GST - Apportionment of the cost of bare land for the purposes of a change-in-use adjustment

All legislative references are to the Goods and Services Tax Act 1985.

Question

We have been asked to clarify the Commissioner's position on apportioning the cost price of bare land for the purposes of section 10(8)(a). This question arises where land is purchased for the principal purpose of making taxable supplies and part is used for non-taxable purposes thereby giving rise to a deemed supply under section 21(1)(a).

Answer

The Commissioner considers that a pro rata method of apportionment of cost for the purposes of section 10(8)(a) will generally be appropriate for deemed supplies of bare land under section 21(1)(a).

However, where it is not realistic to attribute the same proportion of the cost to all parts of the land, a pro rata method of apportionment will be inappropriate.

Any method adopted, however, must be made on an intelligible basis, must be based on the facts as known at the time of purchase (Lowe v CIR (1981) 5 NZTC 61,006) and must not be too theoretical or artificial (Lowe v CIR; CIR v Walker [1963] NZLR 339).

Background

Where a registered taxpayer acquires land for the principal purpose of making taxable supplies in the course or furtherance of a taxable activity in New Zealand, the taxpayer can generally claim 100% of the input tax paid in acquiring that land. If the taxpayer uses part of that land for a non-taxable purpose (such as erecting a residential dwelling or erecting accommodation for farm workers), either in the GST return period in which the land is acquired or in subsequent periods, then they are deemed to have made a supply under section 21(1)(a) and must make an adjustment.

In these circumstances, the adjustment reflects the extent to which the land is used for non-taxable purposes. The taxpayer must return output tax on the deemed supply of land used for non-taxable purposes. Section 10(8) deems the value of any adjustment required under section 21 to be the lesser of the cost of those goods or services to the supplier or the open market value of the deemed supply. The adjustment provisions in effect reduce the amount of any input tax claimed on the original acquisition to reflect any non-taxable use.

Legislation

Section 21(1)(a) provides:

(1)	Subject to section 5(3), a registered person is treated as supplying goods and services in the course or furtherance of their taxable activity if -
	(a)	the person acquires or produces the goods and services for the principal purpose of making taxable supplies but applies the goods and services for a purpose other than that of making taxable supplies...

Section 21A provides:

(1)	A registered person must determine the extent to which goods and services are applied for the purpose of making supplies other than taxable supplies according to:
	(a)	actual use; or
	(b)	an alternative method approved by the Commissioner if the method results in allocated amounts that are fair and reasonable.
(2)	A registered person must determine the extent to which goods and services are applied for the purpose of making exempt supplies by either applying subsection (1) or using the formula:  Total value of exempt supplies for taxable period Total value of all supplies for taxable period.
(3)	A registered person must choose a method that ensures a fair and reasonable result.

Section 21C provides:

(1)	A registered person to whom section 21(1) applies must attribute output tax to one of the following times:
	(a)	in the first taxable period in which goods and services are applied for a purpose other than that of making taxable supplies; or
	(b)	in each taxable period in which goods and services are applied for a purpose other than that of making taxable supplies; or
	(c)	in each year in which goods and services are applied for a purpose other than that of making taxable supplies.
(2)	A registered person who applies subsection (1)(a) must make output tax attributions to reflect further changes in use of 20% or more.
(3)	If subsection (1)(a) or (1)(c) applies, a registered person must reduce the output tax attributable by the amount of the output tax attributed to earlier taxable periods for the supply of the goods and services.
(4)	A person may change the time the person attributes output tax only with the Commissioner's approval.

Section 10 provides:

(1)	For the purposes of this Act the following provisions of this section shall apply for determining the value of any supply of goods and services.
...
(8)	Where goods and services are deemed to be supplied by a person under section 5(3) and the goods and services were acquired before 1 October 1986, or where goods and services are treated as being supplied under section 21, the consideration in money for either supply shall be deemed to be the lesser of-
	(a)	The cost of those goods and services to the supplier, including any input tax deduction claimed in respect of the supply of those goods and services to that supplier:
	(b)	The open market value of that supply.

