ATO – Insolvency and the Tax Man Jekyll & Hyde

The title of this paper is named after the character created by Robert Louis Stevenson commonly known today as “The strange case of Dr Jekyll and Mr Hyde”.  The Jekyll and Hyde description usually refers to a person with a split personality, one good and one bad.  So it is that in many cases the Australian Taxation Office (The ATO) seems to have a Jekyll and Hyde approach when it comes to tax payers who are unable to pay their debts due to insolvency.
WHY IS THE ATO THE CENTRE OF ATTENTION

When businesses get into financial difficulty, cash flow becomes extremely tight.  The simple principle is that the noisy cog gets the oil, thus employees are paid before critical suppliers, critical suppliers are usually paid before the landlord, and the landlord is usually paid before the ATO or any other statutory obligations.

In effect, and as a result of the somewhat slow response that the ATO has to its recovery policies, it effectively becomes a tacit funder of businesses that are failing.  In certain industries, it is almost an industry paradigm that the ATO is used instead of a bank overdraft.  Of course the net effect of this is that the ATO has been criticised for funding businesses or business operators that should not be in business.

The apparent inertia of the ATO in its debt recovery program seems to have the effect of lulling business operators who have outstanding tax debts into a false sense of security.  At least initially.  It appears that, prior to the ATO commencing legal proceedings it has historically been quite open to coming to sensible payment arrangements with business operators in relation to reduction of debt.  In fact during the height of the global financial crisis the ATO had demonstrated some considerable tolerance and was entering into remarkably easy repayment plans. Dr Jekyll, if you like.

This position has clearly changed and moreover it appears that the ATO has increased its activity in relation to legal proceedings. Furthermore, it appears that once the ATO has commenced legal proceedings, its ability to negotiate payment plans and concessions seems to disappear.  Mr Hyde has emerged.

The action that the ATO takes in relation to debt recovery depends on whether business is operated as a company or as a partnership or sole trader.  I will deal with the situation affecting individuals first.

ATO ACTION AGAINST INDIVIDUALS

It must first be remembered that the ATO, except for superannuation guarantee charge is an ordinary unsecured creditor when it comes to debt recovery proceedings and as such it has legal rights pertaining to an ordinary unsecured creditor only.  This means that in most cases, the only viable action the ATO can take against individuals is to proceed with a judgement against the individual and then in order to enforce the judgement proceed to what is referred to as a Creditor’s Petition and Sequestration Order.  This means the ATO will be seeking to make the individual bankrupt.  Of course as with any other unsecured creditor, the ATO also has the option of serving a Writ of Execution on the debtor’s property or obtaining a garnishee order against wages or salary.

It is important to note that at any time prior to the granting of the Sequestration Order individuals can step in and take control over their own affairs.

HOW DO INDIVIDUALS TAKE CONTROL?

An individual can either file his or her own Bankruptcy/Debtor’s Petition or appoint a Controlling Trustee with a view to entering into a Personal Insolvency Agreement (P.I.A.).  There is an advantage for the debtor in doing this as he or she can choose the time of commencement of the Bankruptcy or P.I.A. and has the opportunity of appointing his or her own Bankruptcy or Controlling Trustee.  No matter how aggressive the ATO has been in pursuing an individual, once a Debtor’s Petition has been filed all action is stopped and the file is effectively closed.  Mr Hyde now becomes Dr Jekyll.

If the debtor wishes to enter into the P.I.A. a creditors meeting is convened by registered bankruptcy trustee pursuant to Section 188 of the Bankruptcy Act 1966 and a special resolution of creditors is required.  This means that 75% of the value and a majority in a number of creditors who attend the meeting are required to approve the proposal.  Of course if the ATO is a major or dominant creditor it is difficult to obtain a yes vote so Mr Hyde has once again returned.

