01 May 2019

Bankruptcy and income tax returns


2 min

What happens if there’s a tax refund owing?

We often administer bankruptcies for debtors who have large tax debts owed to the Australian Taxation Office (ATO). And just as often, we’re asked what will happen to the debtor’s tax refunds after bankruptcy.

During bankruptcy, the debtor is obligated to lodge their income tax returns each year as normal. Generally, any personal income tax refunds (if any owing) will be retained by the ATO and set-off against the ATO’s pre-bankruptcy debt until the debtor is discharged from bankruptcy.

After being discharged from bankruptcy, the debtor will resume receiving their personal tax refunds. Again, if any apply.

This arises because when debtors are discharged from bankruptcy, they are released from all debts that were provable in the bankruptcy (i.e. during the pre-bankruptcy period). Prior to discharge, tax debts remain owing and the ATO has the power to retain tax refunds and apply them against the debt it is owed. This was confirmed in Taylor v DCT [1987] FCAFC. refund image_OTP

However, once the debtor is discharged from bankruptcy (which is three years from lodgement of the debtor’s Statement of Affairs, unless there is an objection to discharge), the pre-bankruptcy debt is considered to be irrecoverable at law and the ATO ‘writes off’ these debts.

But, the exception to the above scenario is when a tax refund relates to a pre-bankruptcy period, the ATO will retain the refund and set it off against the pre-bankruptcy debt, even after discharge.

It should also be noted that the ATO can determine how the tax refund is set off. For example, we understand that, generally, the ATO will apply a tax refund against a post-bankruptcy debt in preference to allocating it against pre-bankruptcy debts.

It should be further noted that if an undischarged bankrupt receives a tax refund for the post-bankruptcy period, that must be disclosed to their bankruptcy trustee as part of their annual assessment of income. If a bankrupt’s yearly income exceeds the allowances in view of indexed thresholds and number of dependants, this might mean the debtor owes an income contribution into the bankruptcy estate for the benefit of its creditors.

If that tax refund arises from the pre-bankruptcy period, that refund is payable into the bankrupt estate as it comprises property divisible in bankruptcy.

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