Chapter 8 – Insurance pay-outs to third parties
- Current GST rules for insurance
- Intended operation of rules when insurance pay-out is to a GST-registered third party
- Problems occur when a GST-registered third-party is unaware of source of the payment
- Scale of the problem
- Policy options for improving certainty and compliance with GST on insurance pay-outs
- Application date
8.1 The GST rules require GST-registered recipients of an insurance pay-out to return GST on these pay-outs. When a GST-registered recipient of an insurance pay-out is a third party to the insurance contract, they may not be aware they are receiving a payment which is covered by insurance. As a consequence, they may fail to comply with the rules or may be under-compensated as they did not expect to have to return GST on the payment.
8.2 This chapter discusses some potential options for mitigating this issue.
8.3 The GST Act includes special rules for applying GST to general (non-life) insurance. Insurers pay GST output tax on premiums they receive and claim GST input credits on the total amount of their pay-outs.
8.4 If the insured party is a GST-registered person who is insuring their taxable activity they can claim deductions for GST input credits in relation to the GST that is charged on their insurance premiums.
8.5 Section 5(13) of the GST Act requires GST to be returned on insurance pay-outs received by GST-registered persons to the extent that it relates to a loss incurred in the course and furtherance of the person’s taxable activity (for example, their business, rather than a private use). It does this by deeming the GST-registered person to have made a taxable supply to an insurer when they receive a payment under a contract of insurance, “whether or not they are a party to the insurance contract”.
8.6 This means that even if the recipient of the insurance pay-out is a third party to the insurance policy, they will still be required to return GST output tax if they are a GST-registered person and the loss is incurred in the course and furtherance of their taxable activity (such as an asset used for their business).
8.7 This deeming rule is not intuitive, as the GST-registered person has not made a sale or supplied any actual goods or services to the insurer. Also, GST does not generally apply to compensation payments. So, if the third party had received a compensation payment that was not covered by insurance, GST would not apply to the payment.
8.8 Problems can arise when the insurance pay-out is made to a third party, rather than the insured person.
8.9 A typical scenario involves:
- an insured party causes loss to a third party (for example, vehicle or property damage, professional liability, and so on);
- the insurer assists the insured party to reach a settlement agreement between the insured party and the third party which specifies a sum to be received by the third party.
8.10 If the insurer makes a payment to an GST-registered insured party who caused the loss in the course and furtherance of their taxable activity, the insured party is liable to return GST under section 5(13) on the payment, and typically the amount of the pay-out would be grossed up to account for this. The insured party then pays the funds to the third party under the settlement agreement and because that payment is a compensation payment it is typically not subject to GST. This is illustrated in figure 2.
Figure 2: Pay-out to a GST-registered insured party
8.11 However, we understand that insurers will usually direct the payment to the third party, rather than the insured party in cases where the insurance policy is covering a loss to the third party.
8.12 The insurer can claim an input tax deduction in relation to the insurance pay-out regardless of whether it pays the insured party or the third party. However, the third party may be unaware of the nature of the payment.
8.13 If the third party knows the settlement payment is an insurance pay-out and correctly applies section 5(13) of the GST Act, they would return GST output tax on the payment. This is illustrated figure 3 which provides the same overall GST outcomes as figure 2.
Figure 3: Pay-out to third party who correctly returns GST on the payment
8.14 A GST-registered third party may often not know whether the source of the funds is from the insured party or an insurer, as the payment will usually be disbursed from a solicitor’s trust account. The problem is exacerbated by the fact that an insurer may conceal its involvement in the dispute to lower the third party’s expectations of a sizeable settlement. The insurer will benefit where the third party is unaware of the insurer’s involvement and does not require the settlement to be grossed up for GST. This is because the third party may incorrectly assume they are receiving a compensation payment which is not subject to GST and therefore not return any GST on the payment.
8.15 The scenario where the third party does not know they are receiving an insurance payment is illustrated in figure 4, which results in a revenue loss to Inland Revenue and corresponding cost saving to the insurer compared to figures 2 and 3.
Figure 4: Pay-out to third-party who does not know the pay-out is covered by insurance
8.16 Officials do not have enough information to quantify the magnitude of these issues.
8.17 However, the potential fiscal risk is high given the commercial incentives to negotiate a lower settlement amount. For example, reaching agreement on a settlement amount of $10 million, rather than needing to gross that amount up to a $11.5 million (to offset the GST that is required to be paid by the recipient), could represent a $1.3 million cost saving for the insurer.
