Commissioner of Taxation v Lane [2020] FCAFC 184 – Application of priority regime (ss108 and 109 Bankruptcy Act) to distribution of sale of assets of trust – payments to trust creditors – preference recovery proceeds non-trust assets?

By Alicia Hill, Principal, MST Lawyers

The recent full Federal Court decision of Commissioner of Taxation v Lane [2020] FCAFC 184 revisits the issue of the right of exoneration of a trustee from trust assets for liabilities incurred for the trust and the distribution of any amounts recovered. This case dealt with a trustee which carried on a business through a trust structure and non-trust related activities.

The Full Court of the Federal Court of Australia utilised this case to emphasise that the questions both in the liquidation and bankruptcy spheres about the application of the statutory priority regimes to realised asset pools are now determined, treated in the same manner in both jurisdictions and need not be brought back to the Court to trouble the courts going forward, with a limited exception for which guidance is provided.

The facts

On 11 March 1998 the Warwick Lee Family Trust (Trust) was established by deed.

By December 2012 the sole trustee of the Trust was Mr Lee. Mr Lee operated a subway franchise business in Queensland until he sold the business in December 2012, with settlement occurring in February 2013. In his capacity as trustee Mr Lee employed a number of staff at the Subway franchise business.

On 22 February 2013 Mr Lee presented his own debtors petition and Morgan Lane and Raj Khatri (Bankruptcy Trustees) were appointed as trustees in bankruptcy of his estate.

The Bankruptcy Trustees kept and maintained two separate accounts when administering the bankrupt estate of Mr Lee:

• the first, on account of assets on Mr Lee held by him in his capacity as trustee and the liabilities incurred by Mr Lee as trustee of the Trust.
• the second, on account of the personal assets and liabilities of Mr Lee in his own individual capacity.

The Bankruptcy Trustees requested pursuant to Mr Lee’s right of indemnity as trustee (being the right of exoneration) proceeds from the sale of the Subway business to the account dealing with the Trust. This being $4,48,659.49.

Pursuant to section 122 the Bankruptcy Trustees recovered preference payments from the ATO of $322,447.58. The preference payments had been paid to the ATO to discharge debts incurred by Mr Lee as trustee of the Trust.

Of this recovered sum:

• $171,659 was allocated to the account maintained for amounts relating to Mr Lee in his personal capacity as this amount had previously been paid to the ATO by Mr Lee from personal funds;
• $150,788.58 was allocated to the account maintained for the Trust as the amount originally paid to the ATO had been paid from trust funds.

As at 31 March 2017, the asset position of the respective accounts was:

• $599,782.02 (relating to the trust); and
• 183,750.22 (relating to Mr Lee in his individual capacity).

The amounts owed to the three creditors of the Trust totalled $1,317,165.35, Included in this amount was a claim by the ATO for $128,886.09 in respect of superannuation guarantee charge which had arisen in relation to Subway employees employed by Mr Lee as trustee of the Trust.

In May 2017, having finalised all recovery actions and ascertained all known creditors the Bankruptcy Trustees applied to the Court seeking directions pursuant to subsections 90-15 and 90-20(1)(a) of Schedule 2 of the Act, which affords the Court the power to make any order it thinks fit in relation to the administration of the bankrupt’s estate.

Two initial cases were heard and determined and then an appeal was lodged but delayed pending the handing down of the Court’s decision of Carter Holt Harvey Woodproducts Australia Pty Ltd v Cth[1].

Issues

The main issues in dispute were:

• whether the priority regime in sections 108 and 109 of the Bankruptcy Act 1966 (Cth) (Act) applies to the distribution of the proceeds of the sale of asses of the Warwick Lee Family Trust?
• whether in the distribution of the personal estate of the bankrupt amongst all creditors, the trust creditors must bring into hotchpotch the amount which they have received from the proceeds of the sale of the assets of the Warwick Lee Family Trust? and
• in dealing with the proceeds of recovery in a preference action referrable to a preferred payment by the debtor trustee (now bankrupt) to a trust creditor (the ATO) out of the proceeds of the exercise of a right of exoneration against trust assets, whether the trustees in bankruptcy were required to use that recovered money only for the purpose of discharging trust debts or whether the proceeds of recovery were general non-trust assets of the bankrupt estate?

This case note will provide a summary of the Court’s findings with respect to the issues in dispute.

