Tax in insolvency & restructuring
Issues relating to the management of distressed and insolvent entities are becoming increasingly relevant due to the challenges we have been facing in recent times in our global economy.
In the event of a corporate insolvency, tax law and insolvency law often converge – in part because the Commissioner of Taxation (Commissioner) may become a creditor of that entity.
The three common corporate insolvency procedures are:
- liquidation;
- voluntary administration; and
- receivership.
The stakes under each process can be high. ABL’s market leading tax department together with our highly regarded insolvency practice are here to assist any stakeholders with navigating through these complexities.
Key issues
This page will provide a high-level overview of the following key issues:
- business restructuring, for example, debt forgiveness and restructuring, the use of carried forward losses and the liquidation of company assets;
- the Commissioner’s powers to collect tax debts; and
- director duties and director penalty notices.
Restructuring of the business
Restructuring or forgiving of debt
In the context of corporate insolvency, a common restructuring mechanism is to restructure a company’s debt to avoid default. This is particularly so where the company’s underlying business is viable but its balance sheet carries an unsustainable amount of debt.
It is important that company directors and their advisers understand the tax implications of restructuring or forgiving debt, particularly under the commercial debt forgiveness (CDF) rules. For the purposes of the CDF rules, there is a broad range of circumstances in which a debt may be ‘forgiven’.
For instance, a ‘forgiveness’ can include:
- a debt waiver;
- a debt-for-equity swap;
- the assignment of the debt to an associate of the creditor; and
- forgiveness of an intra-group loan.
The CDF rules operate to offset any net forgiven amount against a waterfall of the debtor’s tax attributes in the following order:
- tax losses from prior years;
- net capital losses from previous income years;
- a wide range of deductible expenditure, (e.g. capital allowances in relation to depreciating assets, R&D and capital works); and
- the cost bases of certain CGT assets.
It may be the case that although there is a forgiveness of debt, there may not actually be a net forgiven amount that would trigger adverse tax consequences for the borrower.
There are exceptions to the CDF rules when the forgiveness is effected under the laws of bankruptcy. Important consideration of the timing of the restructure or forgiveness of debt is therefore paramount in determining whether any adverse tax consequences arise to the debtor.
Carried forward tax losses
When the macroeconomic climate is uncertain, many companies tend to be in significant losses. Some of these companies may choose to innovate and adapt so that they can stay afloat. It may be the ability to effectively innovate will make it possible for a struggling company to trade through their period of distress and become solvent. However, this same adaptation may bring with it unintended tax consequences.
Companies can, in theory, carry forward a tax loss indefinitely and use it when they choose. This is provided they satisfy the business continuity tests.
Broadly speaking, a company can carry forward a tax loss if it has maintained the same majority ownership and control.
If 50 per cent or more of the ownership or control of a company changes, and they cannot satisfy the continuity of ownership test, the company would then need to satisfy the:
- same business test; or
- similar business test.
The liquidation of company assets
In some circumstances, it can be difficult to avoid appointing external administrators and liquidating the company’s assets. From a tax perspective, a company’s assets may fall into the following categories:
- trading stock;
- depreciating assets (e.g. plant and equipment);
- CGT assets; and
- non-trading stock revenue assets.
Generally, any income or capital gain made on the sale of the company’s assets by a receiver, liquidator, scheme manager or administrator will still be derived by the company for tax purposes.
External administrators also need to be aware that CGT roll-over relief may be available in connection with certain forms of share exchanges or in connection with the disposal of assets; roll-over relief is not typically automatic. Advice should be sought to ensure that the most efficient tax outcome is achieved.
Where the distressed company has sold its assets it will need to consider what obligations it may have to retain funds for the purpose of discharging its liabilities. This includes its tax liabilities which may arise in connection with the sale of the asset.
Receivers and liquidators should be aware that they may be held personally liable to pay taxes on any income, profits or gains derived by the company in receivership or liquidation in accordance with section 254 of the ITAA 1936. To avoid personal liability, it is important that an appropriate amount of money is retained in the company to discharge any tax obligations which may arise. The agency relationship as between the company and receiver, or liquidator, the status of existing creditors, and the amount of money retained in the company is important in determining who may be liable and for what amount during this process.
