Full Federal Court pronounces on third party preferences and the ATO’s practice of reallocation of payments

Last Friday the Full Federal Court handed down its much anticipated decision in Commissioner of Taxation v Kassem and Secatore [2012] FCAFC 124.  The judgment addresses the interesting and commercially significant issue of third party preferences. It also addresses the even more interesting issue of the ATO’s practice of unilaterally reallocating payments made by taxpayers of tax liabilities from one account (such as the integrated client account) to another (such as the superannuation guarantee or “SGER” account), and whether that enables the Commissioner thereby to avoid the reach of the unfair preference provisions.

In short, like the judgment at first instance, the result again was a comprehensive loss for the Commissioner. The appeal was dismissed with costs. The joint judgment of Jacobson, Siopis and Murphy JJ may be read in full here. My analysis of Nicholas J’s judgment at first instance in March, with more details of the facts of the case, may be read here.

Background

Briefly, third party preferences are where an insolvent company’s debt is paid by a third party (often a related entity), and the recipient creditor – here, the ATO – defends an unfair preference claim by the liquidator by pointing to the fact that the payment was made not by the company but by a third party, and arguing that the payment is not voidable as an unfair preference as it falls outside the reach of s 588FA (and s 588FC) of the Corporations Act 2001 (Cth) (“the Act”).

In this case, the tax debts of the insolvent company Mortlake Hire Pty Ltd were paid to the Tax Office by a related company Antqip Pty Ltd. This gave rise to the first substantial argument run on appeal. The Commissioner contended that what took place by Antqip paying Mortlake’s tax debts for it, was a substitution of a new creditor of Mortlake’s (Antqip), for the existing creditor (the Commissioner). On this basis, so the Commissioner argued, there was no unfairness, thus there was no “unfair preference” and therefore the payments were not caught by the provisions.

The second substantial issue concerned the purported exercise of power by the Commissioner to allocate payments received from, or on behalf of, Mortlake to an account other than that to which the funds were initially credited. The payments totalling $70,000 had been made by EFT into an ATO account, the integrated client account, for Mortlake’s indebtedness for its primary tax debts which were said to consist of income tax, GST and other related liabilities and exceeded $600,000. Four months later, the ATO had unilaterally reversed the payments made into that account and reallocated the payments to the superannuation guarantee or SGER account. Their Honours described this as a purported exercise by the Commissioner of his power under s 8AAZD of the Taxation Administration Act 1953 (Cth) (“the Administration Act”).

Tellingly, their Honours noted that this reallocation was made shortly before the commencement of the winding up of Mortlake [at 7]. What lead to this action was revealed by a file note dated 31 July 2007 made by an ATO employee. The employee had telephoned the New South Wales Supreme Court to ascertain the hearing date for a winding up application that had been filed against Mortlake. The employee was told the hearing date was set for 23 August 2007 [see 23].

At first instance, his Honour made what the Full Court described as several critical factual findings  [see 25-37] –

1. That although the funds were physically transferred to the integrated client account by Antqip, they were funds lent by Antqip to Mortlake and paid to the ATO at Mortlake’s direction;

2. That the moneys borrowed by Mortlake were applied by it in payment of a pre-existing debt;

3. That the relevant “transaction” for the purposes of s 588FA of the Act was a bipartite transaction between Mortlake and the Commissioner, not a tripartite transaction which included Antqip;*

4. That the “reallocation” by the Commissioner had the effect of increasing the balance recorded in the integrated client account and reducing the indebtedness recorded in the SGER account. The Full Court observed that Nicholas J’s use of the word “reallocate” suggested he was of the view that the funds had been initially allocated to the integrated client account;

5. That the evidence established there was little prospect of the Commissioner receiving any dividend out of the winding up.

* Respectfully, I suggest that the Full Court were wrong in this. They say that this conclusion is “clear from what his Honour said at [36]”. Respectfully, in my view, it is not. His Honour had at [36] expressed that he was “satisfied that Mortlake and the Commissioner were parties to transactions whereby the Commissioner received $70,000 from Mortlake”. Those are conditions which must be met before the preference provisions can apply – see ss 9 and 588FA(1)(a) and (b) , and see the discussion below. What Nicholas J said does not, in my view, suggest there were no other parties to the transactions, which of course Antqip was as the third party which actually made the payments, from its own funds, on Mortlake’s behalf.

First issue – “Substitution”, “transaction” and “unfairness”

“Substitution” and “Transaction”

On appeal, the Commissioner argued that Antqip was substituted as creditor for the Commissioner, as it stepped into the Commissioner’s shoes by paying Mortlake’s debt. Counsel cited no authority for this argument, and it was rejected by the Full Court as contrary to the proper characterisation of the transaction in question (see [38-39]).

The source of the payments was the bank account of Antqip, and this was said to be a clear example of a lender paying moneys advanced to a borrower’s creditor in accordance with the borrower’s directions. The Full Court observed that the position was no different than if Mortlake had borrowed the funds on overdraft from its bank and paid the creditor with those funds (see [63]).

