Inside this Issue. Tax Issues With Insolvent Entities

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1 March 2008 Inside this issue: Tax Issues with Insolvent Entities Directors: Inside this Issue Given the current climate and whilst not wishing to put a damper on things we thought it timely to outline some key tax issues relevant for entities in trouble. If you have any comments on this or previous articles, or wish us to cover a particular topic in future newsletters please feel free to call on or fax at or Keith at [email protected]. Finally, we note that this newsletter is not intended to provide an exhaustive or comprehensive statement of tax law and it should not be relied on as the basis for any decision or legal action. Detailed professional advice should always be sought in order to verify the applicability of the relevant legislation to the specific case. Tax Issues With Insolvent Entities The Income Tax Act 2004 and Goods and Services Tax Act 1985 have provisions (section HK 11 and section 61 respectively) that may impose a personal liability on a director or shareholder of a company where the company has deliberately left itself unable to satisfy its tax liabilities. Potentially the provision has wide application, however in a situation where a company is insolvent and unable to satisfy its tax liabilities due to a true trading loss, the provisions are unlikely to apply. Certainly IRD has not invoked them in relation to insolvent companies as a matter of course, probably on the basis a deliberate arrangement is required on the part of the director/shareholder. With those provisions in mind, as well as the provisions of the Companies Act 1993 which apply, we discuss below various tax issues which can arise with an insolvent entity. 1. Mortgagee Sales and GST It is clear that a mortgagee which sells a property in the GST net by mortgagee sale is first required to account to the IRD for the GST i.e. IRD has priority over the mortgagees security. The Edgewater decision confirmed this. However, where a mortgagor has entered into a sale and purchase agreement and the GST time of supply has been triggered prior to the entity entering liquidation, the mortgagee will have priority over the unsecured creditors (including IRD) in relation to their security. This was confirmed in Rob Mitchell Builders (In Liq), a 2004 Court of Appeal decision. Timing is very important in this context and we are aware IRD have sought to invoke section 61 where Page 1 of 5

2 the mortgagee had initially sought to undertake a mortgagee sale yet subsequently changed their position and the mortgagor sold the property. IRD s view was there was an arrangement with the effect of leaving the company unable to satisfy the GST. We are not aware of the outcome. If a mortgagor validly enters into a sale and purchase agreement and triggers time of supply for GST purposes, and the liquidator completes the sale, Rob Mitchell Builders is authority the GST liability will be the company s, not the liquidator s (personally) or the mortgagee. Section 61 is unlikely be an issue if the liquidator were simply discharging the company s liabilities in terms of the priority of the company s securities. 2. Inter Company Loans and Liquidation Where a non trading company has a debt to a sister or parent company, tax issues need to be considered before liquidating the non trading borrowing company. This scenario is particularly complex from a tax technical perspective as deemed dividend and accrual issues arise. Even in a wholly owned group company situation, the dividend exclusion rule may be excluded in certain situations. Assuming the deemed dividend issues are satisfied, the inter company loan will be subject to the financial arrangement or accrual rules, and upon liquidation any debt is deemed to be remitted as the borrower has effectively been discharged from making all remaining payments under that loan. For the borrower accrual income will arise to the extent of the remission. This will be taxable. No bad deduction will be available for the lender. Under the accrual rules, as the parties are associated, and if the loan is a division two loan (i.e. entered into after 20 May 1999) a deduction is not available for the expenditure that is deemed to occur when the loan is deemed remitted as the parties are associated. For division one loans, a deduction may be possible in certain scenarios. 3. Liquidation for Tax Purposes In 2005, IRD issued Public Ruling BR Pub 05/14 Anything Occurring on Liquidation - When a Company Requests Removal From the Register of Companies, and the ruling applies from 8 November 2005 to 31 December This ruling concerns the meaning of anything occurring on liquidation in paragraph (b) of the definition of liquidation in section OB 1 of the Income Tax Act 2004 where companies Page 2 of 5

