Reflections on the Australian Building Systems case
WHO SHOULD READ THIS
- Insolvency practitioners, mortgagees or other secured creditors and their advisors.
THINGS YOU NEED TO KNOW
- Despite the ABS case, there are still possible tax benefits for a secured creditor to enforce their security by way of a mortgagee in possession rather than appointing a receiver. This is particularly so where the creditor’s possession of a debtor’s assets may persist for a long time or where there is a prospect of an ATO garnishee order. In such situations a MIP arrangement allows for a smoother distribution of proceeds to a secured creditor than a receiver where income tax may still be a hurdle.
WHAT YOU NEED TO DO
- When considering your options in enforcing a security consider the tax issues related to dealings with debtor assets.
Prior to the High Court’s decision of FCT v Australian Building Systems Pty Ltd (in liq)  HCA 48 (ABS case) some secured creditors had elected to enforce their securities as a mortgagee in possession (MIP) rather than as a receiver so as to avoid the risk that section 254 Income Tax Assessment Act 1936 (ITAA 36) would apply to impose a personal obligation on the receiver to retain sufficient funds from the proceeds of an asset sale, so as to meet the debtor company’s tax obligations in respect of such a sale. Where section 254 applies it effectively provides the Australian Taxation Office (ATO) with a ‘super priority’ to sale proceeds over other creditors (whether secured or unsecured).
A MIP arrangement does not fall within section 254’s ambit because a MIP is neither a ‘trustee’ (as defined for the purposes of the ITAA 36) of, nor an agent of the debtor. A MIP is not a trustee or fiduciary of the mortgagor because it acts for its own benefit and not for the benefit of others: FCT v General Credits Ltd 87 ATC 4918. Nor is a MIP an agent of the mortgagor because it enjoys possession in its own right, albeit it is for the purpose of securing payment of the mortgage money and the MIP does have an obligation to account to the debtor for what they have received or ought to receive: Falk v Haugh (1935) 53 CLR 163. The fact that a MIP may use an agent to enforce its security rights also does not cause section 254 to apply to the MIP arrangement on the basis that it would not make sense to consider an agent of the MIP a ‘trustee’ for section 254 purposes but not their principal (being the MIP): Chant v FCT 94 ATC 4733.
The fact that a MIP arrangement is not caught by section 254 effectively allows a secured creditor to recover the whole of their debt from sale proceeds of a secured asset without a tax leakage. This contrasts with the position of a liquidator or receiver who are expressly included in the definition of a ‘trustee’ for the purposes of the ITAA 36, and to whom a section 254 obligation may apply.
The High Court’s decision in the ABS case clarified that the personal obligation of a liquidator, or receiver under section 254(1)(d) ITAA 36 to retain funds from post appointment sales of a debtor’s assets does not arise until after a tax assessment has been issued. Effectively the ABS case allows a liquidator or receiver to distribute proceeds from the sale of a debtor’s assets to secured creditors where those proceeds are received and swiftly distributed prior to the issue of a tax assessment.
Since the handing down of the ABS decision, there is one less reason for a secured creditor to enforce their security via a mortgagee in possession than via a receivership, however, there are other matters which need to be considered.
In this Focus Alert we consider other insolvency/tax aspects which may still cause a secured creditor to prefer a MIP arrangement over a receivership.
Multiple secured assets
The ABS case involved the sale of a single asset on which a single taxable capital gain was derived. Distribution of a single capital gain prior to the issue of a tax assessment can be managed relatively easily. Where a debtor has multiple assets that must be disposed of to recover a secured creditor’s monies, a liquidator or receiver may still be subject to a personal obligation under section 254. This is because the obligation to retain under section 254 extends to ‘any money’ which comes to the liquidator or receiver in their representative capacity after the tax assessment has issued. In a situation where a number assets need to be sold it may be that the time frame for sales occurs over a number of financial years, in which case a debtor company may already have been issued a tax assessment at the time it receives some sale proceeds.
By contrast if a secured creditor appointed a MIP over each asset there would not be a section 254 concern even if sales occur over a number of financial years.
The ABS case concerned the taxation of a capital gain. An issue arises as to how trading profits are dealt with in the roles of liquidator and receiver as opposed to a MIP. A liquidator or receiver would have a personal obligation under section 254 to retain funds from such profits to cover the debtor company’s tax liability arising from such profits. This is because section 254 covers income, profits and capital gains derived by the liquidator or receiver in their representative capacity.
For a MIP, the application of section 254 to trading profits is less clear as there is little case law in the area. No doubt this is because normally a debtor company would have such large tax losses that any trading profit derived would be completely offset. However, that is not always the case and the longer an MIP trades a business and generates income, the more likely tax losses will be used up entirely.
