Q & A – INSOLVENCY, DIRECTORS DUTIES AND CONSEQUENCES OF INSOLVENT TRADING

What is Insolvency?

Insolvency is the point at which the organisation or individual can no longer meet its financial obligations with its lenders/creditors as their debts fall due. Common signs that your company/business may be in financial difficulty may include:

• Continued losses
• Poor cash flow
• Incomplete financial records or disorganised internal accounting procedures
• Increasing debt (liabilities becoming greater than assets)
• Creditors unpaid outside usual terms
• Overdraft limits reached or defaults on loans and interest payments
• Overdue tax and superannuation liabilities

What are my duties as a Director?

Generally, as a director your fiduciary duties are to your company’s shareholders and to ensure compliance within the laws of the company operations. However, if your company is insolvent, or there is a real risk of insolvency, your duties expand to include creditors (including employees with outstanding entitlements).

In addition it is the director’s duty not to be trading whilst being insolvent. This means that before you incur a new debt, you must consider whether you have reasonable grounds to suspect that the company is insolvent or will become insolvent as a result of incurring the debt.

An understanding of the financial position of your company only at the time you sign off on the yearly financial statements is insufficient. You need to be constantly aware of your company’s financial position.

Your company must keep adequate financial records to correctly record and explain transactions and the company’s financial position and performance. A failure of a director to take all reasonable steps to ensure a company fulfils this requirement breaches the Corporations Act.

For the purposes of an insolvent trading action against a director, a company will generally be presumed to have been insolvent from the point where it can be shown to have failed to keep adequate financial records. This highlights the importance of having accurate and timely financial records.

What are the Consequences of Insolvent Trading for Directors?

The Corporations Act does provide certain statutory defenses for directors. However, directors may find it difficult to rely upon these if they have not taken appropriate steps (as mentioned above) in order to keep themselves adequately informed about the company’s financial position.

Civil penalties

Breaching the insolvent trading provisions of the Corporations Act can result in civil penalties against directors with penalties of up to $200,000.

Compensation proceedings

Compensation proceedings for amounts lost by creditors can be initiated by ASIC, a liquidator or a creditor against a director personally. A compensation order can be made in addition to civil penalties.

Compensation payments are potentially unlimited and could potentially lead to the personal bankruptcy of directors. The personal bankruptcy of a director disqualifies that director from continuing as a director or managing a company.

Criminal charges

If dishonesty is found to be a factor in insolvent trading, a director may also be subject to criminal charges which can lead to a fine of up to $220,000 or imprisonment for up to 5 years, or both. Being found guilty of the criminal offence of insolvent trading will also lead to a director’s disqualification.

The good news is that taking steps to ensure your company remains financially sound will minimize the risk of an insolvent trading action. It may also improve your company’s performance.

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GST ADJUSTMENT FOR CHANGING INTENT – PROPERTY DEVELOPMENT

For our clients in the building and construction industry times are tough; the State Government is forecasting a 26% decline in project commencements compared to last year and prices in some suburbs have decreased sharply. For many this means projects can’t be sold for the price they need to make a profit or break even on their project and as a result many are looking to rent out houses over the short to medium term.

However, it is important to factor in the GST consequences before doing so. The legislation covering GST and property developments is complex but broadly speaking a change of intent from ‘build and sell’ to ‘build and rent’ means the developer is no longer entitled to claim back all of the GST on the costs. The entitlement to GST credits reduces each year for five years or until the property is sold, whichever is shorter, and each year the developer must remit the difference to the ATO. The majority of the GST remitted is paid back in the first year meaning short term rentals also incur a significant adjustment.

On a large scale development this can involve paying tens of thousands of dollars to the ATO each year, sometimes leaving clients worse off than if they had sold the property at a discounted price.

Let us consider the following example:

• Tim and Monica have just finished a three-unit development in their trust, TM Property Trust. The trust is registered for GST
• The land cost them $450,000 including duties and legal fees and they have elected to apply the margin scheme
• The build cost was $550,000 and they claimed $50,000 in GST credits over the 12 months it took to finish construction, bringing their total outlay to $950,000
• A recent valuation by an agent suggested an average sale price of $330,000 per unit
• After paying GST of $16,364 on each unit and agent selling costs, Tim and Monica would receive approximately $305,000 per unit and make a loss of $35,000
• Instead they choose to rent the properties and receive $360 per week for each unit as this will cover their loan repayments.

Over the years the ATO have released a substantial number of rulings on how to reasonably calculate your adjusted GST entitlement, with different methods applicable to different circumstances. In Tim & Monica’s case the most appropriate method is based on how long the intention was to ‘build and sell’ vs how long the intention is to “build and rent”, resulting in over $32,744 being remitted to the ATO after the first year and $44,583 being remitted over the full five years. After 1 year of renting Tim & Monica would need to achieve a sale price of $341,000 per unit to be better off than they would have been selling immediately and $352,581 to break even on the development.

Once a property has been leased it is too late to avoid making an adjustment to GST, even where it is only rented for a short time, and as you can see from the above example the consequences of doing so are complex and costly. We therefore strongly encourage any of our clients who are considering a decision like the above to contact us beforehand to discuss your situation.

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