Tax controversy update vol. 15 - Insights from Supreme Court precedents on the input tax credit - Part 1

This issue will continue our coverage of consumption tax topics by taking a closer look at some Supreme Court precedents from recent years. The court rulings we examine in this issue are rare examples of consumption tax issues that ultimately required scrutiny from the Supreme Court due to the complexities surrounding the input tax credits taken by two real estate companies - company A and company M.

Company A and company M both purchased second-hand condominiums for the purpose of resale and accordingly used the "required only for taxable sales" purpose category line of their consumption tax returns when adopting the itemized method. However, these second-hand apartments already had tenants residing in them at the time the properties were purchased, and the two companies were collecting rental fees (non-taxable sales) from the tenants until the properties were sold. As a result, the tax authorities imposed corrections, insisting that the applicable line on the return should actually be "required for both taxable and non-taxable sales" and only the input tax credit for the portion related to taxable sales would be recognized.

Both the cases of company A and company M were similar in nature, and arguments for both even took place concurrently. However, the final rulings of the lower court differed for each case, garnering quite the attention from those following the cases. The following table contains an overview of the cases and rulings, and the “Additional charge for deficient return” will be discussed in issue 16.

Company M's ruling was handed down first, with the district court ruling against company M's arguments. The primary reason for the ruling was that “the purpose category of taxable purchases should be deemed objectively, and moreover, there is no reason that such purpose should be understood as limited to the ultimate or main purpose of the taxable purchase.” However, in the case of company A, which was handed down approximately one year later, the district court agreed that there was merit in the argument of “consumption tax related to taxable purchases being appropriately categorized into purchases which accumulate tax burden and purchases which do not”, and subsequently upheld the assertions of company A, noting that treating the purchase of the second-hand condominiums as “required for both taxable and non-taxable sales” would be unreasonable - especially when considering the insignificance of the rental income in both company A's business motives and overall revenue streams.

When the case of company M was taken to appeals at the high court, the court ruled against company M on the primary argument regarding the purpose category of taxable purchases (just as the district court did). However, the high court partially upheld the petitions of company M regarding the additional charge for deficient return, stating there was a “due cause” for company M to treat it as a purchase “required only for taxable sales”. In a complete reversal to its earlier results, company A had all of its arguments dismissed at the high court and no due cause was upheld.

Unsurprisingly, company A decided to appeal to the Supreme Court in response. Company M, on the other hand, accepted the high court ruling regarding the purpose category of taxable purchases and did not file for any further appeal at the Supreme Court. Instead, the state filed for an appeal, claiming that the high court ruling regarding the additional charge for deficient return was unreasonable.

The Supreme Court ruling was handed down on the same date by the same panel for both cases. The Supreme Court ruled against the taxpayer in both cases. In the case of company A, the original high court ruling was adhered to. In the case of company M, their “due cause” for their tax treatment was denied and the state's petitions were upheld.

The Supreme Court ruling was based on a literal interpretation of the clauses of the Consumption Tax Act, on the grounds that the intent of the Act is to have the purpose category of a taxable purchase determined objectively, and not subjectively by the taxpayer’s interpretation. In this sense, the Supreme Court's ruling can be evaluated as being consistent with the basis of tax laws (following the letter of the law), and the district court's ruling in the case of company A can be seen as a more “aggressive” ruling (that put more weight on the spirit of the law).

Legislative measures were taken to ensure the issues in these cases would never arise again. However, we can also surmise from these Supreme Court rulings that if a business has any amount of non-taxable sales, the door is open for the tax authorities to impose the application of the "required for both taxable and non-taxable sales" purpose category. Such a request from the tax authorities would indeed have an impact on businesses with a low ratio of taxable sales. In order to mitigate the occurrence of this scenario, it is necessary for companies to be able to objectively explain that any purchases under scrutiny align with the company's standard business model and are not tied to “non-taxable sales.” Submitting an advance request to the tax authorities to designate your business' taxable sales ratio (especially if your business deals in large amounts of non-taxable transactions, such as transfers of land) is also highly recommended to limit relevant risks.
 

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