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31 Jul 2017

When tax planning and insolvency collide


4 min

Worlds apart

The liquidation of a popular restaurant in Perth has highlighted that, what on the surface may have appeared to be a fairly innocuous exercise in tax planning around the Australian Taxation Office’s (ATO) Division 7A issues, may have significant adverse consequences in an insolvency scenario. The issue at stake (excuse the pun) was how to prevent Division 7A—concerning taxable dividends—applying to two directors’ debit loan accounts, created from weekly drawings being paid.

The directors tried to avoid creating these loan accounts by setting them off against the third director’s loan account, which was in credit (and for a similar amount).  The journal entry effecting this was done 30 June.

The company fell into liquidation a few months after and as liquidators, we found the company was insolvent for at least 12 months, and critically, insolvent at 30 June, when the loan accounts ‘offset’ happened.

On face value the transaction was neutral to the company; that is, the company lost the benefit of being able to recover the debit loan accounts from two of the directors but gained the benefit of not having a liability to the third director.

But, the question arose as to whether the third director received a preference under section 588FB of the Corporations Act 2001.

At the heart of this section is the principle that unsecured creditors in a liquidation should not be prejudiced by unsecured debts being paid to particular creditors within six months of the winding up. In this case, the third director, through his loan account being ‘satisfied’ using the company’s limited cash resources or (in this case), releasing the debit loan accounts, in favour of other directors.

Around the same time as this liquidation, a NSW court handed down a decision relating to preferences in similar circumstances.  That case involved a subcontractor working on construction site for a head contractor. Prior to the subcontractor going into liquidation, the company formally requested that the head contractor "pay its creditors directly, on the Company’s behalf".

Separately, the head contractor requested an urgent conference with their union (CFMEU).  Following that meeting, the head contractor terminated its contract with the subcontractor company and subsequently wrote the CFMEU stating that, among other things, it would make direct payment to the subcontractor’s creditors on behalf of the subcontractor company.

The liquidator of the subcontractor sought to recover these payments made to its creditors by the head contractor, as a preferential claim.

The Judge commented that if the liquidator was to be successful, it must be shown that the creditor (being the defendant creditors of the subcontractor) received the actual benefit of a company asset at the direction of the company and, but for that direction, the company would have been entitled to the benefit. Given that the court found that the head contractor’s payment was not made pursuant to the subcontractor’s request, but rather, by union pressure (CMFEU), and that the head contractor didn’t actually owe any money to the subcontractor, the liquidator’s claim failed.

However, in coming to that conclusion, the court made the following clear:

To be successful in recovering the payments as a preference, it must be established that:

  • the payment was made with the insolvent company’s authorisation or ratification; and

  • the monies paid represent an asset or benefit to which the insolvent company was entitled.

That principle is directly relevant to my liquidation scenario described above because:

  • the debit loan accounts owed by the first two directors were company assets that it was entitled to; and

  • the transaction by which the loan accounts were set-off was clearly done with the company’s authorisation.

Consequently, it follows that company assets (i.e. the debit loan accounts) were applied in satisfaction of a debt due to the third director, who therefore received a preference, and (subject to the various defences to preference claims, which are difficult for a director to meet) that third director is at risk of being liable to repay the amount that this loan account was reduced by—even though this director might not have even received any cash).

While the set-off of the debit and credit loan accounts were primarily undertaken to achieve a tax benefit under Division 7A, that action has exposed the third director to a preference recovery action.

Lesson:  At a time when a company is insolvent, careful consideration must be given to tax planning outcomes, where assets otherwise available to a company are applied in discharge of or in reduction of the liabilities of one or more creditors.  

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