As an alternative to a P.I.A. experience indicates that Section 73 of the Bankruptcy Act is far more effective.  In short Section 73 applies to an individual who is already bankrupt.  The Act provides that a person in this circumstance can simply request his or her trustee to convene a creditors meeting for the purpose of putting a proposal to the creditors for an arrangement or a composition. The voting requirement is the same as for a P.I.A. that is a special resolution.  However, experience indicates that creditors including the ATO are far more receptive to supporting a proposal under Section 73 than a similar proposal under the provisions found in Part X.  Dr Jekyll is back.

There are a number of reasons for this.  The first is that creditors are far less suspicious of a debtor who is already bankrupt proposing an annulment of the bankruptcy than an individual who is not yet bankrupt but trying to avoid the same.  The second is, once an individual has become bankrupt most creditors seem to write off the debt or alternatively the file is passed to a different department.  Furthermore experience demonstrates that meetings convened under the Section 73 attendances can be poor to non existent and this has the added advantage of removing the anxiety and stress from the individuals who are making the proposal.  This is an important consideration for professionals advising debtors as the emotional state of clients is very important.

ATO ACTION AGAINST COMPANIES

Where the ATO is pursuing a company, the process is slightly different.  Again it must be remembered that the ATO is merely an unsecured creditor (except for S.G.C) and it cannot appoint a Receiver or an Administrator.  The ATO must proceed as with any other unsecured creditor in obtaining a judgement, issuing a statutory demand and then commencing winding up proceedings.

It is important to note and this is somewhat different to the position in bankruptcy that once the ATO has commenced formal winding up proceedings, it is not possible for the directors of the company to commence the Voluntary Liquidation of the company.   The only option available to directors in these circumstances is to appoint an Administrator.

Furthermore, this is not without its complications.  It must be remembered that once the ATO has commenced winding up proceedings a hearing date has been set. An Administrator will need to have the winding up hearing adjourned to enable him to complete the normal investigations, Report to Creditors and convene the requisite meeting to consider the company’s future.  In most cases the Court will grant an initial adjournment providing the Administrator gives certain undertakings in relation to not holding the decision meeting of creditors without first referring to the Court.

Once the Court does provide the initial adjournment, the Administrator’s task is to prepare a report to the creditors and to submit the director’s proposal for consideration.  Clearly the proposal will need to provide a better outcome to creditors than the winding up. The matter usually then goes back before the Court for considering a further adjournment to enable the creditor’s meeting to be held and this adjournment is not automatic.  Frequently the ATO opposes the adjournment and often the reason given is not commercial but that the company should be wound up “in the public interest”.  Issues such as the taxpayer’s compliance history and the extent to which public funds have been used to support the failing company’s business are often put forward as reasons for discontinuing the operation of the business.  It looks like Mr Hyde is back. In most cases the Court takes an objective view of this and looks for evidence that there are other creditors whose interests need to be served, thus justifying the need to proceed.

If the Court grants the second adjournment the creditors meeting can proceed and the outcome and future of the company will then depend on the resolution of creditors.  It is important to note that this vote will simply be on a bare majority number and value (a poll) and if the numbers and the values disagree, the chairman has a casting vote.  It should be obvious that once it gets to a creditors meeting stage it is far easier for a company to enter into a Deed of Company Arrangement than the counter part in the bankruptcy jurisdiction in relation to a Personal Insolvency Agreement which of course requires a special resolution for acceptance.

Again as a matter of experience even if the ATO votes against the proposal, providing the other creditors are sufficient to out vote the ATO, it is unusual for the Court to grant a winding up Order unless there are some extenuating circumstances. This could be if the resolution was passed due to related entity claims.

EARLY ACTION IS GOOD

If the company goes into Administration before the ATO commences legal action the situation is totally different.  Clearly there is no Court involvement and the matter will be dealt with at a creditors meeting by a simple vote (a poll).  In most cases the ATO will be out voted and must acquiesce unless there are unusual circumstances.  As a consequence, the attitude of the ATO again returns to that of the good Dr Jekyll.