Discussion

A deemed supply of a part of a parcel of bare land under section 21 is valued under section 10(8) to be the lesser of the cost of the goods and services to the supplier and the open market value of the deemed supply. The phrase "the cost of those goods and services to the supplier" in section 10(8)(a) necessarily requires that the cost of the whole land be apportioned in order to determine the cost of the deemed supply.

Meaning of "cost"

The word "cost" is not defined in the Act. Therefore, it must be given its ordinary meaning. The Concise Oxford Dictionary (11th edition) relevantly defines "cost" as:

n. the amount that something costs; the effort or loss necessary to achieve something.

In Wilke v CIR (1998) 18 NZTC 13,923 it was held, in the context of section 10(8), that "cost" means the money or money's worth given up to get something. Panckhurst J in Wilke v CIR adopted the reasoning of the Canadian Federal Court of Appeal in Kettle River Sawmills Ltd v Minister of National Revenue (1993) 64 NR 241, which states (at page 249):

Cost means the money or money's worth which is given up by somebody to get something. It is generally viewed as an objectively determinable historical fact, the answer to the question 'how much was paid?'

Similarly, in CIR v Lundy Family Trust & Behemoth (2005) 22 NZTC 19,637 the Court of Appeal considered the meaning of the word "cost" in the context of section 10(8) and stated:

The term "cost" would be ordinarily understood as the acquisition cost and we consider that is its meaning in the present context.

Valuation of which supply?

Section 10(8)(a) states that the value of a deemed supply may be the "cost of those goods and services to the supplier, including any input tax deduction claimed in respect of the supply of those goods and services to that supplier". It is considered that this refers to the original purchase price of the goods or services (in this case, bare land) apportioned to reflect the amount properly attributable to the deemed supply made under section 21(1).

Apportionment of "cost"

Section 10(8) operates to value a deemed supply arising out of a change in use adjustment under section 21. Section 21A applies to apportion the goods and services subject to a change in use adjustment between taxable and non-taxable use. Therefore, the Act envisages that sometimes only a part of goods or services acquired for taxable purposes may be applied to a non-taxable use. It is considered that it is possible, and indeed required by the legislation, to determine the cost or value of a part of an undivided whole when only the cost of the whole is known.

It is therefore necessary to consider how to apportion the cost of bare land for the purposes of section 10(8). Section 10(8) does not provide any basis for the apportionment of "cost" and there are no cases on apportioning the cost of land under section 10(8) of the Act, or in a GST context more generally.

Section 21A provides several apportionment methods. However, this section is concerned with how to apportion between taxable and non-taxable use to identify which part of the supply of goods or services (in this case land) has changed in use. Section 10(8), on the other hand, is concerned with valuing the deemed supply. The Commissioner considers that the fact that the land can be divided up between taxable and non-taxable use under section 21A, does not necessarily mean that the cost of the land can be divided up in the same proportions under section 10(8). This is because different parts of a parcel of land may contribute differently to the overall cost of that land. It is therefore considered that section 21A does not provide any direct guidance on apportioning "cost" under section 10(8)(a).

In the absence of any guidance from the Act or any GST cases, it is necessary to look outside the GST context. The leading case on the method of calculating profit for the purposes of income tax is Lowe v CIR. The Court in Lowe v CIR held that where the provisions of the Income Tax Act do not specify how to calculate the income of the taxpayer, the income is to be calculated using commercially accepted principles and methods. If there is more than one alternative commercially acceptable method then the method which provides the "truer picture" of the taxpayer's income should be used.

