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Heading for a fall

Feature Articles

Cite as: (2008) 82(10) LIJ, p. 44

Directors need to be vigilant and fully aware of their company’s tax debts to avoid personal liability.

By Van Do

Since the LIJ published an article in 2005 on the potential for directors to be personally liable for tax defaults of their company,1 no less than 20 cases have arisen on this issue. Nearly all have been decided against the directors, resulting in personal exposure to the unpaid tax liabilities of their companies.

This matter is of great concern for directors, given the clear manifestation of an active pursuit of directors by the Commissioner of Taxation and the reluctance or, more likely, the inability of the courts to grant a director relief.

While there are other powers the Commissioner can use to attack a director or officer,2 the recent cases discussed in this article concern the operation of two key provisions, Division 9 of the Income Tax Assessment Act 1936 (Cth) (ITAA) and s588FGA of the Corporations Act 2001 (Cth).

Directors’ obligations for unremitted PAYG amounts

The offence

Division 9 of the ITAA imposes a penalty on a director where a company fails to remit PAYG amounts to the Commissioner, equal to the unremitted amount. Although this section appears to be limited in its scope, unremitted PAYG tax is usually one of the largest unpaid taxes of a company on a winding up and is the most frequently liquidated area.

To invoke the penalty, the Commissioner must give a director’s penalty notice (DPN) to each director (ss222AOE, 222APE), which gives the director 14 days to do one of the following:

  • discharge the liability by paying the unremitted tax;
  • enter into a payment agreement with the Commissioner to pay the liability under s222ALA of the ITAA;
  • put the company into administration; or
  • wind up the company. In practice, it is unlikely that the winding up of a company will be able to start within the required 14 days.

If one of the above is not complied with in the 14 days, all directors of the company at any time when PAYG tax is unremitted become personally liable for the amount of unremitted taxes.

A new director is also liable if, within 14 days after they become a director, the company has not complied with the requirements (ss222AOD, 222APD).

Australian Taxation Office’s (ATO) position

The ATO’s position is set out in its ATO Prosecution Policy which states (para 14.4.2) that:

“Debtors can expect that in most cases, director penalty notices will issue as a matter of course in order to maximise both the compliance effects and the revenue collection potential of the legislation. The notices will issue as soon as practicable after the due date for payment (or after service of a notice of estimate) if the company has not taken one of the necessary steps.”

The Commissioner may issue a DPN at the same time as other recovery action is being taken against the company. Given the many cases in recent years, it is apparent that the Commissioner is putting policy into practice.

Service of a DPN

Given the draconian consequences of a DPN, directors have sought to challenge whether it has been validly issued.

Generally, the Commissioner can serve a DPN if it appears from an Australian Securities and Investments Commission (ASIC) document (broadly, a return lodged with ASIC) that the person was a director within the past seven days. The Commissioner can deliver or post the DPN to an address that appears from the ASIC documents as the person’s place of residence or business (s222AOF ITAA).

Where the DPN cannot be so served (for example, if the director’s current details are not in any ASIC document), the Commissioner can serve notice under reg 40 of the Income Tax Regulations 1936 by posting or delivering the DPN at the director’s “preferred address”, such as at the postal address given in a director’s personal tax return: DCT v Guastalegname.3

Directors have to be careful as there is (effectively) deemed receipt even if a director does not actually receive a DPN, as illustrated by the following cases:

l A transposition error made by the Commissioner on a DPN did not prevent valid service: DFC of T v Arnold & Ors;4

l The court in DCT v Meredith5 affirmed that even if the director could prove non-receipt, this would not bear on the validity of the service as the meaning of “service by notice” in the relevant interpretation legislation deems that a prepaid post to a person is received on the fourth working day after posting, unless proven to the contrary.

The court in Meredith commented on a potential “way out” for a director, by stating (at [92]) that:

“Assuming that a document was sent by post, evidence that it was not received by the intended recipient, if accepted, may, depending on the circumstances, give rise to an inference that it was not delivered, either in the ordinary course of the post or at all.”

