As a general rule, a company provides its shareholders with ‘limited liability’. This means the extent of resources a shareholder risks when they invest in an enterprise is limited to the amount of capital they put into the company (or agree to put in). If the company runs out of resources, or gets hit with a nasty surprise, the capital may all be lost, but the shareholders are not obliged to put anything additional in. They have just ‘done their dough’.
The limitation of liability for shareholders has not really changed much over the centuries that limited liability companies have been around. What has changed, is the role and responsibility of directors.
The role and responsibility of directors
Directors are the professional management layer of a company. Shareholders place their capital in the company and then entrust it to the directors. The directors set the strategy and broad policy framework for the enterprise, and then recruit capital and human resource to execute on that strategy. Their job is to then keep a keen eye on things, to ensure that all goes according to plan. (In small, closely-held and family companies the shareholders and directors are often the same people. This can cause confusion when we talk about ‘personal liability for company debts’ because people do not focus on the role in which this liability arises – it is always the role of director.)
Our company law imposes a number of obligations on directors to make sure they take due care when putting the shareholder’s capital to work. If the directors do not fulfil these duties, then shareholders and/or the company can bring a claim against the director personally. These obligations are loosely referred to as ‘directors’ duties’.
Over time the circumstances in which a director can be held personally liable for things has massively expanded. Not only are directors now answerable to the company and its shareholders, they are also personally answerable to a number of other third-party ‘stakeholders’. For example, they can be liable to employees who are injured on the job, they can be responsible for the environmental damage caused by the company’s production or products, and they can be responsible for certain third-party liabilities and debts.
As to debts, a director is generally only liable for debts that are incurred by the company at a time it is ‘insolvent’, i.e. when the company did not have sufficient ready assets to meet all its current liabilities. This period is known as ‘insolvent trading’.
The policy behind this law is to incentivise directors to keep a watchful eye on the solvency of the company, and to stop it trading before it is no longer able to meets all its obligations as and when they fall due. The policy aim is to protect people from giving a company money and other resources at a time when it has already failed. Importantly, the policy is not to punish directors if the company becomes insolvent and has to stop trading. Insolvency itself (i.e. the company not being able to meet all of its obligations) is OK – and is a normal part of commercial life for everyone involved.
All good so far.
The difficulty with this policy is that it can be difficult to determine when a company has passed across the line of insolvency. Furthermore, it can be expensive to prove insolvency and then chase a director. That said, this does occur. ASIC reports that there were 8,425 administrators’ reports lodged between July 2016 and July 2017, of which 63% included evidence of alleged insolvent trading. While very few of these run to court, anecdotally, it is common for directors to cough-up cash to settle an insolvent trading claim.
Now you would think that the concept of insolvent trading would be enough to also enable authorities like the Tax Office to recover unpaid taxes. For example, they could identify when the company became insolvent, and then seek to make the directors personally liable for any taxes that were incurred after that date, i.e. during the insolvent trading period. We don’t really have any problem with this concept. It is fair and reasonable. It would also incentivise the ATO to employ some of its significant resources to help other creditors establish the time of insolvency. (We would also support any changes to the law necessary to deem a tax debt to have arisen in the period to which it relates.)
But this is where policy starts to significantly deviate from what we consider to be fair and reasonable.
Rather than being on an equal footing to all other creditors, the public servants at the ATO wanted a leg-up. They wanted an easier path to chasing directors – because the law set by our government for all the other creditors was too hard for the powerful ATO to use.
Enter, the ‘Director Penalty Notice’ regime
The beauty of this regime is that it is easy for bureaucrats to administer. In fact, they don’t really need to administer it at all. It takes care of itself. If a director fails to cause the company to assess certain taxation obligations, and it is later found that the company had the obligation and is not able to pay it, then the ATO can issue a Director Penalty Notice (DPN). The effect of this DPN is to make the director personally liable for certain of the company’s tax debts (at present, SGC and PAYGW).