8.18 Inland Revenue has dealt with an increasing number of disputes involving section 5(13). Several tax and legal advisors have also raised concerns with us that GST may not be properly considered in negotiated settlements with third parties, leaving the third party undercompensated or at risk of an unexpected GST liability.
8.19 We are interested in submitters’ views about the scale of the problem described above and their experiences with trying to apply the existing requirements.
8.20 In particular, is it obvious when a payment is an insurance payment (subject to GST) or a compensation payment (not subject to GST)? Are the legal advisors that deal with claims or settlements involving insurance generally aware of the existing requirements of section 5(13) of the GST Act? Do they take care to ensure the agreed amount is grossed up to include GST and that GST-registered recipients of insurance payment correctly return output tax as required by section 5(13)?
8.21 We have identified three main options for mitigating this issue and providing more certainty for third parties who are negotiating such settlements.
Making the insurer responsible for the GST obligations
8.22 We consider the most effective way to address the problem would be to make the insurer (rather than the person receiving the pay-out) responsible for the GST obligations.
8.23 This could be achieved by amending section 5(13) so it operates as a reverse charge on the insurer. This would mean that the insurer, rather than the third party, would be deemed to make a taxable supply and required to pay the GST when the requirements of section 5(13) apply. This is illustrated in figure 5.
Figure 5: Pay-out to third party with a reverse charge on insurer
8.24 Alternatively, section 20(3)(d) could be amended to deny the insurer an input tax deduction for insurance pay-outs where the current section 5(13) applies to the payment (that is, the payment is to a GST-registered person and relates to a loss incurred in the course and furtherance of that person’s taxable activity). Under this approach, a consequential amendment would be made to repeal section 5(13) so there would no longer be any GST output tax on the recipients of insurance payments.
Figure 6: Pay-out to third party with no input credit for insurer
8.25 Limiting the input deduction under section 20(3)(d) would appear to be simpler than a reverse charge but we invite submissions on which type of amendment would be less costly for insurers to implement.
8.26 Either of the proposed amendments would require the insurer to determine whether the person receiving the pay-out is GST-registered and whether the insurance pay-out relates to a loss incurred in the course or furtherance of their taxable activity (as opposed to a private or exempt activity).
8.27 This would increase compliance costs for insurers as they would need to request information about the recipient’s GST status, and they would need to implement new systems to treat pay-outs differently depending on the GST status of the recipient.
8.28 In cases where a damaged asset is partly used for a taxable and non-taxable activity (such as a residential home with a home office, or a work vehicle with private use) it would also be necessary to determine to what extent the insurance payment relates to a taxable asset. In such cases it could be difficult for the insurer to obtain information from the recipient of the pay-out to correctly account for GST on payment.
8.29 One possible solution to this issue could be to require the insurer to account for the full amount of GST output tax (or not claim any input tax credit) when an insurance payment is made to a GST-registered person (regardless of the extent to which the payment was connected to the registered person’s taxable activity). A corresponding amendment could be introduced to allow a GST-registered person who receives that payment to be able to claim a new type of GST deduction under section 20(3) to the extent to which the insurance payment was made in respect of an asset that was not used by the registered person to make taxable supplies (for example, a private or exempt use).
8.30 We note that non-resident suppliers of remote services (which includes general insurance) are already required to determine if they are supplying services to a GST-registered person as part of that person’s taxable activity (see section 8(4D)). In that case the Commissioner can agree that a supplier can use an alternative method for determining if they are making supplies to a GST-registered person. This type of approach could be used to assist insurers if they were required to determine whether they were making a pay-out to a GST-registered person.
8.31 Australia’s GST rules for general insurance require insurers to distinguish between pay-outs in relation to insurance contracts with GST-registered persons and contracts with unregistered persons. Under Australia’s rules the insurer is only entitled to a GST deduction (called a decreasing adjustment) in cases where the insured party did not claim a GST deduction in respect of the premiums paid on that insurance contract. We would be interested in submitters’ views about any compliance costs that this differing GST treatment of insurance claims creates for Australian insurers.
8.32 Making the insurer responsible for GST could reduce compliance costs on other GST-registered businesses as they would no longer have to return GST on insurance pay-outs, and they could treat insurance pay-outs the same as compensation payments (which are not subject to GST).
8.33 In addition, as discussed above the insurer will know the settlement payment is an insurance payment, whereas a GST-registered third party is often unaware of the nature of the payment. Even if they knew the payment is insurance, they may not be aware of the GST rules (in section 5(13) of the GST Act) which require them to return GST on insurance payments.