However, in practice, if a director does not actually receive a DPN in the mail (through no fault of their own), it would be virtually impossible for the director to prove that the document did not get “delivered”.

While on the one hand such a deeming provision is understandable because of the need for certainty and consistency, it seems nonetheless a harsh result because a director could be unaware of the issue and expiry of a DPN, which gives rise to substantial personal liability. Further, if a director fails to notify ASIC of an updated address, this will not affect the validity of service, as held in Kavanagh v DFC of T.6 Further, the Commissioner does not have to search the actual return or notice lodged with ASIC; it is sufficient to search the database that extracts the information: DC of T v Nercessian.7 This latter point gives rise to the question of whether service can be valid if the ASIC database details of a director’s address, which the Commissioner relies on in service of a DPN, have not been updated for recent ASIC documents lodged by the company regarding a director’s new address. Given the strict and literal interpretation of the courts on the service of DPNs, it will be unlikely the court will find service of such a DPN to be invalid.

Further, the Commissioner is not required to issue another DPN merely because an amount given on the first DPN has now been reduced. Therefore, a director cannot allege that another 14 days’ notice should be given from the time that a liability in an original DPN has been reduced.8

It is submitted that the strict interpretations of the law is at odds with the intent of the requirement to give notice. Before the introduction of s222AOE, directors were required to be convicted of failing to pay unremitted amounts before they became personally liable to pay the amounts. The introduction of s222AOE therefore raised the onus on directors to cause their companies to pay unremitted amounts; however, as stated by the Explanatory Memorandum to the enacting legislation,9 a penalty can only be recovered if the Commissioner gives written notice to the person concerned and the director then has four options they can comply with to get out of the provisions.

Given the raising of the onus on directors under s222AOE, it could hardly have been the intention that directors will have personal liability without receiving actual receipt of a notice which alerts them to the requirement to implement one of the four options within a short period of 14 days. The courts could adopt a purposive approach to the interpretation of legislation, an approach which is endorsed by s15AA of the Acts Interpretation Act 1901 (Cth) and which may result in a fairer application of these onerous provisions. For some reason the courts do not adopt such a purposive approach in considering these provisions and more fairly balancing the interests of revenue for the Commonwealth and directors’ interests.

Payment agreement

In many instances, entering into a “payment agreement” can be a way out for a director. The director must be careful to meet all requirements for a valid payment agreement.

For example, a director should not simply assume that a payment agreement proposal put to the Commissioner will be accepted, and needs to be careful that all stipulated conditions are satisfied: DFC of T v Johnston.10

Further, the amount paid by the company in Johnston to the Commissioner (which was intended to be for the unremitted tax pursuant to the DPN) was instead allocated by the Commissioner to other outstanding taxes and therefore did not reduce the DPN liability as intended.

While a payment agreement can discharge other liabilities as well as the PAYG liabilities, the payment agreement must separately identify the different liabilities being discharged. The court in Paola & Anor v DCT11 held that a payment agreement which dealt with the company’s unremitted tax, GST and interest and penalties, but did not allocate the total liability of the company under the remittance provision, could not discharge the DPN liabilities and accordingly did not relieve the director from personal liability for unremitted tax.

Defences

A director has two potential defences under ss222AOJ and 222AQD ITAA:

1. The director took all reasonable steps to ensure that the directors complied with the DPN, or there were no such steps that could be taken.

2. If the person was a director when a payment agreement was made, they must also prove that they had reasonable grounds to expect, and did expect, that the company would be able to comply with the agreement. This is an objective test.