OTHER REMEDIES AVAILABLE TO THE ATO IN RELATION TO COMPANIES

The ATO has the capacity to issue a Director Penalty Notice in relation to outstanding PAYE Group Tax deductions.  This notice is sent to the Director’s home address and it gives the directors 21 days to comply.  Compliance means the company either, pays the debt, make arrangements to pay the debt, goes into liquidation, or appoint an Administrator.  Default means that the director or directors will be personally liable for the outstanding debt and the ATO can then commence personal bankruptcy proceedings against the directors.  It is important to note that this notice is not sent to the company’s registered office, nor is it sent to the company’s tax agent and as a result it is often overlooked and by default expires.

The notice itself is somewhat bland and certainly less intimidating than much of the other correspondence being received by directors whose companies are facing financial difficulty.  This is another reason why the notices are often overlooked.

Another tactic the ATO can use against companies is to serve a Garnishee Notice on the company’s debtors or bank accounts pursuant to Section 260-5 of the Taxation Administration Act.  If this tactic is used it can be somewhat fatal to the company’s operation as it has the effect of cutting off the company’s cash flow.  This can happen to a company at any time and without notice and the company director should therefore be aware of the potential of this axe falling at any time.

Clearly the conclusion again that should be reached in relation to all of the above matters is that if a company is facing financial difficulties it is far better to act earlier than later.

ANTI FRAUDULENT PHOENIX LEGISLATION

The Government announced in the 2011 budget that it would expand the current director penalty notice regime to include superannuation guarantee amounts and to deny directors the benefit of PAYG credits when such payments are not remitted to the government or to the ATO.  Most importantly the new legislation denies the 21 days grace period where there is unreported debt exceeding 3 months.

This legislation is purportedly aimed at preventing fraudulent Phoenix activity whereby directors purposely use a succession of companies in a cyclic manner specifically to avoid statutory debts.

The legislation has been criticised on a number of levels.  Firstly, it has been submitted that the ATO has already significant debt recovery tools which it currently under utilises.  Secondly, the fact that the ATO is so tardy in relation to its debt collection proceedings will not be solved by the new legislations.  This is an administrative issue not a legislative one.  Thirdly, it is quite clear that the directors would not take positive steps unless they are forced to and in the absence of serving directly penalty notices it is unlikely that the directors or failing companies will take any action whatsoever.

The fifth issue is that the broader economic concerns will not be addressed by this legislation and may get worse. If the ATO relies on the new legislation and “cherry picks” directors it wants to pursue rather than address the administrative issues the net effect will be inefficient business will continue to be propped up.  This has significant impact on the competitive environment in particular it allows inefficient businesses to unfairly compete with legitimate and honest businesses that are paying all their taxes as and when they fall due.

Finally and most importantly, there is no mention in the Legislation of “Fraudulent Phoenix Activity” and many commentators believe that the Legislation whilst intended to attack such activity misses the mark entirely and simply allows the ATO to cherry pick those directors it intends to pursue.

We have submitted that the legislation by and large is well intended and conceptionaly sound, but we have suggested amending the legislation such that grace period be deleted where there is an unreported debt of 3 months and the directors have been an officer of a previous failed company within the last 5 years OR the ATO can prove that there is a “Fraudulent Phoenix Activity”. (to be defined)

We further believe that notwithstanding the fact that no notification is required, there is sound public interest issues involved with the ATO serving some sort of warning notification as the business community generally is unaware of the ramifications and most directors will not take action unless some critical issue occurs.

Importantly the legislation should not replace more rigid administrative procedures in relation to debt recovery.

We believe that without the amendments suggested, that many innocent directors will be caught by the legislation, the community will not be well informed and not served by this legislation and that struggling businesses will continue to be propped up by the ATO as there is no clear evidence that the ATO will use its new tools any more aggressively than the tools it currently has.

CONCLUSION

In a subtle way the Jekyll and Hyde theme continues because it is the lack of action by the ATO in regard to debt recovery that causes most of the harm to the business environment.  This is so firstly because it creates a false sense of security to poor performing businesses and secondly by effectively propping up such inefficient businesses it adds unfair competitive pressures to compliant tax payers.