Even if the payments were not properly characterised as a loan from Antqip to Mortlake, the Full Court noted that the payments by Antqip to the ATO were made by or on behalf of Mortlake [42] . Their Honours said that: “the transaction which s 588FA then looks at is the transaction between Mortlake and the Commissioner. That was the approach taken by Gordon J in Burness v Supaproducts Pty Ltd [2009] FCA 893; (2009) 259 ALR 339 [link] where payments were made to a creditor by a related company of the insolvent debtor.”

I pause here to suggest, respectfully, that the brevity with which the Full Court summarised Gordon J’s approach in Burness to what is a “transaction” in this context, coupled with the other matter referred to above, could create problems for Courts – and indeed companies engaging in commercial activity – seeking to apply this judgment. In my view, respectfully, it over-simplifies the analysis that her Honour undertook in Burness and often falls to be undertaken by the Courts in evaluating whether a third party payment of a company’s debt to a creditor can be treated as part of one multi-step dealing that is caught by the definition of a “transaction” in s 9 and 588FA of the Act. And it glosses over the analysis as to whether that transaction can be treated as one by the company, in the sense that (1) the company must be a party to the transaction (ss 9 and 588FA(1)(a); (2) the unfair preference must be “given by the company” under s 588FC; and (3) the creditor must have received more “from the company” than it would if it had to prove for its debt in the winding up (s 588FA(1)(b)) . (There are many cases, but the principal authority is Re Emanuel (No 14) Pty Ltd (in liq); Macks v Blacklaw & Shadforth Pty Ltd (1997) 147 ALR 281; see also Capital Finance Australia Ltd v Tolcher [2007] FCAFC 185; (2007) 245 ALR 528 (link))

In Burness, Gordon J’s analysis on this focussed primarily on the question of whether before a payment made by a third party of a failing company’s debt can be taken to be a payment “accepted” or “made” by the debtor company, there must be evidence of an arrangement between the debtor and third party whereby  the debtor directed or authorised the third party to make the payment, or the third party was under an obligation to the debtor to do so. Her Honour’s view was that the evidence did not need to go so high; “where the third party payment is authorised by the debtor, nothing more is required. The debt is discharged by the third party at the request of or with the acceptance of the debtor” (see [45-46] and indeed [34-47] of Burness). The reason the problem arises is that if the third party payment is unauthorised by the debtor, in law the debt is not necessarily discharged (although it may be subsequently ratified or accepted by the debtor). Without the debtor’s act making the third party’s payment effective to discharge the debtor’s debt owed to the creditor, it is more difficult for a Court to find that the debtor was a party to the transaction (as required by s 588FA) and in effect made the payment to its creditor, using the third party as its instrument.

To return to the present judgment – The Full Court noted that the conditions required for the transaction to fall within s 588FA(1) were satisfied – the company Mortlake and the creditor the Commissioner were parties to the transaction, the transaction resulted in the Commissioner receiving from Mortlake more than he would receive if the transaction were set aside and he were to prove in the winding up [at 44-46].

“Unfairness”

The Commissioner then submitted that the payments could not fall within the definition of an unfair preference in s 588FA(1), because “unfairness” is a necessary element of the definition and, in his submission, there was nothing in the payments that satisfied this requirement. Their Honours reviewed the authorities and at [54-55] said this –

“[T]he observations of the plurality in Airservices and the doctrine of ultimate effect, as applied by Ormiston JA [in Dye] to the present statutory regime, provide a short answer to [the Commissioner’s] submissions. This is because in the present case there are only two transactions between the debtor and the creditor, each of which consisted of a payment which had the ultimate effect of extinguishing the indebtedness of Mortlake to its creditor. That is to say, each transaction had the effect of paying the Commissioner 100c in the dollar in respect of Mortlake’s indebtedness of $70,000…[T]he payments constituted an unfair preference because the Commissioner received full payment of the debt whereas other creditors would receive nothing in the winding up. As Ormiston JA explained in Dye at [39], s 588FA was intended to strike down transactions that would dislocate the statutory order of priories among creditors…That is what happened in the present case.”

The Commissioner ran the submission there was no unfairness because the payments did not result in a decrease in the net value of assets available to meet the demands of other creditors. The Full Court held there was such a decrease and stated that they did not then need to determine whether there must be a diminution in the value of the debtor’s assets for a payment to be caught by the provision (see [58-61]). (See the similar argument run by the defendant in Burness at [49], although advanced in a different way.)

Second issue – Allocation of payments by the Commissioner 

The Commissioner pointed to his power to allocate payments to the SGER account by virtue of the provisions of Div 2 of Part IIB of the Administration Act. Section 8AAZD confers power on the Commissioner to allocate a primary tax debt to an RBA, such as the SGER account, which had been established for that type of tax debt. In exercising the power of allocation, the Commissioner is not required to take account of any instructions from a tax payer: see s 8AAZLE (at [68]).

The Liquidator submitted that the two payments in question were allocated to the integrated client account. He pointed to the crediting of the two payments to the integrated client account, and relied on the fact that interest charged by the ATO on the balance of that account had been calculated taking account of the reduction of the balance by virtue of the two payments.