In DFC of T v Blaikie & Anor,12 a company could not comply with a payment agreement because of the receipt of a significant fine from the Industrial Relations Commission and a demand for compulsory workers compensation insurance premiums that were not taken into account when the payment agreement was entered into. The court held that the director did not have reasonable grounds to expect the company could comply with the payment agreement. This was based on his subjective confidence in the financial future of the company by relying on weekly cash flows which did not identify non-routine financial demands. At the time of the payment agreement, the director either knew or ought to have known the likely cost to the company of these allegedly “unexpected” sums.

However, the requirement does not require certainty that the company would be able to comply. In DFC of T v Freudenstein13 the director was able to prove he had reasonable grounds to expect compliance with the payment agreement. Here, the expectation of future revenue from trading (which did not come to fruition or was delayed) at the time of entering the agreement, was “reasonable”. This was because the nature of the business was such that it was adversely affected by the 11 September 2001 bombing of the World Trade Centre and given the 20 years experience of the director, the court was prepared to rely on his assessment of the possibility of the revenue.

Given the unusual facts in Freudenstein, directors cannot expect that courts will necessarily reach this conclusion in other cases. The courts will not readily accept that there are reasonable grounds if a director is not vigilant and inquires about potential revenue and expenses.

“Honesty” as a defence?

In 2006, the decision by the NSW District Court in Deputy Commissioner of Taxation v Dick14 brought hope to directors when it was held that s1318 of the Corporations Act was available as a defence to directors against claims under Division 9 of the ITAA.

Section 1318 provides a discretion on a court to relieve a person from liability for negligence, default, breach of trust or breach of duty where the person has acted honestly and ought fairly to be excused for the breach.

However, such hope was short-lived, as the Court of Appeal overturned the trial judge’s decision in 2007.15

Stantow JA said: “I consider that conflict between the specific requirements of Divs 8 and 9 and the generality of s1318 preclude the one being accommodated to the other. A proper process of statutory construction reveals the former to be a code and that code to be exhaustive, leaving no room for s1318 to apply.”

The taxpayer was refused special leave to appeal to the High Court and, accordingly, the NSW Court of Appeal decision stands.

Voidable transactions

Another area of recent litigation is where a court sets aside a payment by a company to the ATO on the basis that it is a “voidable transaction” under s588FF of the Corporations Act. As a result, the Commissioner must repay the amount to the company. The Commissioner then has a right under s588FGA to seek indemnity for “loss and damage” from a director of the company.

ATO’s position

As outlined in the Prosecution Policy, the ATO will try to invoke s588FGA wherever possible:

  • It will take action against the directors under s588FGA where it is required to repay amounts to a company under a “voidable transaction” order (para 14.4.8).
  • It may encourage a liquidator to pursue directors in insolvent trading cases where there is a significant amount of tax involved and there is potential for recovering that amount by initiating action (para 14.4.9).
  • If it is clear that a transaction was voidable, the ATO will not oppose an action by a liquidator and will consent to judgment (para 22.4.4). Where the directors’ indemnity is to be pursued, notice of any proposed consent order should be given to the directors before the order is made to afford them the opportunity to raise any objection. This is necessary so as not to compromise the Commissioner’s ability to enforce the indemnity under s588FGA (para 22.4.10). However, as evident from Harris & Anor v Commissioner of Taxation & Ors (Harris),16 discussed below, the Commissioner will depart from this policy where it suits.

Where the Commissioner defends the liquidator’s claim, the Commissioner may join directors as third parties to the action and enforce indemnity in the event that the court makes a voidable transaction order (para 22.4.9).

Recent cases

Recent cases have clarified the “loss or damage” for which the director is liable under s588FGA. In addition to the principal tax and interest, the costs incurred by the ATO in relation to the indemnity action against the directors can be claimed (see Condon v Cmr of Taxation17 and Palmer v DC,18 which both awarded 60 per cent of the costs to the Commissioner under the indemnity). The Commissioner cannot claim costs from the director in respect of expenses incurred in defending the claim made by the liquidator: Sims v Commissioner of Taxation.19

Two recent cases, Young v Commissioner of Taxation20 and Harris, have also tested whether an indemnity arises if a court order for insolvent trading was made pursuant to consent judgments or admissions from the Commissioner and the liquidator (as opposed to a court order made following a review of the documents). In both cases, the court held that the ATO can seek indemnity under s588FGA for court orders made pursuant to consents from both parties.