Consider the situation of a debtor trust owning a retail shopping centre in a regional area which is badly affected by the decline of the mining boom. Declining rent income causes the debtor trust to fall behind in its loan obligations and its secured creditors choose to take possession of the shopping centre under a MIP arrangement. The MIP has difficulty selling the shopping centre for an appropriate price due to the decline in the regional economy and decides instead to continue to carry on the business, whilst seeking new tenants to improve the rental income and increase the value. This continues for years with the result that the tax losses of the debtor company are completely used up. Would a MIP in this situation be required to personally lodge tax returns and pay tax in respect of such trading income?
Case law indicates that rent income derived over a property controlled by a MIP is derived by the debtor company and not the MIP: FCT v R&D Holdings Pty Ltd  FCAFC 107. This is so even if the rent income is directed to be paid directly to the MIP. This is because the debtor company is still the legal owner of the property. From first principles (provided the security documents under which the MIP has been appointed are drafted to ensure that the MIP is not an agent or trustee of the debtor company), arguably section 254 should not apply to impose a personal obligation on the MIP to retain and remit tax on the rent income since that section only applies to trustees (as defined under the ITAA 36) and agents. As such the liability to lodge tax returns and remit tax still rests with the debtor company. The MIP is required to account to the debtor company for the rent received and so the debtor company should have the relevant information needed to pay the tax on the rent income.
Further support for the view that the debtor company is the relevant party liable to pay income tax on the rent income derived can be found in Faulk v Haugh (1935) 53 CLR 163. In that case the High Court considered that the only time a MIP is liable to pay income tax on such rent income is where such rent income is appropriated to pay the interest accrued on the loan owed to the secured creditor. In such case, the MIP would be liable to pay tax on the interest income received. Where the rent income received is applied to the outstanding principal of loan, a MIP has no income tax liability with respect to the rent income since no income is derived by the MIP. Properly drafted security documents would usually provide the MIP with a power to allocate income derived between the payment of loan principal and interest.
In informal discussions which we have had with the ATO on this issue it appears that the ATO accepts that section 254 should not apply to impose a personal obligation on a MIP to the extent that the secured debt remains outstanding.
The Full Federal Court case of FCT v Park  FCAFC 122 (Park case) also shows the income tax advantage that a MIP has over a receiver. In that case a trustee in bankruptcy sold property with the permission of two of the debtor’s secured creditors. After exchange, but before settlement, the ATO served the purchasers with a garnishee notice under section 260-5, Schedule 1 to the Taxation Administration Act 1953 requiring the purchasers to pay the sale proceeds to the ATO to settle the debtor’s unpaid tax debt. The garnishee notice disrupted the settlement of the sale as both secured creditors desired to have all the sale proceeds paid to them to satisfy their debts. Eventually, it was agreed that the first mortgagee would be paid out its debt in full from sale proceeds in return for releasing its mortgage. The second mortgagee agreed to release its mortgage to allow the sale to proceed on the proviso that the remaining sale proceeds were paid into a solicitor’s trust account pending a determination of the court as to whether the garnishee notice was effective in relation to the remaining sale proceeds.
Broadly, section 260-5 allows the ATO to garnishee an amount which a third party owes or may later owe a tax debtor. The Full Federal Court in the Park case held the garnishee notice to be effective with respect to the remaining sale proceeds. Amongst other things, the Court rejected the second mortgagee’s arguments that it had a security interest in the sale proceeds which overrode section 260-5, holding instead that the second mortgagee only had a security interest in the land and once the second mortgagee released its mortgage to allow the sale to proceed it lost its secured status. The Court also rejected the second mortgagee’s policy argument that section 260-5 could not be used to affect its security rights to the remaining sale proceeds. The Court held that a garnishee notice under section 260-5 could not deprive a secured creditor of their security but in the second mortgagee’s circumstances it had released its security which then allowed section 260-5 to operate.
Since section 260-5 operates where a third party owes an amount to a tax debtor, it is interesting to compare the position of a MIP with that of a receiver. Since a receiver acts as an agent of the debtor company rather than the secured creditor, the reasoning in the Park case would suggest that a garnishee notice is effective against a receiver. This is because the purchaser owes the sale price to the receiver as agent for the debtor company. In contrast a MIP does not act as an agent for the debtor company. Rather a MIP acts for itself in disposing of the asset to satisfy its loan and the sale proceeds it receives are owed beneficially to the MIP and not the debtor company. Consequently, a section 260-5 garnishee notice is not effective against a MIP since the debt owed by the purchaser is owed to the MIP and not to the debtor company.
The above discussion indicates that there are still income tax advantages in a secured creditor enforcing their security via a MIP arrangement despite the ABS case. Readers should note that the position with respect to GST is different from income tax, as MIPs are liable to remit GST on a sale of debtor assets where the debtor would otherwise be required to remit GST on the sale. As a result a MIP may be the in same position of personal liability for GST as liquidators and receivers.
In deciding whether to enforce through receivership or as a MIP, a secured creditor should weigh up the various commercial benefits of each role carefully to ensure that their initial choice is appropriate. Changing from a receivership to a MIP arrangement halfway for tax reasons may raise issues as to whether the general tax anti-avoidance rules apply.
This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. It is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.