Tax Updates – 10th August

Court Awarded Costs & GST

IR has released Interpretation Statement IS 26/11, setting out when court-awarded costs and disbursements — and equivalent out-of-court settlement payments — attract GST. The short answer for most litigants: they don’t. But there are important exceptions, and the GST status of the party receiving the award can still affect how much they end up with.

The general rule: costs awards are compensation, not consideration

When a court orders one party to pay another’s legal costs and disbursements, or when the parties settle those costs out of court, the payment is not normally subject to GST. IR’s reasoning follows well-established principles: for a payment to be consideration for a supply, there needs to be reciprocity between the payment and something supplied in return.

A costs award doesn’t have that reciprocity. The unsuccessful party isn’t paying for legal services rendered to them — they’re compensating the successful party for costs that party incurred in the litigation. Because there’s no supply between the parties, the recipient doesn’t need to return GST or issue taxable supply information (the modern term for a tax invoice), and the payer can’t claim an input tax deduction.

This outcome holds regardless of the recipient’s GST status, and regardless of whether the court increases the award to account for GST the recipient couldn’t recover from the Revenue (more on that below). Increasing the dollar amount for irrecoverable GST doesn’t turn the award into consideration for a taxable supply.

Two situations where GST does apply

1. Payments under a contract of insurance — section 5(13)

Section 5(13) deems a payment received under a contract of insurance to be consideration for a supply, where the recipient is GST-registered and the payment relates to a loss incurred over the course of their taxable activity. This applies even where the recipient wasn’t a party to the insurance contract — for example, where an unsuccessful litigant’s insurer pays a costs award directly to the successful party. IS 26/11 confirms this extends to costs and disbursements, not just other forms of loss: if an insurer meets a costs award on behalf of the unsuccessful party, and the recipient is GST-registered in relation to the underlying activity, GST is payable on that receipt.

2. Costs and disbursements in tax litigation — section 20A(4)

A separate deeming rule applies to costs and disbursements awarded or settled in tax litigation. Broadly, section 20A(2) allows a taxpayer an input tax deduction for costs incurred in determining a tax liability. If the taxpayer later recovers those costs — by award, settlement, or otherwise — section 20A(4) deems that recovery to be consideration for a taxable supply. This statement doesn’t deal with section 20A(4) in detail, but it’s a useful reminder that the treatment of costs awards in tax disputes differs from the general civil litigation position.

Why the GST status of the recipient still matters

Even though the award itself usually sits outside the GST net, the recipient’s ability to recover GST on their own costs and disbursements can influence how much the court awards in the first place. NZ courts award costs on one of three bases, and GST is treated differently under each:

• Scale costs (the default, based on a set daily rate and time allocation for the type of proceeding) are always GST-exclusive, regardless of the recipient’s GST status. Scale costs are a reasonable contribution to costs, not a reimbursement of actual costs, so GST is simply not part of the calculation.
• Increased costs (an uplift from scale, generally awarded because the other party unreasonably added to the cost of the proceeding) are usually also awarded GST-exclusive. If the recipient can’t recover some or all of the GST on their costs, they should tell the court, which may adjust the uplift so the award doesn’t over- or under-compensate once irrecoverable GST is factored in.
• Indemnity costs and disbursements are approached differently, because the goal is full reimbursement rather than a contribution. If the recipient is unable to recover GST — because they’re unregistered, or partially exempt — the court will generally award the amount GST-inclusive so they aren’t left out of pocket. If the recipient says nothing about their GST position, courts will usually assume they’re registered and able to recover GST, and award on a GST-exclusive basis.

The Employment Court takes a different default approach: because employees aren’t GST-registered in respect of their employment, it adds GST to costs and disbursements awards to employees as a matter of course.

Partially exempt litigants need to do more work

A partially exempt person — for example, a trust that both leases commercial premises (taxable) and residential premises (exempt) — can only recover GST to the extent their costs relate to the taxable side of their activities. IS 26/11 suggests that where such a litigant is seeking increased costs, indemnity costs, or GST on disbursements, they should put evidence of their GST recovery ratio before the court — typically an affidavit from a tax manager, financial controller, or CFO, setting out the ratio and how it was calculated, supported by the underlying apportionment method (whether IR-approved, agreed with the Commissioner, or otherwise, e.g. floor area, turnover, or time-based).

Out-of-court settlements: the same principles apply

Settlement payments for costs and disbursements are treated the same way as court awards — compensatory, not consideration for a supply, unless a deeming provision applies. IR also uses IS 26/11 to reject an argument that had been put to it: that when an unsuccessful party agrees to pay a successful party’s disbursements (for example, directly to the successful party’s expert witness or barrister), there’s a supply from that supplier to the unsuccessful party. The Commissioner’s view is that the decisive factor is who the supplier has assumed a contractual obligation to — and that’s the successful party, not the party footing the bill under the settlement.

Where a settlement covers a global sum for damages, costs, and disbursements together, and part of that sum does relate to a taxable supply, the parties will need to apportion the settlement sum on a properly attributable basis — this is a separate question from the costs and disbursements analysis, and IS 23/07 (IR’s earlier, broader statement on court awards and settlements) has more detail on how to approach it.

Practical Takeaways

• Most costs and disbursements awards and settlements sit outside the GST net entirely — no output tax for the recipient, no input tax deduction for the payer.
• The main exceptions are payments under a contract of insurance (s 5(13)) and recoveries of costs previously deducted in tax litigation (s 20A(4)).
• If you act for a client who is unregistered, partially exempt, or otherwise unable to recover GST on their litigation costs, raise this with the court when seeking increased costs, indemnity costs, or disbursements — otherwise the award will likely be calculated on the assumption that GST is fully recoverable.
• Partially exempt clients should be ready to produce evidence of their GST recovery ratio, ideally by affidavit, if they want the court to factor in irrecoverable GST.
• Employees litigating in the Employment Court can generally expect GST to be added to any costs award as a matter of course.