 

President’s Award


 

Business Recovery Specialists Jones Partners Receives Prestigious President’s Award From Civil Contractors Federation of Australia (NSW) Branch

On the 16th November, 2012 I received a coveted award from the Civil Contractors Federation of Australia (NSW) Branch.  The “President’s Award” was presented in recognition of Jones Partners’ commitment to educating and consulting with the Civil Contractors Federation and the industry in general.  Business recovery specialists, Jones Partners understand the trauma business owners suffer in the face of financial adversity. The award also signifies Jones Partners’ dedication to serving businesses facing difficulties due to the collapse of major corporate entities in the industry such as Reid Constructions and St. Hilliars.

The Multiplier Effect of Infrastructural Development Expenditure

The prestigious award was presented at the Federation’s Grand Gala Ball held at the Sydney Town Hall. The event was attended by the Minister Mr Greg Pearce, department heads and industry leaders.  In accepting the award I pointed out the contribution of the Civil Contracting Industry to the Australian economy.  In particular, I referred to the economic multiplier effect of expenditure by governments on infrastructural development activities such as roads and bridges. I explained how the benefits of this expenditure extend beyond the main cities to regional and rural areas.  Another significant benefit the industry provides is the enduring assets left behind when Civil Engineering endeavours are completed.

The Financial Pain of Major Players in Civil Contracting

The Civil Construction industry has been under considerable financial pressure over the last few years and the pressure has been particularly evident by the recent major players such as Reid Construction and St. Hilliars.

Reid Construction went into voluntary administration on the 15th June, 2012.  At the first meeting over 250 creditors attended.  Unfortunately, the administrator was unable to convince the Court there was a viable proposal to put forward to creditors. As a consequence, Reid was wound up by the Court on the 19th July, 2012.  It appears almost $50 Million dollars is owed to the company on various government projects. Claims by contractors and other creditors exceed $200 Million dollars.  The original estimate by the administrator was that if a Deed of Company Arrangement could be attained, a dividend of between 4.1 and 5.6 cents in the dollar would be paid rather than a dividend of just 2.5 cents in the dollar if the company went into liquidation.

It now appears more likely that very little will be paid to creditors by the liquidator.

Little Comfort for Sub-Contractors

The silver lining to the outcome in relation to St. Hilliars is that creditors have now voted to accept a Deed of Company Arrangement which will at least enable the company to continue.  The proposal however, will result in funds of between $1 and $4.5 million dollars being distributed to creditors.  Sub-contractors are expected to make claims of between $10 and $20 million dollars and there are additional claims of up to another $30 million dollars.  These figures seem to indicate that the final distribution will still be very small.

The story with other collapses such as Kell & Rigby, the Hastie Group and Southern Cross is similar. The bad news is that the situation is likely to get worse for sub-contractors.

The New South Wales government is conducting an enquiry into the construction industry insolvencies in a move to provide a better protection for creditors and sub-contractors. Despite its best intentions, this is little comfort to those businesses already affected by the situation.

Early Intervention – The Key to Improving Chances of a Business Recovery

The education program conducted by Jones Partners was primarily aimed at assisting members of the CCF affected by these collapses to avoid or minimise the flow on effect, and in the worse cases, outline possible ways of reducing the worst results.

One of the issues faced by the many businesses in the consequences of failure is that usually the directors are found to be individually liable in relation to many of them personally guaranteeing creditors.  This means owners of businesses often face the loss of their personal assets such as their car and home. In the worst case scenario, they may face personal bankruptcy unless a viable alternative solution can be put in place to relieve the situation.

One important message that became a recurring theme throughout all the presentations is the importance of early intervention to assist business recovery. If there’s one important message we have for businesses staring in the face of a financial catastrophe it is to act fast. Potential alternative solutions diminish with time, and if help is deferred, it may already be too late to save the business or its directors.