In Harris, the directors asserted that they were not given the opportunity to make submissions at the time that a consent order was made by the court as they had filed affidavits in which they asserted that they were entitled to a defence because they had relied on an accountant’s advice that the company was not insolvent. Another interesting point in this case was that the Commissioner did not follow its published policy that it would give notice of the proposed consent order to the directors before it consented to judgment. When questioned, the Commissioner stated that it did not follow its policy due to pressures from the liquidator to resolve the issues promptly.

The directors were unsuccessful in their argument that they were denied procedural right.

While the decisions again appear sensible because of practical considerations, the risk for directors is that a Commissioner may simply consent to judgment, including not following its published policies, knowing that it can seek indemnity from the directors (in fact, as discussed above, the Commissioner has stated this will be its policy in cases where it is “clear that the transaction was voidable”). Directors would not have the benefit of an impartial court having full recourse to all materials and making judgment. Rather, it would be relying on the assessment of the Commissioner and liquidator that the transaction was “clearly” voidable.

Conclusion

The two key areas for directors explored in this article are liabilities for unremitted withholdings of their companies and indemnities where there is a voidable transaction affecting the ATO.

The spate of recent cases in these areas demonstrates that the courts have been confined to a strict interpretation of the provisions rather than a purposive interpretation. Unfortunately, this has not generally been to the benefit of directors and signals a significant amount of risk for them. It will be interesting to see in the next few years whether the trend of such cases continues. Lawyers need to help by informing directors of their continuing obligations. What is clear, though, is that directors cannot simply assume that they can escape personal liability for company tax debts. They must take active measures and be fully aware of their company’s financial position to minimise risks of personal liability. The Rudd government has announced that it would reduce and streamline the obligations imposed on company directors as part of its bid to reduce the reach of directors’ legal liabilities, and has reportedly said directors’ liabilities were making boards overly cautious and deterring people from serving on them.21 This at least signals some measure of potential relief for directors, but if the PAYG directors’ penalty regime is not considered, the review will not go far enough.


VAN DO is a solicitor in the Corporate Group with DLA Phillips Fox.

1. Gerry Bean and Jonathon Sprott, “Code red: personal liability of directors for their company’s tax debts”, vol. 79, no.1-2 (Jan-Feb 2005). I would like to thank Gerry for his comments on this article.

2. For example, s8Y(1) of the Taxation Administration Act 1953, s252(1)(j) of the ITAA and s444-15 of the Taxation Administration Act 1953.

3. [2007] VSC 81.

4. 2007 ATC 4393.

5. [2007] NSWCA 354.

6. 2007 ATC 4256.

7. (2006) 67 NSWLR.

8. Deputy Commissioner of Taxation v Craddock & Anor 2006 ATC 4729.

9. Insolvency (Tax Priorities) Legislation Amendment Act 1993.

10. 2006 ATC 4250.

11. (NSW) 2007 ATC 4520.

12. 2006 ATC 4796.

13. 2007 ATC 5113.

14. (2006) 3 DCLR (NSW) 244.

15. Deputy Commissioner of Taxation v Dick [2007] NSWCA 190.

16. (2006) ACLC 648.

17. [2006] NSWSC 745.

18. [2006] NSWSC 656.

19. (2007) 25 ACLC 1,829.

20. (2006) 24 ACLC 240.

21. “Rudd Government to ease company directors’ liability”, The Australian, 19 May 2008: the report said Finance Minister Lindsay Tanner and Small Business Minister Craig Emerson had told state officials the government wanted to reduce and streamline the obligations imposed on company directors by state laws, as part of its bid to reduce the reach of directors’ legal liabilities.

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