The courts have also said that the method of apportioning cost must be reasonable (Lowe v CIR), commercially acceptable (Lowe v CIR; Barwick J (dissenting) in FCT v McClelland (1967-1969) 118 CLR 353 at 365; 60 ATC 4001; 15 ATD 204), and made on an intelligible basis (Lowe v CIR); but cannot be too theoretical (CIR v Walker; Lowe v CIR), artificial (McClelland v FCT (1967-1969) 118 CLR 353; 14 ATD 529; Elsey v FCT (1969) 121 CLR 99; 69 ATC 4115) arbitrary (Lowe v CIR; Chapman v FCT (1968) 117 CLR 167; CIR v Walker) or unjustifiable (McGuiness v Commissioner of Taxation (Cth) (1972) 3 ATR 22; 72 ATC 4023). However, the courts have not provided more guidance on these features. Nevertheless, the case law is useful in so far as it provides judicial comments on the appropriateness of various methods of calculation used in specific circumstances. Ultimately, it would appear that the validity of a method of calculation will depend upon the particular circumstances of each case.

In the context of section 10(8) and bare land, the Commissioner considers the pro rata method would generally give the truer picture. Courts are reluctant to use methods that are too theoretical or artificial. The pro rata method, also called the area method, takes the proportion of land subject to the deemed supply and uses it to apportion the purchase price of the whole block of land in order to calculate the "cost" of the part.

The Commissioner considers that the courts will generally accept a pro rata approach under section 10(8), even when the land is not completely uniform. However, it is possible that the courts may depart from a pro rata approach and accept some other method in situations where there is evidence that it would not be realistic to attribute the same proportion of the cost to all parts of the land.

These situations could include where:

• a parcel of land is not uniform in nature because it is made up of areas of significantly different features (Elsey v FCT). For example, flat pasture land, land bordering on a beach or lake-side, mountainous land, or swamp;
• part of the land is zoned differently under a district plan (CIR v Walker); or
• a right attaches to a specific part of the land, for example a right of way or easement.

In addition, generally, where the parties explicitly agree in the sale and purchase agreement that part of the total cost of the land attaches to a part disproportionately in relation to its size due to one or more of the factors above, then that will be evidence of the cost of the different parts of the land.

The actual future use of the land will not be a factor that influences whether a particular method of apportionment is appropriate (Lowe v CIR).

Any method of apportioning cost under section 10(8) must be based on the original cost price of the land.

Whether valuations can be used to determine "cost"

One alternative method to pro rata is where valuations are used to apportion the cost price of land to determine how much should be attributed to the land subject to the deemed supply. The "cost" of the deemed supply would be calculated with reference to the respective land valuations (as at the time of purchase) of the land used for taxable purposes and the land used for non-taxable purposes. The valuations of the different parts of that land would be used to divide up the cost. Such valuations must be based on facts known at the time the land was purchased, and cannot take into account the actual future use of the land. Such valuations may, depending on the particular circumstances, need to take into account the fact that the land is one undivided whole.

It might be argued that using valuations to identify the cost of part of an area of land cannot be correct because it might mean that the two bases for valuation in section 10(8) - cost and open market value - would effectively be the same.

However, the "cost" and "open market value" options are different enquiries. The Commissioner considers that the two bases for valuing the deemed supply under section 10(8) provide distinct methods for determining the value of a deemed supply under section 21(1). The market value is the current market value of the deemed supply at the time of the deemed supply, and the cost is the original cost to the purchaser of the land (deemed later to be supplied) when the whole of the land was purchased. There is no guidance in the Act regarding appropriate methods of apportioning "cost" where only part of the land is subject to a deemed supply. The Commissioner considers that valuations can be used to apportion cost, but only if they reflect the value of the different parts of the land at the time the land was purchased.

Examples

Example 1

A person registered for GST buys a 10 hectare block of bare land for $200,000 (including GST) for his market gardening business. The land is made up of flat pasture land and rolling hills. The new owner claims an input tax deduction for the GST paid on the purchase of the land. Some months after purchasing the property, the owner decides to set aside 1 hectare of the land for a house for his family. The current market value of similar 1 hectare sections in the area is $50,000.