Critically, there is no need for the ATO to establish that the company was insolvent during the time period over which the tax debt was accrued. It is enough that the tax debt was ultimately not paid. There is no need for the ATO to take any timely action, or concern itself with the issue of the timing of insolvency.
If we applied this same approach to debts generally, directors would become personally liable for any deficiency in a company’s assets after it has ceased to trade. The link between insolvency and personal liability would be broken. For a debtor who does not get paid by a failed company, this idea may seem like a good one. So why do we introduce the link between insolvency and personal responsibility? Because it is not always possible for a company to perfectly manage risk.
A company may incur a liability, and later become unable to meet it when it falls due because of some intervening event that causes the company to become insolvent. The policy of linking insolvency and personal responsibility is all about encouraging a healthy (but commercial) level of risk-taking by directors. Otherwise, they would never incur any liability unless they had 100% of the funds in the bank to cover it when it fell due (often years later).
For example, let’s say a company borrowed money to build some plant in 2010. At the time it drew-down the funds, the business was booming. But then in 2019 there is a downturn in the market, and the company goes broke, and the lender is out-of-pocket. Under current law (and absent any personal guarantees), the directors would not be liable for the deficiency, because the company was solvent when the debt was incurred. Absent this connection, what director would ever take on a liability that was not already fully provided for?
However, under the ATO’s DPN regime – issue a DPN notice – and presto, the director can be liable…
So what is the justification for removing this protection for directors in the context of taxation liabilities? Well, to be honest, it’s hard to come up with one… (Other than because the bureaucrats were sick of answering to Parliamentary inquiries as to why they were only finding out about massive unpaid tax obligations months and years after they arose and a company went belly up.) The official justification was that the regime protected ’employee entitlements’. But this is complete nonsense. From the Government’s point of view there is no difference between not receiving PAYGW, and not receiving company tax, or GST, etc. Why do we know this – because this is exactly what they are currently arguing to justify expanding the regime, but we’re getting ahead of ourselves…
Is there any real protection against personal liability under the DPN regime?
Like all good ideas, the DPN regime started with some appropriate protections – to keep the civil libertarians and thinking citizen happy enough to open the door on the idea. When they introduced the DPN regime there were some safeguards available to directors to fairly manage this potential personal liability.
To start with, provided the director caused the company to go into administration within a period of time after receiving the DPN (21 days), then personal liability was avoided. This encouraged directors to call ‘time out’ quickly after receiving a DPN, effectively recognising the fact that the company was probably insolvent.
This made life a little difficult for the ATO, because the policy of the DPN regime started to be effective. So they changed the rules.
Next, the ATO came up with ‘sudden death’ DPNs (or ‘lockdown’ DPNs). Basically, if the company has not lodged a return within 3 months of the return’s due date, then irrespective of when the company is put into administration, the director becomes personally liable on the serving of the DPN – there is no way out. The policy behind this change was to encourage timely reporting by the director, so the ATO is aware of escalating debt and can take appropriate action to issue a normal DPN and force the company into administration. This was all about encouraging timely reporting, and makes some sense.
But, you guessed it. This made life a little difficult for the ATO, because the policy of the DPN regime started to be effective again (i.e. timely lodging, even if the company couldn’t pay). The ATO ‘observed behaviour’ where directors were reporting tax liabilities within the 3 month period to avoid personal liability. What a surprise… exactly what the legislation was designed to encourage. And this made it difficult for the ATO to chase the directors personally.
So more changes are in the works
Starting with the Superannuation Guarantee Charge (SGC) liabilities, the sudden death is now completely sudden death, no matter what is reported. So, if the company does not pay its SGC then the directors can be made personally liable for it simply by the issuing of a DPN. No excuses, no reporting protection, no administration protection. Nothing. A complete wipe-away of all of the general principles justifying personal liability in the first place. (See Treasury Laws Amendment (2018 Measures No.4) Act 2019.)