8.34 Officials are concerned that this option would impose high compliance costs and systems changes on insurers and welcome submissions explaining these costs. Officials are also interested in working with insurers, legal and tax advisors and affected businesses to develop some alternative options to address the problem. Two of these alternatives are discussed.
8.35 However, if these alternatives are not effective at improving GST compliance and Inland Revenue continues to observe and receive feedback that the commercial incentives to not disclose insurance make complying with GST too difficult, it may become necessary to shift GST obligations onto the insurer if this is the only way to effectively address the fiscal risk and fairness concerns.
Requiring disclosure that the payment is covered by insurance
8.36 An alternative option would be to require the insurer to disclose in writing to the third party that the amount of their settlement payment is covered by insurance and that if they are registered for GST, they may be required to return GST on that amount under section 5(13).
8.37 This information would allow the third party to be aware of their GST obligations and consider if the amount of the settlement is sufficient (or if it needs to be grossed up to account for GST).
8.38 The timing of the disclosure would need to be considered. In order to be fair to the third party, they would need to know about the GST implications prior to agreeing to the settlement. However, such a disclosure requirement may lead to the agreed settlement amount being significantly higher in those cases where it is covered by insurance. This could have a flow-on effect in increasing the costs for businesses in obtaining public or professional indemnity insurance to cover the risk of potential damages to other GST-registered persons.
8.39 Another consideration is the consequences for the insurer if they fail to disclose the information. One potential consequence would be to shift the GST liability to the insurer (as opposed to the GST-registered person) but this may create uncertainty and disputes about who is liable for the GST. Another possibility would be a separate standalone penalty on insurers who fail to disclose the information, but it may be difficult to set this penalty at the right amount to promote compliance (considering the potential cost savings from non-compliance will vary depending on the amount of the payment).
8.40 Information disclosure requirements could also lead to confusion. For example, a large number of insurance recipients are not registered for GST, but may become prompted by an information disclosure to consider whether or not GST obligations apply to them. This may lead to increased contacts and questions to insurers, advisors or Inland Revenue. One way to mitigate this could be to target the information disclosure requirement so it only applies to those insurance products where the problem is most likely to arise such as commercial property or professional liability insurance.
No law change, but provide education and guidance
8.41 The least disruptive option would be to retain the current insurance rules but provide education and guidance for advisors and GST-registered businesses.
8.42 If third party claimants were aware of the potential GST risk they could ask for advice as to who is paying the settlement amount, or the source of the settlement amount, and ask for either a GST gross-up and/or a GST indemnity.
8.43 For example, when negotiating settlement agreements, a third party could include a warranty that the payment they are receiving is not a payment of insurance or require the settlement amount be “plus GST, if any”. Under such an agreement, the third party would be able to require the payment to be grossed up by the insured party in those cases where they discover they must return output tax on an insurance payment under section 5(13) of the GST.
8.44 However, in our view, this option is unlikely to be effective. It relies on the third party (or more likely their tax and legal advisors) being both:
- aware and sufficiently concerned about the GST risk; and
- being able to obtain information that the insured party (or their insurer) has commercial incentives to not provide (in order to lower the third party’s expectations about the amount of an acceptable settlement).
8.45 Also, just because the settlement agreement includes a “plus GST if any” clause or a GST indemnity it does not mean that the recipient will return GST on insurance payments as they may mistakenly believe that the payment is not subject to GST. If the recipient of an insurance payment fails to return GST, they could be liable for penalties and interest if the error is subsequently identified. The third party could also be exposed in cases where the insured party goes out of business.
8.46 It could be difficult to adequately alert the potentially affected parties (or their advisors) of the issue, particularly as negotiating a large insurance settlement will be an unlikely or rare event for most GST-registered persons.
8.47 Any law change would apply prospectively from a future date after the date the relevant legislation was enacted (which could be in 2021).
8.48 We invite submissions on how much lead time submitters consider could be necessary (for example, following enactment of any new legislation) for the affected parties to prepare their systems in order to comply with the potential legislative options discussed above.
8.49 We also invite submissions on potential compliance costs and systems impacts of the policy options described above and if there are ways to design the proposed rules to mitigate some of these impacts.
Questions for submitters
- When a damaged third-party receives an insurance or compensation payment is it difficult for them to determine whether or not the payment comes from an insurer?
- In what situations does the problem occur and what information is available to assess the potential scale of the problem?
- What are the costs, benefits and practical issues associated with the policy options? How much lead time would insurers or other affected parties need to implement these options?