Chapter 6 - Sales in satisfaction of debt under section 5(2)

6.1 Under normal commercial practice, when a borrower (usually a mortgagor) is in financial difficulty and unable to make repayments on a loan, the lender, usually a mortgagee, may use its statutory or legal powers to take possession of the mortgagor’s property and sell it to recover the debt. If the property has been used in a taxable activity, section 5(2) of the GST Act regards this as a sale in satisfaction of debt and the mortgagee is required to furnish a special return to account directly to Inland Revenue for the output tax on the property. GST does not apply if the mortgagee sale is of the mortgagor’s private dwelling.

6.2 Sales in satisfaction of debt are usually easy to identify because of the legal process the mortgagee must follow to force the sale of the mortgagor’s property. Recently, however, there has been an increase in sales in satisfaction of debt that are being presented as “ordinary” sales by mortgagors in the course of their taxable activities. The sale may be organised by the mortgagee by, for example, engaging the estate agent, paying the auctioneer’s fees or signing the sale and purchase agreement. Once sold, the mortgagee may receive the sale proceeds directly and use them to pay off as much of the debt owed to it as possible.

6.3 Unlike a normal sale in satisfaction of debt, under these arrangements, which are sometimes described as “de facto mortgagee sales”, the mortgagee never officially takes possession of the property. As a result, it can be argued that section 5(2) does not apply and that the GST component of the property sale must be returned by the mortgagor, who is usually unable to pay.

6.4 The rules for sales in satisfaction of debt are intended to ensure that the liability to account for GST rests on a person who is likely to be solvent rather than a person who might be insolvent. In doing so, the government does not seek to assert a priority in the distribution of the assets of the mortgagor as Inland Revenue’s claim under section 5(2) lies directly against the mortgagee rather than against the proceeds of sale.

6.5 The government recognises that there have been increased sales in satisfaction of debt because of the difficult economic times. However, differential tax treatment based on whether there is an open or a covert sale by a mortgagee is distortionary and inconsistent with the policy intent of section 5(2).

6.6 Although Inland Revenue may use a number of measures, such as anti-avoidance provisions in the event of a de facto sale, these remedies are an inadequate long-term solution as they are only available when Inland Revenue becomes aware of the sale. Even then, these approaches may have an uncertain outcome. A legislative solution is proposed to ensure that all sales in satisfaction of debt are taxed in the same manner.

The proposal

6.7 It is proposed to supplement the current rules on sales in satisfaction of debt by treating a sale as covered by section 5(2) if certain additional criteria apply. The aim of the criteria is to identify whether a mortgagee initiated and/or controlled the sale.

6.8 The indicators would include one or more of the following:

• a mortgagee taking control of, or inducing the sale of, the property by exercising a power under a contract with a mortgagor;
• a mortgagee signing the sale and purchase agreement, or requesting the mortgagor to sign the sale and purchase agreement as already negotiated by the mortgagee;
• a mortgagee organising services related to selling the property, such as building, conveyancing, auctioning or advertising services;
• a mortgagee paying directly for the services related to selling the property;
• a mortgagor’s solicitor also being the mortgagee’s solicitor;
• a purchaser being associated with the mortgagee.

6.9 A sale would be considered to be a mortgagor sale rather than a mortgagee sale only if it was initiated and controlled by the mortgagor, with no undue encouragement by the mortgagee. If any of the above indicators were present in the transaction, the sale would in the first instance be treated as a sale in satisfaction of debt under section 5(2) and the mortgagee would be required to account for the GST. The Commissioner would, however, have the discretion to review individual cases and determine that, notwithstanding the criteria, a sale should not be treated as a mortgagee sale if it was more in the nature of a genuine mortgagor sale.

6.10 The proposal to introduce a domestic reverse charge affects how tax is to be paid and deductions claimed for certain goods sold in the normal course of business. As noted in chapter 2, the DRC would not apply to transactions to which section 5(2) applies.