The owner must make an adjustment of the GST input tax deduction claimed on purchasing the land and return an amount of output tax that relates to the land set aside for the family home. Section 21C gives the taxpayer the option to make a one-off adjustment, a periodic adjustment, or an annual adjustment. The taxpayer chooses to make a one-off adjustment. The amount of output tax that must be paid on the deemed supply is calculated by applying the tax fraction to the value of the deemed supply. Under section 10(8), the value of the deemed supply is the lesser of the cost or the market value of the deemed supply of land.

In this situation it would be appropriate to calculate the cost of the land set aside for the family home by apportioning the cost of the whole parcel of land on a pro rata basis.

A pro rata method of calculating the "cost" of the 1 hectare section results in a price per hectare of $20,000. As the "cost" of the section is less than its market value of $50,000, the value of the deemed supply under section 10(8) is $20,000.

Example 2

A person registered for GST buys a 150 hectare block of land adjacent to his dairy farm for $1.5 million (including GST) and claims an input tax deduction for the GST paid on the purchase of the land. The land is flat pasture land near the coast close to a popular holiday destination. One year after purchasing the property to extend his farm, the owner decides to set aside the hectare of land that has access to the beach for the family home. The current market value of 1 hectare sections with beach access is $250,000.

The owner must make an adjustment of the GST input tax deduction claimed on purchasing the land and return an amount of output tax that relates to the land used for the family home. Section 21C gives the taxpayer the option to make a one-off adjustment, a periodic adjustment, or an annual adjustment. The taxpayer chooses to make a one-off adjustment. The amount of output tax that must be paid on the deemed supply is calculated by applying the tax fraction to the value of the deemed supply. Under section 10(8), the value of the deemed supply is the lesser of the cost or the market value of the deemed supply of land.

Using a pro rata method, the "cost" of the beach-front section would be $10,000. However, at the time that the property was purchased, similar sized beach-front sections in the area were sold for $200,000, and local dairy-farm land sold for $12,000 per hectare. In this situation, a calculation of "cost" as a price per hectare will be inappropriate because it would not accurately reflect the cost attributable to the land with beach access compared with the rest of the farm land.

A more appropriate method is to identify the respective market values of the farm land and the residential section at the time of the original purchase and calculate what percentage of the aggregate market value of the land relates to the residential land. This percentage is then applied to the original cost of the land to determine the "cost" of the residential land.

The market value of the farm land at the time of purchase (based on the sale prices of local dairy-farm land) was $1.788 million for the 149 hectares of farm land at $12,000 per hectare. The market value of the 1 hectare section at the time of purchase (based on the market value of similar beach front sections at the time of purchase) was $200,000. Therefore the total market value of the land at the time of purchase was $1.988 million. (The owner purchased the property for below market value.)

The market value of the residential land ($200,000) is divided by the total market value of the whole parcel of land ($1.988 million) in order to calculate a percentage. In this situation, the market value of the residential land is 10.06% of the market value of the whole parcel of land. This percentage should then be applied to the purchase price of the whole land ($1.5 million) to identify the proportional values of the farmland and residential land and so calculate the "cost" of the residential land. This results in the "cost" of the 1 hectare section being $150,900.

Market value of 149 hectares of rural land:	$1.788 m
Market value of 1 hectare of residential land:	$200,000
Total aggregate market value:	$1.988 m
Percentage of the total market value of the land attributable to the residential land:	$200,000 × 100% = 10.06%
	$1.988 m
Percentage of the total market value of the land attributable to the residential land applied to the original purchase price:	10.06% × $1.5 m = $150,900

Therefore, under section 10(8), the "cost" of the beach-front section under paragraph (a) is $150,900, and its market value at the time of the deemed supply under paragraph (b) is $250,000. As the "cost" of the section is less than its market value, the value of the deemed supply under section 10(8) is $150,900.

The above answer necessarily sets out general principles only. The facts of particular cases always need to be considered carefully, and it may be necessary to obtain advice from a tax advisor.