On 26 June, Inland Revenue (IRD) released Interpretation Statement 20/05. The statement describes how GST applies to the sale of a dwelling that is included within a wider supply of land.
A common example that the statement applies to is the sale of a farm that comprises both farmland and a farmhouse. The generic GST treatment in this situation is for the farmland to be zero-rated, while the farmhouse is treated as an exempt supply. This treatment arises pursuant to section 5(15) of the GST Act, which splits off the farmhouse and deems it to be a separate supply. It comprises an exempt supply because it is either the sale of the ‘family home’ or akin to the sale of a residential rental property (if it was used by a farm worker).
The IRD statement considers the above treatment to be an “oversimplification”. Instead, IRD’s view is that if the farmer has used the farmhouse in the farming operation, its sale maybe subject to GST at 15%.
Now the problem… a long-standing practice exists in which farmers are able to claim income tax deductions for expenses relating to the farmhouse. This approach was formalised by IRD in Interpretation Statement 17/02. It allows an automatic deduction for 20% of the expenditure in relation to a farmhouse because it is essentially the “headquarters” of the farm. By virtue of claiming income tax deductions in this way, it leads to the view (from IRD) that the farmhouse has been used to make taxable supplies (to which GST applies) and therefore the sale of the farmhouse is subject to GST. Because the farmhouse is treated as a separate supply that does not qualify for zero-rating, and GST is payable at 15%.
An offsetting deduction in relation to the private use portion is allowed. However, that deduction is calculated with respect to the original cost of the property. Hence, in most cases the net GST liability will equate to the full change in value of the farmhouse.
Consider the following example: Bill, a GST registered farmer agrees to sell his farm for $5m, including two farmhouses. The main farmhouse has been occupied by Bill and his family, it cost $200k and now has a value of $600k. The second farmhouse has been rented by farm employees and is worth $400k. Under the guidance of IS 17/02, Bill has claimed income tax deductions for 20% of the expenses relating to the main farmhouse.
Section 5(15) applies to the supply of the farm. The two properties and the farmland are each a separate supply and must be considered independently. Upon sale, it is determined that the farmland is zero-rated and the second farmhouse an exempt supply. However, the main farmhouse is subject to GST at 15%. Bill will be required to disclose the sale of the farmhouse on his GST return and the applicable GST amount of $78,260 (3/23rds of $600k). No GST has previously been claimed on the house, so an offsetting deduction based on 80% of the private use of the property is able to be claimed, but it is limited to $26,087 (3/23rds of $200k). The net GST liability is $52,173, i.e. GST on the $400k increase in the value of the farmhouse.
IRD’s view differs to current practice. Hence, there is a risk that vendors and purchasers will not take the same approach and contract disputes could arise as a result.