Decision

Allsopp CJ, Perram and Farrell JJ found:

• in respect of the first issue that:
  • the principles of equity and trusts governing a trustee’s right of indemnity apply equally to both personal and corporate trustees. Citing Gordon J in Carter Holt as to there being no logical or countervailing reason why the principle would be any different under bankruptcy regime
  • when the assets and such beneficial interest are sold they are transformed into funds of the bankrupt; as proceeds of the property of the bankrupt. The proceeds of the exercise of the right, by the sale of the property with the beneficial interest, have a limitation on their use; only for payment of trust creditors. The proceeds are nevertheless property of the bankrupt in the hands of the trustees in bankruptcy and are subject thus to the priority provisions of the statute[2].
  • By virtue of the right of exoneration conferring a beneficial interest in the trust assets, the Bankruptcy Trustees were and are entitled to realise and distribute trust assets and their proceeds to trust creditors in accordance with the statutory priority regime. ..The proceeds realised from the trust assets (being the profits from the sale of the Subway franchise) should be distributed in accordance with the priority regime provided for in section 108 and 109 of the Act.
• in respect of the second issue that:
  • there is a requirement for trust creditors to bring into hotchpot their dividends from the exercise of the right of exoneration against the property of the trust as this comprises part of the one fund of the bankrupt estate;
  • all creditors, trust and non-trust, are unsecured, equally ranking creditors of the one person: the bankrupt (now trustee)….there arises a feature or incident of some property of the bankrupt and the personal obligation of the trustee which makes the proceeds payable to only some creditors. Otherwise the creditors will be equally ranking creditors of the one debtor, even if, for the working out of entitlement, there can be seen, in the one insolvency, to be separate funds;

The proper approach would be:

• first, the priority trustee creditors will receive a distribution from the account with the Trust proceeds (this includes the ATO’s SGC claim, limited by the statutory cap);
• second, all trust creditors will receive a distribution from the account with the Trust proceeds (funds permitting);
• third, all priority creditors, will receive a distribution from the account of proceeds of Mr Lee’s individual capacity and those creditors from the first step who had not had their debts fully discharged would be required to bring into hotchpot should there be any other creditors of equal priority to them (here the ATO had no other creditor of equal priority); and
• fourth, all creditors will receive a distribution from the account of proceeds of Mr Lee’s individual capacity (funds permitting) with those creditors in step two being required to bring into hotchpot the distribution received from the trust estate.

in respect of the third issue that:

• the Bankruptcy Trustees were required to use the recovered funds only for the purposes of discharging trust debts and these funds were not general non-trust assets of the bankrupt estate;
• this occurs in light of the following circumstances:
  • the monies belonging to the bankrupt estate that the creditor is taken to have received were the proceeds of the exercise of the right of exoneration and thus property of the property of the bankrupt estate representing the bankrupt’s proprietary interest in the trust property;
  • the creditor is remitted or restored to its position as a trust creditor in the trust property enjoying its right of subrogation to the bankruptcy trustee’s beneficial interest in the trust funds;
  • the preference that is the subject of the operation of s122, by treating the payment as void against the trustee, is one concerned with, and only with, the relative mutual standing or positions among trust creditors. …the general creditors are not disadvantages as they were never entitled to participate in the trust proceeds fund.

Conclusion

The Court delivered this judgement on the basis that whilst the parties had waited for the decision in Carter Holt and then submitted appeals, part of which was by consent in light of the High Court’s decision in Carter Holt, the Court said:

“it is appropriate to fully explain why that agreement was soundly based, not only because the Court does not allow appeals simply on the agreement of the parties… but also because the point is an important one affecting the practice of jurisdiction in bankruptcy, and it will arise again. Its future resolution should not be left for further agitation if this matter is seen to be resolved only by agreement of the parties”.[3]

Having now addressed the situation and given detailed guidance on situations where trustees have situations where trust and non-trust funds comprise part of the estate the Court is encouraging the end of further litigation of these types of scenarios.

However the door has been left ajar somewhat with the Full Court citing Justice Gordon’s comments in Carter Holt that where practical difficulties and expense arise an available mechanism for receivers and liquidators [and although not referenced trustees] remains s 434 of the Corporations Act, s 90-15 of Schedule 2 of the Corporations Act or s 90-15(1) and 90-20(1)(a) of Schedule 2 of the Act.

If you have any queries, please contact Alicia Hill on (03) 8540 0292 or alicia.hill@mst.com.au

 

[1] [2019] HCA 32

[2] At [63]

[3] At [4].