Family feud becomes very costly.
A breakdown of corporate governance processes can have significant financial implications for any business. This was certainly the case in a recent liquidation being handled by the Worrells’ Melbourne office. The circumstances involved a dispute between business owners (who also happened to be family members) that had been ongoing and unresolved for several years (perhaps a familiar scenario to some readers!).
The company, which was trustee of a discretionary trust, held significant assets (represented by cash at bank) at the time of its winding up. While the company had minimal outstanding liabilities, those liabilities had not been paid due to a deadlock between the directors/shareholders, who were also beneficiaries of the trust. This led to a creditor issuing a statutory demand for payment of their outstanding debt, and subsequently applying to wind up the company.
The cash held at bank was more than sufficient to discharge all liabilities in full (and many times over). These funds represented proceeds from the sale of a commercial property, previously occupied by a related entity (which was now also in liquidation).
The directors and shareholders held the view the company was solvent given the significant surplus assets, and they applied to court seeking to terminate the liquidation on grounds of solvency. The court ordered the liquidators prepare a report on the company’s solvency for its consideration as part of the application.
Preparation of the solvency report required the liquidators to consider the company’s outstanding liabilities, including any liability to the Australian Taxation Office (ATO). Relevantly, the commercial property sale had generated a large capital gain. As such, the primary concern for determining the company’s solvency was identifying the party liable for capital gains tax (CGT) arising from the sale of the property.
This is where things took a turn for the worse.
The directors/shareholders/beneficiaries’ lengthy and ongoing dispute extended to failing to execute minutes of distribution (or otherwise make an effective distribution) of the discretionary trust’s net income for the year in which the property was sold. The lack of an effective distribution resulted in no beneficiary of the trust being entitled to any share of the trust’s income for that financial year.
In these circumstances, section 99A of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) applied to render the trustee (being the company in this case) liable to tax on the trust’s net income at a flat rate of 49 percent.
Another consequence of section 99A of the ITAA 1936 is that section 115-222(4) of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) operates to deny access to the CGT discount normally available to capital gains recognised by trusts, under Division 115 of the ITAA 1997. Consequently, the tax applied to the full capital gain.
The net effect of the company bearing liability for capital gains tax on the entire (undiscounted) capital gain, and at a higher tax rate than would otherwise have been applied in the hands of the beneficiaries (had an effective distribution been made), was that the previously “solvent” company was no longer in a position to pay its outstanding liabilities in full. These liabilities now included a debt to the ATO totalling in the millions of dollars.
Needless to say, the application to terminate the liquidation was withdrawn and the liquidation continues. The lesson for your clients is to ensure they have procedures in place to maintain proper corporate governance, especially in times of dispute. The financial consequences of not doing so can be dire.
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