The Commissioner’s powers to collect tax debts
Company rehabilitation and payment priority
When a company becomes distressed, one of the key issues for consideration will be whether it can be rehabilitated in accordance with the voluntary administration or scheme of arrangement regimes, or whether the company ought to commence liquidation proceedings to be wound up.
The Commissioner’s general position is that when evaluating and voting on an alternative to bankruptcy and liquidation, he will consider the individual merits of each case and generally support a proposed arrangement which can provide the Commonwealth with a greater proportion of the provable debt within a reasonable time period than would be received under bankruptcy or liquidation.[1]
Where a company is rehabilitated under the voluntary administration or scheme of arrangement regimes, the Commissioner will typically be treated as an unsecured creditor. For instance, if a company enters into voluntary administration and its creditors vote in favour of a Deed of Company Arrangement (DOCA), the Commissioner will be bound by the DOCA. This is notwithstanding that the Commissioner may have voted against the DOCA.
Exceptions apply in certain circumstances, for instance, where the Commissioner furnishes a garnishee notice or enters into a security arrangement (e.g. in exchange for lifting a freezing order). This will effectively place the Commissioner in the position of a secured creditor, and allow him to be paid in priority to the unsecured creditors. To this end, the Commissioner notes in Practice Statement Law Administration PS LA 2011/18 that even where a garnishee notice places him ahead of certain earlier secure creditors, he will not always enforce his right to be paid first.[2]
This does not always provide much comfort to the company’s other creditors, considering the Commissioner’s practice statements are not binding, and his questionable track record in this regard. For example, in Commissioner of Taxation v Park,[3] the Commissioner enforced his right to be paid ahead of two secured mortgagees in circumstances where the second mortgagee lost access to the proceeds of a sale of secured property.
[1] Australian Taxation Office, Practice Statement: Insolvency – Collection, Recovery and Enforcement issues for entities under external administration (PS LA 2011/16, 14 April 2011) [28]-[29].
[2] Australian Taxation Office, Practice Statement: Enforcement Measures for the Collection and Recovery of Tax Related Liabilities and Other Amounts (PS LA 2011/18, 14 April 2011) [119].
[3] (2012) 205 FCR 1. The Full Federal Court in that case held that this was within the Commissioner’s power. However, the majority in Park recognised that the situation would be different if the mortgagee was entitled to foreclose.
Director duties
Where a company is in distress, its directors need to be particularly careful to ensure that they are aware of their duties as they may be penalised, held personally liable or a transaction may be declared void where for instance, they have given an unfair preference to a particular creditor.
Directors must exercise their powers and discharge their duties:
- with reasonable care and diligence (although the business judgment rule operates as a defence);
- in good faith;
- in the best interests of the company; and
- for a proper purpose.
The director may breach these duties by failing to ensure the company complies with its taxation obligations. The same conduct may trigger a director penalty and a breach of directors’ duties.
Director penalty regime
The perils of corporate directorships are well known to advisers in Australia. The director penalty regime imposes on directors[5] an obligation to ensure that companies ‘comply with its obligations’ to pay the following amounts to the Commissioner by the due date:[6]
- certain amounts withheld under the PAYG-W provisions;
- superannuation guarantee charge;
- assessed net amounts of GST; and
- GST instalments.
Directors are made personally liable to a penalty equal to the unpaid amount of such corporate debts at the end of the due date for payment of the amount.[7]
Although the debts of a company cannot typically be imputed to its directors, the directors may become personally liable for the company’s debts when things go wrong. The duties placed upon company directors to act properly and in the interests of the company are onerous and the degree of attendant regulation is ever-increasing.
Directors should also be aware that they may be obligated to indemnify the Commissioner in circumstances where a court makes an order against the Commissioner, for instance, where the company enters into a transaction that is later voided, and the PAYG paid to the Commissioner is clawed back as a consequence.
Given the potential risk of penalties and personal liability, a director should promptly seek independent legal advice if they believe there is a risk that the company will become insolvent.
[5] As defined in the Corporations Act (i.e., it extends to de facto directors and shadow directors).
[6] Taxation Administration Act 1953 (Cth), sch 1 s 269-10(1).
[7] Taxation Administration Act 1952 (Cth), sch 1 s 269-20.
Contact our tax team
ABL is the tax controversy sector leader in end-to-end management of taxation disputes and litigation arising from ATO compliance activities and audits. If you have identified issues or would like assistance in reviewing risks or uncertainties, please contact one of our team members below.
