This article was updated on Tuesday 1 October, 2024.

In a decision handed down by Downes J on 4 July 2024, the Federal Court of Australia provided guidance on the treatment of capital gains in bankruptcy, and endorsed the approach that has been taken by the ATO: Robson as trustee for the bankrupt estate of Lanning v Commissioner of Taxation [2024] FCA 720 (Decision).

Key takeaways

• Prior to June 2021, when a bankruptcy trustee disposed of a capital gains tax asset in administering a bankrupt estate, the view was that the bankruptcy trustee was not responsible or liable for any capital gains tax arising on the disposal. Section 106-30 of the Income Tax Assessment Act 1997 (Cth) (1997 Act) operates to deem all assets of a bankrupt estate as being owned by the bankrupt individual, notwithstanding that the assets vest in the bankruptcy trustee on their appointment. As a result it was understood that any capital gain or loss made on the disposal of a capital gains tax asset by a bankruptcy trustee would be attributed to the bankrupt and not the bankruptcy trustee.
  
• However, the ATO’s position on trustee liability for capital gains tax on the sale of assets in bankrupt estates, as notified to practitioners by AFSA, subsequently changed due to its revised interpretation of s 254 of the Income Tax Assessment Act 1936 (Cth) (Act) to also apply to bankruptcy trustees, such that:
  • bankruptcy trustees are required to meet the tax obligations arising from capital gains that they have derived in their ‘representative capacity’ as bankruptcy trustee in administering bankrupt estates;
  • if bankruptcy trustees derive a capital gain during the course of their appointment they are required to apply for a tax file number and lodge a tax return for the bankrupt estate; and
  • bankruptcy trustees are required to retain money to pay any resulting taxation liability following receipt of a Notice of Assessment from the ATO.

• In the Decision, the Federal Court confirmed that bankruptcy trustees are bound to comply with the requirements of section 254 of the Act.

Background

Prior to becoming bankrupt, Mr Lanning (Bankrupt) owned two properties within the Noosa local government area (Properties). On 12 December 2019, Mr Robson (Trustee) was appointed by court order as the Bankrupt’s bankruptcy trustee. In the course of his appointment, the Trustee entered into contracts of sale to sell the Properties for amounts totalling $388,000.

The Trustee subsequently sought a private ruling in respect to the application of s 254(1) of the Act in relation to the capital gains made on the sales. In response, the ATO advised that the Trustee would be personally liable for the payment of any resulting capital gains tax liability.

On 24 April 2023, the ATO disallowed an objection by the Trustee (Objection Decision) for the following reasons:

• The Trustee was a ‘trustee’ within the definition in s 6(1) of the Act.
• Under s 254 of the Act, the Trustee was answerable as taxpayer in respect of any profits or gains of a capital nature made from the sale of the Properties.
• Once an assessment has been made, the Trustee would be subject to the retention obligation in s 254 of the Act.
• The Trustee is not personally liable under s 254 of the Act in respect of any tax payable on the gains made from the sale of the Properties prior to receiving an assessment on the tax liability of those gains.
• The Trustee will be personally liable under s 254(1)(e) of the Act in respect of any tax payable on the gains made from the sale of the Properties after receiving an assessment of the tax liability on those gains, to the extent of their retention obligation.

The Trustee sought to have the Objection Decision reversed by the Federal Court. The case was funded by the Commonwealth pursuant to section 305 of the Bankruptcy Act 1966 (Cth) (Bankruptcy Act).

The Trustee’s arguments

Whether the Objection Decision would be upheld by the Court depended on whether the Trustee was found to be subject to s 254 of the Act, such that they would be liable for the tax payable on the capital gains from the sale of the Properties that vested in him by operation of s 58 of the Bankruptcy Act.

The Trustee argued, amongst other things and based on the historical position of bankruptcy trustees, that:

• he did not derive any profits or gains in his “representative capacity”. Rather, he merely received the proceeds of the sale of assets which had vested in him pursuant to the terms of the Bankruptcy Act. The Trustee’s position was that he received the proceeds of the sales of the Properties in his capacity as trustee of a statutory trust, for statutory purposes, to be administered in accordance with the Bankruptcy Act to mean s 254 of the Act did not apply;
• a bankruptcy trustee is not a trustee “in the ordinary sense of the word”;
• pursuant to s 106-30 of the 1996 Act, the sale of the Properties would be deemed to have been undertaken by the Bankrupt, meaning that any capital gain or loss would be made by the Bankrupt and not the Trustee; and
• the consequence of construing s 254 of the Act as applying to capital gains derived by a bankruptcy trustee would be to cause a substantial alteration to the order of priorities by which debts are payable under the Bankruptcy Act by giving preferential treatment to tax debts.

The decision

In upholding the Objection Decision, the Court relevantly found that:

• section 254 of the Act expressly states that it applies to “every trustee”, which would include a bankruptcy trustee;
• the concept of “representative capacity” is broad enough to encompasses when a bankruptcy trustee derives a capital gain in that capacity and not in their personal capacity;
• the primary tax liability for any capital gains derived by a bankrupt estate is on the bankrupt rather than the bankruptcy trustee. However, this does not prevent the obligations under s 254 of the Act, which is a “liability imposing and collecting provision”, from applying to bankruptcy trustees; and
• the liability of a trustee to pay tax under s 254 of the Act is a personal liability that arises in the course of disposing of an asset, and is part of the cost of selling that asset. Section 109 of the Bankruptcy Act provides priority status to expenses, such as tax liabilities, incurred by a bankruptcy trustee in administering a bankrupt estate. Any post-appointment tax liability is not provable in the bankruptcy, and is a cost involved in realising a bankrupt estate’s assets.

Conclusion

ARITA is raising the Decision and its implications with the ATO, Attorney-General and the Treasurer, as it has been doing since at least October 2021 after the ATO’s updated position on s 254 of the Act was communicated to practitioners.

The ATO’s interpretation of s 254 of the Act, as now endorsed by the Decision, is a departure from the position as previously understood by bankruptcy trustees. It also creates a number of anomalies, including that:

1. The ATO will receive preferential treatment in respect of any post-appoint CGT Liability at the expense of other priority creditors such as employees.

2. A bankrupt and bankrupt trustee will be required to lodge tax returns in respect of the same income. In such circumstances, the ATO has said it will assess both claims, but only collect the assessed amount once.

3. Bankruptcy trustees now need to ensure that they make adequate provision for any tax liability arising during their appointment before making any distributions to creditors.

4. A trustee’s liability to pay capital gains tax arises at the time an assessment is made. Theoretically, funds could be dispersed before an assessment is made without leaving the trustee with personal liability. However, this is obviously a risky approach and may expose a trustee to claims of breach of duty.

5. It might not be commercial for bankruptcy trustees to sell assets where a post-appointment CGT liability arises, particularly if the costs of selling the asset will be high or there is a secured creditor with an interest in the asset.