As noted, the DPN regime was initially brought in under the guise of protecting ‘employee entitlements’, so it only applies to SGC and PAYGW. However, there is now moves afoot to extend this to GST, (the bill introducing these changes was before the House of Representatives before the election was called). As usual, the ATO has ‘identified behaviour’ that justifies this expansion, and there are probably instances of fraudsters claiming GST credits that they are not due. But that’s not how the new law reads, it’s not targeted at fraudsters, (who have bigger concerns that DPNs). It captures everyone (as it always does).
A director’s responsibility for preferences
So, you may be thinking that it would be a good idea for a director to ensure they lodge their PAYGW and SGC returns on time, and pay the freaking tax to avoid personal liability! This sounds like a fine idea. But there’s more…
In the period leading up to insolvency is it common for directors to pay certain liabilities in preference to others for strategic reasons – usually because some creditors are being more demanding and threatening than others. However, as you can now see, there is a very clear strategic reason for directors to pay the ATO its SGC and PAYGW to avoid personal liability.
After an administrator is appointed, one of their key powers is to look back over the company’s payments and identify any ‘preferential’ payments the company has made to one creditor, versus others. The review period is ordinarily 6 months. The policy here is to ensure that all creditors (including the ATO) are treated equally and fairly.
Given the ATO is one of the major instigators of insolvencies, and is also a common creditor across almost every insolvent company, payments of tax to the ATO are favourite pickings for liquidator preference claims. So even though the DPN has encouraged the directors to look after the ATO prior to insolvency, the ATO often finds itself disgorging this cash back to the liquidator.
Once again, the ATO wasn’t happy about this state of affairs. Even though every other creditor can suffer the same ignominy of having to pay an insolvent company back preferential payments, the ATO managed to get its own special treatment baked into the insolvency laws. You guessed it – an indemnity against the directors for the amount of the preference payment paid back to the liquidator – ‘personal liability’ for the director once again. (See section 588FGA of the Corporations Act 2001)
[Note this indemnity only operates if the Supreme Court or the Federal Court orders that a payment is an unfair preference. If the Commissioner settles an unfair preference claim with the liquidator without a court order being made, the Commissioner will not be entitled to the indemnity.]
A reflection on policy
There is no doubt that companies use the Australian taxpayer as a ‘last resort bank’ prior to throwing in the towel and calling in the insolvency administrator. It is also fair to say that companies on the verge of insolvency often drop the ball when it comes to lodging tax returns, paying super contributions and remitting PAYGW amounts. All honest and successful taxpayers share in this ‘cost’ (in the form of lost tax revenue and compensation for employee entitlements).
A regime that encourages timely reporting of tax debts (and other debts), and which encourages directors to throw in the towel in a timely manner when their company is obviously no longer solvent, are all good policy objectives.
But these policy objectives are common to all creditors, and not just the ATO.
Furthermore, recent changes have moved away from promoting these policy objectives (of timely reporting and timely insolvency), to simply making a director personally responsible for certain tax amounts, irrespective of their action or inaction. This is a serious concern from a policy perspective.
We do not have a problem per se with a strict insolvency regime. But we do have a problem with an unfair playing field between the ATO, company directors and ‘us other creditors’.
Furthermore, our law needs to reflect the practical realities of commerce – as it generally does, absent these recent ATO perks. If we want companies to take sensible commercial risks, then we need to accept that when companies fail, not only the shareholders, but certain creditors, will be impacted. People dealing with limited liability companies need to take some responsibility for gauging the solvency of their counterparts, and the ATO needs to take some responsibility for a timely administration of our tax laws.
Yes, there are fraudsters and rouges that game the system – and always will. But our laws are never really effective against these types in any event. The ATO (and public servants generally) use these fringe examples to justify serious departures from balanced policy that impact all of us.
We seem to be in a policy mindset at the moment where we continue to push the boundary in favour of bureaucratic monoliths like the ATO (ASIC, ACCC, BIG BANKS, etc), at the expense of business owners and other creditors. At some point, the punters are going to call ‘time out’ on risk-taking, and then let’s see how much tax revenue is left to pay for our intolerant public servants and mounting social security bills.