Treatment of capital gains tax in bankruptcy

Inspector-General Practice Guideline 3 explains the treatment of capital gains tax in bankruptcy

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  1. Introduction

    1. In June 2021[1], the Australian Tax Office (ATO) published guidance for bankruptcy trustees (Trustees) reminding practitioners of the ATO’s position that capital gains tax (CGT) applies to assets sold in a bankrupt estate and is to be remitted to the ATO, a requirement which makes Trustees personally liable for payment.
    2. The purpose of this guideline is to outline the Inspector-General in Bankruptcy’s (Inspector-General) expectations about the treatment of CGT in the administration of a bankruptcy, in accordance with the ATO’s view of the tax law.
    3. This guideline is relevant for Trustees, controlling Trustees and Personal Insolvency Agreement Trustees (collectively for the purposes of this document referred to as ‘Trustees’) who realise an asset of the administration for which CGT applies.
  2. A change to past practices

    1. The Inspector-General acknowledges that the ATO’s June 2021 article drawing attention to its interpretation of section 254 of the Income Tax Assessment Act 1936 (ITAA36), as applying to Trustees, is a change from the way Trustees have administered bankrupt/Part X estates (collectively for the purposes of this document referred to as ‘estates’) in the past. 
    2. The Inspector-General also acknowledges that CGT considerations and implications relating to the administration of estates will increase the complexity of Trustees’ work, and potentially will increase the time spent in administering estates.
    3. It is important that Trustees understand their legal obligations under the ITAA36 and to the extent that income tax obligations apply in relation to the role of a Trustee. It is the Inspector-General’s expectation that Trustees will administer estates consistently with these obligations.
    4. In September 2022, the ATO updated its website content to provide further guidance for Trustees about their tax obligations.[2]Now that the Inspector-General has also issued guidance within this document, Trustees should be sufficiently aware of their obligations under the ITAA36 to enable them to make decisions on CGT implications when administering estates.
  3. Retention of funds to pay CGT

    1. The ATO guidance recognises, applying relevant High Court authority, that the obligation to retain funds under section 254(1)(d) of the ITAA36 to pay any CGT is not enlivened (does not arise) at the time the CGT event occurs, or when the Trustee receives any proceeds from the event. The obligation to retain funds, and the accompanying personal liability on the trustee, only occurs upon a relevant tax assessment being made.
    2. When realising an asset which is likely to give rise to a capital gain, the Trustee will be aware that tax may subsequently be assessed on that gain. The Trustee will also be aware that available money will later need to be applied in discharge of the tax. The Trustee is not required to calculate the potential tax payable. Until a relevant assessment has been made, there is no tax law requirement for the Trustee to withhold/quarantine any funds from the proceeds of the gain (or any other source), or delay making distributions or otherwise take action in relation to the administration of the estate in anticipation of a tax liability. However, it is the expectation of the Inspector-General that a Trustee, in practice, would reasonably take the prospect of the future expense into account in planning the appropriate administration of the estate.
    3. Once a relevant assessment has been made, the Trustee must retain, out of the funds available to them at that time, and any additional funds that come to them in their representative capacity, sufficient funds to pay the assessed tax. This money should be retained until such time as either the bankrupt pays the tax, or the Trustee pays the ATO a distribution in recognition of the tax, consistent with the applicable priority rules under the Act and reg 25 of the Regulations (see 5.1). A failure to retain sufficient funds will render the Trustee personally liable for the amount that should have been retained under section 254(1)(d). In accordance with paragraph 5 of this guidance, which sets out the priority of payment in relation to assessed tax, the monies used to pay the assessed tax would come from any funds which are held by the Trustee in the estate. There is no requirement to quarantine the specific proceeds from the sale of the asset that gave rise to the tax liability.
  4. Lodgement of tax returns

    1. A trustee’s obligation to lodge a tax return, be assessed and pay tax is triggered by the Trustee deriving income, profit or gains (IPG) of a capital nature in a representative capacity. These obligations are ancillary to the primary obligation, which rests on the bankrupt. Therefore, whether the Trustee is required to lodge will depend on the circumstances of the estate.
    2. Likewise, the amount of information and the cooperation of the bankrupt will vary from case to case. There may be circumstances in which a Trustee attempts to comply with this ancillary requirement but considers that they have inadequate information available. Importantly, a Trustee’s obligation to lodge a tax return only relates to the IPG derived by the Trustee. There should at least be some information available to enable lodgement (even if a Trustee is of the opinion that it is inadequate). It would be prudent for a Trustee to lodge a return based on what information can reasonably be obtained, given the potential personal liability attached to failure to comply with obligations under section 254 of the ITAA36.
    3. On request, the ATO can disclose information about the bankrupt to the Trustee to assist in gathering required information for lodgement.[3]
    4. In circumstances where a Trustee is satisfied that a gain which is generated by realising an asset is not going to become an assessed tax liability, and therefore is not an expense of the estate because an exemption applies to it (for example, it is covered by the main residence exemption), and there is no other income, profit or gain realised, the Trustee will not have to lodge a tax return.
    5. The Inspector-General would expect that a Trustee would take reasonable and cost-proportionate steps to obtain information to lodge a tax return and comply with their obligations under section 254 of the ITAA36.
    6. Subject to complying with statutory timeframes, and any call from the Commissioner of Taxation for a tax return, the timing of the lodgement of a tax return by the Trustee is a matter for their judgment, based on the circumstances of the case.
    7. As noted in 3.1, the obligation to retain amounts for tax and the personal liability on the trustee are enlivened only upon a relevant assessment. While there isn’t any obligation under the tax law to pay tax on a capital gain until an assessment is made, a Trustee must be conscious of the likely consequences of being in receipt of a capital gain. A Trustee should reasonably consider the likely tax liability, as an expenses of the estate, in planning their administration of the estate, including deciding whether to realise an asset which may incur a tax liability.
    8. It is the Inspector-General’s expectation that a Trustee, in exercising judgment and discretion regarding the application of CGT in the estate, will make and maintain thorough contemporaneous file notes of the decision-making process and relevant considerations, particularly if it is deemed uncommercial to realise an asset due to the CGT that may be payable.
  5. Priority afforded to CGT payments

    1. Where tax has been assessed on a capital gain derived by a Trustee in managing an estate, and the bankrupt has not or will not pay the tax, the Trustee should treat the post-appointment tax liability as an expense of the estate within the meaning of s 109(1)(a) of the Act and reg 25 of the Regulations. Depending on the nature of the event giving rise to the tax liability, it could potentially be covered by item 3 or item 5 of the table in reg 25(1) of the Regulations.
    2. To the extent that there are sufficient funds available, consistent with these priorities under the Act and Regulations, the Trustee can then pay the tax (or such portion of the tax as it is able to pay as a distribution to creditors in accordance with s 109).

[1] ATO and Tax Practitioners Board update appeared in AFSA’s June 2021 Personal Insolvency Regulator newsletter.

[2] ATO’s guidance on its website, ‘What bankruptcy trustees must do’, last modified on 30 September 2022: What bankruptcy trustees must do

[3] The ATO’s Law Administration Practice Statement PS LA 2011/16 notes that a bankruptcy trustee is a ‘covered entity’ within the tax law, which allows disclosure of some taxpayer information, see the following link: PS LA 2011/16.