Buyers of property with sitting tenants will be liable for GST on the leases, following the High Court's decision yesterday in Commissioner of Taxation v MBI Properties Pty Ltd [2014] HCA 49.

The sale of the property with sitting tenants

The dispute at the heart of MBI had its genesis in the South Steyne litigation which dealt with the question of whether the purchaser of land subject to an existing lease makes a supply to the continuing tenant under that lease.

Imagine A owns a residential unit and leases it to B. In doing so, A makes a supply to B, amounting to the grant of all the rights under that lease.

A then sells its interest in the property ("the reversion") to C, subject to B's continuing rights as a tenant of that property. B continues in possession of the property, notwithstanding the sale to C. The only thing that changes is that, after the sale, B will pay rent to C.

In South Steyne, the Full Federal Court said there was no supply made by C to B under the continuing lease. This came as a surprise, as it had been assumed that C, as the incoming lessor, would make a supply to the continuing tenant in consideration for the rent being paid by that tenant.

The Commissioner challenged this earlier holding in South Steyne in the High Court against MBI.

The lease in South Steyne and MBI was of residential premises – which meant that the lease was an input taxed supply (GST not payable but restrictions on input tax credits for things used in making the supply). So in neither case was the court directly confronted with the more difficult question – is GST payable by the entity that originally granted the lease or the entity that bought the property subject to the existing lease?

GST-free supplies and Division 135's clawback

Rather, in MBI the issues in dispute arose out of the operation of Division 135. This is a rather strange provision in the GST Act that operates where (amongst other things) a business is purchased as a going concern. The supply of a business as a going concern is GST-free (GST not payable without restrictions on claiming input tax credits for things used in making the supply). As such, the purchaser of the business does not have to work out whether they can claim input tax credits on the acquisition of the business.

So, if the purchaser uses the business to make input taxed supplies (the non-taxable supplies that restrict access to input tax credits) then the purchaser would be better off where it acquires the business as a going concern.

Division 135 seeks to (albeit imperfectly) address this by clawing back by way of an increasing adjustment for the purchaser an amount equal to benefit that would arise by acquiring a business as a GST-free going concern where that business is used to make input taxed supplies.

In this case, the sale of the property to MBI with sitting tenants was treated as a GST-free supply of a going concern. Following the decision in South Steyne, the lease of the property to that tenant was an input taxed supply of residential premises. So, if after acquiring the property MBI was making input taxed supplies to the continuing tenant, MBI would be exposed to the increasing adjustment.

Based on the logic of the Full Federal Court in South Steyne, MBI resisted the Commissioner’s view that it was making any supply at all to the continuing tenant – and as such the increasing adjustment under Division 135 could not arise.

Sitting tenants are receiving a taxable supply under GST law

The High Court found that there was a supply when the leases were granted but there continued to be a supply made to the continuing tenant after MBI purchased the property subject to the lease.

It started by noting "it is wrong to consider that one transaction must always involve the making of just one supply. It is similarly wrong to consider that the making of a supply must always involve the taking of some action on the part of the supplier… The concept of supply as employed in the GST Act is of wide import."

When an executory contract, such as a lease, is entered into and then performed, there are at least two supplies:

  • a supply which occurs at the time of entering into the contract, in the form of both the creation of a contractual right to performance and the corresponding entering into of a contractual obligation to perform. In the case of a lease, that supply is the grant, the creation of contractual rights, and the entry into contractual obligations; and
  • a supply when the contract is performed. That performance includes not doing something, or tolerating a situation. In the case of a lease, that supply is the landlord allowing the tenant quiet enjoyment of the premises.

This means that the lessor, for the purposes of the GST Act, is engaging in an "activity" done "on a regular or continuous basis, in the form of a lease". In MBI’s case, the supply to the tenant was input taxed and the Division 135 increasing adjustment arose. But more importantly, it means for the first time since South Steyne, we have certainty that the purchaser of a reversion of commercial property is the entity that is liable for GST payable on the taxable supplies to continuing commercial tenants.