that position in writing with the insurer.

Falling short of s 78-50 — seeking GST relief

An insured who has not complied with s 78-50 may apply to the Commissioner of Taxation seeking a private ruling [4] that the insurance settlement is not consideration for a supply, and is therefore not liable to GST.

To achieve a favourable outcome, the insured would need to provide clear and cogent evidence as to the reason this may be the case. It may be sufficient, for example, if the insured could clearly demonstrate that the persons arranging the cover (such as the broker or relevant claims officer) and the insurer always had it in their mind and acted on the basis that the insured was entitled to a full ITC and there was no positive evidence that the insurer was not notified at the relevant time. However this should not be viewed as a default strategy. There is no guarantee that the Commissioner will make a favourable determination — particularly where the insured has simply omitted to make the appropriate disclosure at the prescribed time.

Inform, inform to avoid GST risk

As with any risk, prevention is better than cure. As well as ensuring that full disclosure has been made to the insurer of the insured's ITC entitlement, remember — timing is everything. The insured must inform the insurer strictly in accordance with the timeframe prescribed by the GST Act. A failure to comply with the law will expose the insured entity to potentially unforeseen and adverse tax implications — reducing a significant settlement amount to something much less.

 

This article was first published in Inhouse Counsel, Vol 19 Nos 1-2, April 2015

 


[1] On a literal reading of s 78-50, the notification of the entitlement to an ITC must be made after the premium is paid. Back to article

[2] “Insurance policy” is defined in s 195-1 of the GST Act to mean a policy of insurance (or of reinsurance) against loss, damage, injury or risk of any kind, whether under a contract or at law. However, it does not include such a policy to the extent that it does not relate to insurance (or reinsurance) against loss, damage, injury or risk of any kind. Back to article

[3] Section 78-50 therefore have no application if the premium payer is a private consumer or otherwise has no entitlement at all to an ITC for the premium. It also is specifically not applicable to a compulsory third party scheme. By virtue of s 78-50(1)(d), insurance policies issued under compulsory third party schemes are also expressly carved out. Back to article

[4] A private ruling is binding advice that sets out how a tax law applies to a taxpayer in relation to a specific scheme or circumstance. Typically, a taxpayer would apply for a private ruling to seek certainty from the ATO as to how a tax law applies to its particular set of circumstances. Back to article

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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.