Taxing Recoveries – successful litigation by Inland Revenue

QCL-MEDIA-FINAL_4804-rossThis week consultant Ross Dillon looks at how a good run of successful litigation’s by the Department of Inland Revenue could have far-reaching effects. To find out more about Ross Dillon click here. If you are negotiating a tax debt with the Department of Inland Revenue get good legal advice for a successful settlement.  Ignoring a tax debt or capitulating to the Inland Revenue demands could cost you or your business a substantial amount of money. Unlike other debts the Inland Revenue have special powers of recovery and they are happy to exercise them.To read more articles by Ross Dillon click here.

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The Department of Inland Revenue (“CIR”) has been on a very good run of successful litigation challenging payments that at first blush would not strike you as having adverse tax effects. The latest one – CIR v Jennings Roadfreight Ltd ( in Liquidation) [2013] NZCA 455 – could have much more far-reaching effects than might be apparent from what was a very narrow and specific set of facts.

A company was in financial difficulties.   The CIR issued a notice to the company’s Bank, requiring it to pay funds held to the credit of the company, to the CIR in reduction of outstanding PAYE ($50,000) and GST ($294,000).   It held $14,000.00 in its bank account, and so paid that out to the CIR.  The company went into liquidation that same day.  To be precise, $10,000 was paid 2 hours prior to the liquidation, and $4,000 paid was paid afterwards – which does become relevant to the case and how it was resolved.  As is so often the case, the devil is in the detail.

In the normal course of a liquidation, the Liquidator is able to recover payments made within 6 months of Liquidation, and use the sums recovered to pay out creditors in an order of priority fixed in the provisions of the Companies Act.   Other creditors have priority over the CIR under that Act ( relevantly for this case, the liquidator for fees, and employees for wages and salaries, holiday and redundancy pay).

CIR objected to the attempt to recover the payments, on the grounds that the company held the funds in trust for CIR.  If that was correct, the trust funds were not those of the company, which therefore escapes the Companies Act priority for application of company assets.

CIR based its argument on section 167 of the Tax Administration Act (TAA), which provides:

(1) Every amount of tax withheld under the PAYE regime “shall be held in trust for the Crown”.

Which may seem a reasonable position for CIR to hold, except that the next part of the same section provides:

(2) If the employer has failed to deal with the tax withheld in subsection (1) then the tax unpaid to the CIR “ shall, in the application of the assets of the employer, rank…upon the liquidation of the company…(as)…provided for in…the Companies Act.”

One would think that given the liquidation, subsection (2) applies and the CIR is thus subject to the priorities set out above.

The majority of the Court of Appeal has decided this is not the case.

Rather, that a trust is created by the statutory language in subsection (1), which subsection (2) does not displace.   The employer does not have to do anything to create the trust, apart presumably from not paying it immediately to the CIR when the wages or salary upon which it is based becomes payable (as provided by section 4A (2)(b) of the TAA), or when it is due for payment by the employer (PAYE is meant to be paid within one month – TAA s.RD4).taxing

In effect, the Court of Appeal held that because the payment made prior to liquidation was in satisfaction of the trust obligation, it escaped the usual Liquidation priority rules.  It could not be recovered from the CIR as a preferential payment.  The payment after the liquidation could also not be attacked, as it was the payment of money that was held in trust for the CIR – and thus was not an asset of the company

There is a lot of criticism of this decision.  It does seem to offend the usual rules in relation to tracing of property – between when the trust arose, and payment was made, the company bank account fluctuated into negative territory.   A beneficiary of a trust can not trace through an overdrawn account – that is, once the money held on trust has been spent (even improperly), it can not be recovered

The employer did not put the money aside into a separate account for tax payment purposes.  There is some criticism that by not doing so, there was no certainty to the formation of the trust – which argues against any trust existing at all.  However, the law on this point is not as certain as some commentators seem to believe, and the Court of Appeal said that this was not required when the trust was created by statute (as opposed to the usual type of trust, created by the trustee who usually is holding the relevant property when the trust is created).

Further, the CIR has been given priority in the scheme of the Companies Act anyway.  As a matter of policy it is hard to see reason for giving the CIR even greater rights than any other unsecured creditor.   The answer to that point is that the priorities are created by Act of Parliament anyway, so if a trust is created by an Act, it should also be given effect.

The particular concern the writer has regarding this decision is one that does not appear to have been noted by other commentators. If the TAA creates a trust, and the company has not met its obligations in relation to that trust, then obviously the company has breached its duty as trustee.   This has two rather chilling effects.

First, a company is a legal fiction.   Trusts are creatures of equity.   Equity looks at the true position, not at legal fictions.  The real trustees (either as constructive trustees or trustees de son tort) are the directors of the company.  They have breached their duties as the true trustees by allowing this to occur. Trustees are personally liable.  Ergo, the directors are personally liable.

Secondly, the Companies Act imposes duties on directors to the company, including relevantly to act in good faith for the best interests of the company (for instance to ensure it does not breach any duties as trustee), not to trade recklessly ( for instance to allow a breach of trust, thereby creating a loss to a company creditor), not to act negligently ( as prior).   Breach of any such duties leaves the director exposed to personal liability under section 301.

Section 301 fixes directors with personal liability, in the following terms:

“If, in the course of the liquidation of a company, it appears to the Court that … a past or present director, … has misapplied, or retained, or become liable or accountable for, money or property of the company, or been guilty of negligence, default, or breach of duty or trust in relation to the company, the Court may, on the application of the liquidator or a creditor or shareholder,—…

(b)        Order that person—

(i)         To repay or restore the money or property or any part of it with interest at a rate the Court thinks just;

If the CIR wishes to use the decision of breach of a statutory trust as a springboard to attack directors personally for breach of trust, it appears that there is now scope to do so.

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