GST consequences of a cancelled contract

Sections 8(1), 9(1), 20(3)(a) and 25 of the Goods and Services Tax Act 1985

Background

We have been asked to clarify Inland Revenue's views on whether GST is chargeable on the amount of a deposit paid under a contract for the sale and purchase of land, when the contract is cancelled (including where the contract is cancelled as a consequence of the vendor's default or as a consequence of the purchaser's default) but the deposit is retained by the vendor.

The question

If a vendor retains a deposit paid under an agreement for the sale and purchase of land, is the vendor required to account for GST on the amount of the deposit and is the purchaser entitled to an input tax credit on the amount of the deposit?

The answer

The cancellation of the contract does not relieve the vendor of the obligation to account for GST in respect of the supply of the land or disentitle the purchaser to an input tax credit in respect of the purchase of the land in the period in which the supply was deemed by section 9 to have been made or (in the case of vendors or purchasers who are registered on a payments basis) the period or periods in which payment was made in respect of the supply. 

However, where an agreement for the sale and purchase of land has been cancelled, the GST effects of entering into the contract will be reversed in the period in which the agreement is cancelled.  Therefore, where a contract has been cancelled, GST will not be chargeable on the amount of the deposit retained by the vendor and the purchaser will not be entitled to an input tax credit on the amount of the deposit.

Analysis

Function of a deposit

Contracts for the sale and purchase of land generally require a deposit to be paid by the purchaser when the contract is entered into.  Such contracts also generally provide that if the purchaser fails to complete settlement, the vendor may elect to cancel the agreement and retain the deposit for the vendor's benefit. 

The legal interest in land is acquired on registration of the transfer of the title to the land to the purchaser.  Before registration the interest of a purchaser under an unconditional contract in the land is known as an "equitable interest" which is still enforceable through the courts although registration has not been effected: Firth Concrete Industries Ltd v Duncan [1973] NZLR 188.  The passing of equitable ownership is conditional on completion of the contract but the passing of equitable ownership then relates back to the point in time when the purchaser is able to obtain specific performance: Rayner v Preston18 Ch D 1.  The purchaser's equitable interest would be terminated by cancellation of the contract: Field v Fitton [1988] 1 NZLR 482. 

A deposit is part-payment of the purchase price: Howe v Smith 27 Ch D 89; Martin v Finch [1923] NZLR 570; Soper v Arnold[1889] App Cas 429.  A deposit does not relate to a separate supply of a chose in action (being the equitable interest in land).  The equitable interest in the land is not severable from the legal interest: Case W11 (2003) 21 NZTC 11,100; Case W22 (2003) 21 NZTC 11,212 (upheld on appeal: Ch'elle Properties (NZ) Ltd v CIR (2004) 21 NZTC 18,618).  A contract for the sale and purchase of land involves only one supply: Nicholls v CIR (1997) 18 NZTC 13,265. 

Where a vendor cancels a contract as a consequence of the failure of the purchaser to perform the contract, the deposit retained by the vendor relates to compensation for the purchaser's breach and not to any supply under the contract.  The deposit represents liquidated damages for the breach of the contract, being a pre-estimate of damages in respect of a breach: Robophone Facilities Ltd v Blank [1966] 3 All ER 128; Stockloser v Johnson [1954] 1 All ER 630.  If the deposit is a penalty, the court may grant relief against forfeiture of the deposit. A deposit of 10 percent is not regarded as being penal in nature: Worsdale v Polglase [1981] 1 NZLR 722.

GST consequences of entry into the contract

Where both parties are registered on an invoice basis, the vendor is required to account for GST on the full amount of the sale price and the purchaser is entitled to an input tax credit on the full sale price in the period in which the supply is deemed by section 9(1) to take place (that is, when the deposit is paid or an invoice is issued): Case L67 (1989) 11 NZTC 1,391; Case N24 (1991) 13 NZTC 3,199; Auckland Institute of Studies Ltd v CIR (2002) 20 NZTC 17,685. 

A vendor who is registered on a payments basis is required to return GST on land supplied or deemed by section 9(1) to have been supplied in any period to the extent that a payment is received in respect of the supply of the land during the period.  A purchaser who is registered on a payments basis is entitled to an input tax credit in respect of land supplied or deemed to have been supplied to the purchaser in any period to the extent that a payment has been made in respect of the supply of the land: sections 20(3)(b) and 20(4)(b); Nicholls v CIR (1999) 19 NZTC 15,233.

GST consequences of cancellation of the contract

Where a contract for the sale of land is cancelled, an actual supply of the land will not be made and no other supply will be made in return for the deposit.  For there to be a supply of services to the purchaser in return for the deposit, the vendor must have done something for the purchaser (such as providing a right to the purchaser) rather than against the purchaser: Case S65 (1996) 17 NZTC 7,408.  The Commissioner considers that services would not be provided by the vendor to the purchaser for a deposit forfeited as a consequence of the purchaser's breach.  The forfeiture and retention of the deposit because of the purchaser's breach of the contract is an action against the purchaser rather than the provision of a right or a benefit or advantage to the purchaser.  Where a contract for the sale of land is cancelled because of the vendor's default, the vendor is required to refund the deposit to the purchaser. 

If the purchaser has claimed input tax on the supply of a property under a contract that has been cancelled, the amount of the excess tax charged to the purchaser as a consequence of the cancellation is deemed by section 25(4) to be tax charged in relation to a taxable supply by the purchaser.  Such output tax is attributable to the taxable period in which a credit note is issued to the purchaser or the purchaser otherwise receives notice or other knowledge that the input tax deducted by the purchaser exceeds the output tax properly charged.  Refer Case W11; Case W22. 

If the vendor has returned output tax on the supply of a property under a contract which has been cancelled, as a result of the cancellation the vendor will have accounted for an incorrect amount of output tax.  Therefore, under section 25(2), the vendor is entitled to make an adjustment deducting the GST previously accounted for in the return for the taxable period during which it has become apparent that the output tax accounted for is incorrect.

The GST consequences do not depend on whether the contract was cancelled as a consequence of the vendor's default or as a consequence of the purchaser's default.   In each case the question is whether a supply has been made for the deposit retained by the vendor and under section 25 the reason that a supply was cancelled is irrelevant.   The purchaser's inability to recover a deposit paid under an agreement that has been cancelled also does not affect the GST consequences: see Case W11 (2003) 21 NZTC 11,100 para 82-83.

The purpose of section 25 is to require adjustments to GST where a transaction fails after the time when a supply is deemed by section 9 to have been made.  In such circumstances Parliament's intention was that the supplier is not required to pay GST in respect of goods or services not supplied and that the recipient cannot obtain an input tax credit in respect of such goods or services.  See Case W11. 

[This item does not deal with the application of section 76 of the Goods and Services Tax 1985 or the circumstances in which section 76 could apply to vary the above consequences.]