Once so allocated, he submitted, they constituted the relevant transaction for the purposes of s 588FA(1) (see [69]). The Full Court agreed [79], holding that the transactions that fell to be considered under s 588FA(1) were the two payments made in March and April 2007. On this approach, the Commissioner’s reallocation was irrelevant to the question of whether the transactions fell within s 588FA(1).

On the evidence, their Honours could not determine whether there was an actual agreement between Mortlake and the ATO to appropriate the $70,000 to the integrated client account [77]. Therefore, their Honours said, the rule in Clayton’s Case would apply and the payments are presumed to be appropriated to the debts in the order in which the debts were incurred. However there was no evidence to establish that sequence.

Nevertheless, the Full Court saw considerable force in the Liquidator’s submission that the ATO Tax Agent Portal, recording the payments and the interest charge referred to, gives rise to a strong inference that the payments were allocated to the integrated client account. This was reinforced by the fact that the payments remained credited to that account, in full satisfaction of the pre-existing debt of $70,000, until the reversal on 1 August 2007 [78]. As noted above, their Honours concluded that the two payments were the relevant “transaction” and thus the ATO’s later reallocation and the argument they sought to mount as to the priority accorded the Commissioner for payments of superannuation guarantee charge liabilities was irrelevant.

Their Honours noted at [80 onwards] that even if they were wrong on that, the allocation or reallocation on 1 August 2007 did not change the result, in that the Commissioner still received more than he would were he to prove for the debt in the winding up, and thus received an unfair preference.

The Full Court observed that it was also implicit in the Liquidator’s submissions that on the proper construction of s 8AAZD of the Administration Act, the power of allocation does not extend to a power of reallocation to another ATO account. Thus the Commissioner had no power to so reallocate [70]). The Full Court took the view that it did not need to determine this question [88].

However in the final two paragraphs of their judgment, the plurality went on to observe that there was a further answer to the Commissioner’s claim to be able to rely upon the purposed (re)allocation which took place on 1 August 2007. The Full Court went further than the judge at first instance had done, and made a specific finding that it was plain the Commissioner took the step of reversing and (re)allocating the payments to the SGER account “with a view to obtaining a priority over other unsecured creditors in the event that [the petitioning creditor] obtained a winding up order when the matter was due to come before the Supreme Court on 23 August 2007” [90]. Their Honours observed at [91] that –

“It is a fundamental principle of the law of unfair preferences that the present statutory regime, and its predecessors are…intended to render void any transaction which, if allowed to stand, would dislocate the statutory order of priorities amongst creditors.”

Yet, so their Honours specifically held, “that is precisely what the Commissioner intended to achieve”.

An extraordinary case. The Commissioner’s appeal was dismissed. The fact that costs were awarded against the Commissioner, suggests that despite the fact that only $70,000 was at stake and that the principles are clearly of some importance, the Commissioner has not been funding the Liquidator’s costs as is sometimes done in “test cases”. One cannot help but wonder how the Commissioner will respond to this loss at Full Federal Court level – whether he will bat on and seek special leave to appeal, or call it a day. We await any further developments with interest.

Postscript:  A final word on unilateral reallocation of payments between accounts by the ATO

The argument that the Commissioner sought to mount, relying upon his office’s unilateral reallocation, warrants a moment of slower scrutiny:  that the effect of the reallocation was to elevate the priority of the debt in the winding up of Mortlake in accordance with the provisions of s 556 of the Act, so as to give it priority over other unsecured debts. The Commissioner contended that this had the consequence that the payments could not constitute unfair preferences because, at the time of the allocation to the SGER account, there were no other outstanding debts with priority equal to or higher than that which applies to the superannuation guarantee charge under s 556(1)(e) of the Act.

If this argument had succeeded, it would mean that for each corporate taxpayer sinking towards liquidation, the Commissioner could take steps to artificially circumvent the operation of the preference provisions and stride ahead of other unsecured creditors. All the ATO need do is reverse the allocation of payments made into the taxpayer’s integrated client account, reallocate them to the SGER account, and then claim the payments were thereby out of the liquidator’s reach.

If the Commissioner is unconstrained in purporting to exercise his allocation power under s 8AAZD of the Administration Act in this way, and rely upon it to seek such an advantage, one wonders what the answer might be to this rhetorical question:

Now that directors can be made personally liable for the unpaid and unreported superannuation guarantee charge liabilities of their companies (since 30 June 2012), what is to stop the Commissioner from purporting to exercise  his allocation power to reallocate in the other direction? That is, what is to stop the ATO from enlarging the company’s SGC liability balance by reversing payments already made against it and reallocating them instead against GST liability recorded in the integrated client account, thereby artificially enlarging the debt that can be claimed personally against the directors? I note that the ATO has previously sought to have the DPN regime extended by the legislature to other tax liabilities including GST liabilities, however Parliament (or rather, the Parliamentary committee) has declined, and limited the extension of the DPN regime beyond a company’s PAYG to now also its super guarantee charge liability. Conceivably, the ATO could skirt around that legislative constriction too, to enlarge the size of the personal liability it can sheet home to directors. Troubling.