ARTICLE
5 November 2024

Understanding director loans in liquidation: A guide for stakeholders

CP
Cathro & Partners

Contributor

Cathro & Partners are experts in providing insolvency and restructuring services that help to create and preserve business value. With a reputation for delivering high quality results, we can assist your business to overcome strategic and financial challenges. You can rely on our team to find the right solution for you and protect the interests of stakeholders. We pride ourselves on identifying tailored solutions for your business.
Director loans are common assets which liquidators identify once they are appointed liquidators of a company.
Australia Insolvency/Bankruptcy/Re-Structuring

Introduction

Director loans are common assets which liquidators identify once they are appointed liquidators of a company. As liquidators, we often see situations whereby the company is not making any profits and the directors use the company's funds during a financial year to fund their personal lifestyle, thereby creating the director loan. While the provisions of Div 7A of Income Tax Act 1997 ("Div 7A") are relevant, we rarely see any proper documenting of such loans by directors.

The ATO has published on their website that Division 7A extends the meaning of 'loan' to include:

  • an advance of money
  • a provision of credit, or any other form of financial accommodation
  • a payment for a shareholder or their associate, if they have an obligation to repay the amount whether it's
    • on their account
    • on their behalf
    • at their request
  • a transaction (whatever its terms or form) that is the same as a loan of money.

A loan is considered to be made at the time the amount is paid either as an ordinary loan, or if any of the above is done in relation to a shareholder or an associate.

When a company is placed into liquidation, a liquidator is faced with trying to understand these loans and why they were created in the first instance.

"This article explores the implications of director loans during liquidation, shedding light on recovery processes, challenges, best practices for directors, and the importance of understanding personal tax positions, as a director."

What Are Director Loans?

Director loans refer to funds that a director either borrows from the company or lends to it. These arrangements can occur in various scenarios, such as funding personal expenses, personal luxury items, supporting company initiatives, or making investments. While these loans can be legitimate, they must comply with legal frameworks, often governed by company and tax legislation. For example, we often see vehicles purchased in the company that are for private use only. Technically, the company is liable to pay Fringe Benefits Tax on that. In the event that they do not, it could be captured and classified as a Div 7A loan.

The Role of a Liquidator

A liquidator is appointed when a company enters liquidation, a process aimed at winding up its affairs. This individual or entity is tasked with several responsibilities, including collecting assets, paying creditors, and ensuring compliance with legal obligations. The liquidator acts in the best interest of the creditors and must navigate the complexities of the company's financial situation, including the recovery of any director loans.

Director Loans in the Context of Liquidation

  1. Identification of Loans: During liquidation, the liquidator must identify all assets including any director loans listed on the company's balance sheet or disclosed in the Report on Company Activities and Property ("known as ROCAP) which is required to be completed by directors once the company is in liquidation. Accurate accounting records are essential for this process, as they provide a clear view of outstanding loans and their terms. Usually what we experience as liquidators is that the bookkeeping is very poor, so a forensic tracing exercise is required to calculate the amount that may be owed to the company.
  2. Legality and Recovery: The legal standing of director loans can be contentious in insolvency situations. The liquidator has several avenues to recover these loans, including:
    • Sending formal demands to the directors.
    • Initiating legal proceedings if directors fail to repay the loans.

The effectiveness of these recovery efforts often hinges on the documentation and legitimacy of the loans.

  1. Challenges Faced by Liquidators: Liquidators may encounter various challenges when attempting to recover director loans. Proving the legitimacy of these loans can be difficult, especially if funds were withdrawn in cash or used for personal purposes. The lack of clear documentation can complicate recovery efforts.
  2. Compromising a Div 7A loan or director loan
    In a liquidation the ability of the directors to be able to repay the monies may not exist. When a director has little or some ability to repay the loan in part (but not in full) liquidators may need to seek creditor approval to compromise the debt (an asset of the company). Creditors are given the opportunity under s477 (2A) of Corporations Act to decide and vote on whether they are prepared to accept such a compromise. The outcomes on these votes are mixed and often the creditors will decide based on a combination of commercial logic or emotional anger because of their dealings with the director prior to liquidation.

Implications for Directors

  • Personal Liability: Directors are usually faced with personal liability for unpaid loans if they are found to be still outstanding at the date of liquidation. Directors may also be subject to penalties or claims if they have contravened relevant tax and/or company law. This situation can arise if the loans were not authorised by the company's governing documents or if they contravene regulations.
  • Potential Consequences: The repercussions for directors can be significant. Aside from the financial burden of repaying loans, directors may suffer damage to their reputation, making it challenging to secure future directorships if they act in a role that may be high profile. For smaller liquidations where we identify director loan assets, the directors operate their business in a way that blurs funds that sit in the business and their personal finances.
  • Tax implications: When understanding the tax impact for the individual, the debt recovery or loan compromise undertaken by a liquidator against the individual, the tax effect relating to a Div 7A loan is that the debt will not be treated as a deemed dividend where:
    • it's made in favour of another company, unless the other company owed the debt in its capacity as trustee provided that other company does not go on and loan those funds to the director
    • the debt is forgiven because the debtor becomes bankrupt or because of Part X of the Bankruptcy Act 1966
    • the debt or part of a debt results from a loan that has been treated as a Division 7A dividend in the current or previous income years
    • the Commissioner exercises discretion not to treat the debt forgiveness as a dividend.

In the scenario whereby a director loan has been compromised by the liquidator, the individual who has been a party to the loan being compromised may need to consider whether compromising the loan triggers a deemed dividend for that individual. Individuals should seek to obtain tax advice when considering such a deal with the liquidator. It is the ATO's discretionary right to then determine a course of action and possibly pursue an individual whereby the Div 7A has been triggered as a result of the compromise.

Best Practices for Directors

To mitigate risks associated with director loans, directors should adhere to best practices, including:

  • Maintaining Clear Records: Accurate documentation of loans is crucial for transparency and accountability.
  • Seeking Professional Advice: Before entering into loan agreements, directors should consult legal, tax or financial professionals to ensure compliance with applicable laws.
  • Being Transparent: Directors should maintain open communication with stakeholders regarding any financial dealings to uphold trust and accountability.

Conclusion

Understanding director loans is vital for directors and stakeholders alike, particularly in the context of liquidation. By adhering to best practices and maintaining transparency, minimising the size of the director loan and paying the debt back regularly, directors can protect themselves from potential liabilities and ensure compliance of their director obligations. As the landscape of corporate governance evolves, ongoing education and awareness of these issues will be crucial for successful corporate management.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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