3 apply for strike off under section 318(1)(d) of the Companies Act Directors: The definition of liquidation in section OB 1 of the Income Tax Act 2004 provides that anything occurring on liquidation means anything occurring during the period that starts with a step that is legally necessary to achieve liquidation, including the appointment of a liquidator or a request of the kind referred to in section 318(1)(d) of the Companies Act 1993, and for the purpose of enabling liquidation. Under section 318(1)(d) of the Companies Act 1993, shareholders can request by special resolution that the company be removed from the register on the grounds that: 1. The company has ceased to carry on business, has discharged in full its liabilities to all creditors and distributed its surplus assets; or 2. The company has no surplus assets after paying its debts in full or in part, and no creditor has applied under section 241 for an order putting the company into liquidation. There has traditionally been concern whether section 318(1)(d) can be used to enable companies to distribute capital gains tax free given that section 318(2) requires the company to have distributed its surplus assets prior to making a request for strike off. In BR Pub 05/14 the Commissioner confirms that the first step legally necessary to achieve liquidation under section 318(1)(d) must be an overt act on or following the decision to carry out the necessary actions to satisfy the grounds in section 318(2)(a) with the aim of achieving liquidation. It will usually be a resolution to cease business, pay all creditors, distribute surplus assets and to then request removal. The Commissioner is satisfied that a resolution in these terms is the first step that is legally necessary to achieve liquidation. Any distribution of capital gain amounts occurring after the passing of this resolution will be distributed in the course of liquidation and therefore tax free under section CD 18 of the Income Tax Act 2004 provided the distribution is expressed to be for the purpose of enabling liquidation. Taxpayers making distributions need to ensure they keep adequate records of relevant resolutions so that they can demonstrate that the resolution(s) predated the distribution of the company s assets and that the distributions were for the purpose of enabling liquidation. Page 3 of 5

4 The ruling also discusses the process of liquidation in which a liquidator is appointed and confirms that the appointment of a liquidator is not the first step legally necessary to achieve liquidation. A resolution by shareholders resolving to appoint a liquidator is a legally necessary step that precedes the appointment of a liquidator which is capable of triggering the liquidation period for tax purposes. Often shareholders take drawings leading to overdrawn loan accounts, typically after the company has sold its major asset. This will give rise to a need to charge interest to avoid a deemed dividend or FBT liability. Where the intention is to liquidate the company, advisers should make their clients aware that they should take those first steps to enable liquidation (i.e. by resolving to liquidate) before taking the money out so that non related party capital gains can be distributed tax free in the course of liquidation. 4. Amalgamations and Inter Company Loans Adverse accrual implications can arise where a borrowing company which is insolvent amalgamates with the lending company. Amalgamation is the mechanism whereby two companies effectively merge (amalgamate) into one company. The inter company loan is thereby extinguished, however the financial arrangement rules effectively treat the lender company as having forgiven the loan (as no consideration has passed), giving rise to accrual income to the amalgamated company to the extent of the forgiveness. Various alternatives to amalgamation that may alleviate the tax issue include capitalising the debt, repayment or liquidation (although refer our earlier note on the liquidation option). Advice should be sought on the availability of these options and the most appropriate mechanism. If the amalgamation has taken place, consideration could be given to taking the view the borrowing company is not insolvent for the purposes of the financial arrangement definition on the basis the company was likely to meet its obligations as the debt would not be demanded. To run this argument close consideration of the meaning of balance sheet solvency and trading while insolvent would be required. A further argument may be that any loan represented equity rather than debt. 5. Qualifying Companies When establishing a qualifying company ( QC ) the shareholders guarantee the company s tax. Therefore, if the QC goes into liquidation owing debts, and the liquidation Page 4 of 5

5 triggers a tax liability for the company, the shareholders become liable. There used to be a concern regarding companies with trade creditors which had previously had been deducted and which were unpaid on liquidation of the company. The tax liability used to arise in the income year the deduction was originally claimed, thereby giving rise to a liability for the directors / shareholders. However, in 2004 the rules changed so that the tax liability arises on liquidation. This does not help a shareholder of a QC, however it does enable the shareholder to consider existing the QC regime prior to liquidation commencing. Note that once a liquidator has been appointed it appears to be quite challenging for the liquidator to revoke QC elections. Page 5 of 5