Income tax: Pay As You Go (PAYG) Withholding - Payments made by trustees under the Bankruptcy Act 1966 to former employees

This Ruling provides guidance as to whether an amount is required to be withheld, under sections 12-35, 12-85 and 12-90 of Part 2-5 (the PAYG provisions) in Schedule 1 to the Taxation Administration Act 1953 (TAA 1953), from a payment made to a former employee of the debtor by a trustee under the Bankruptcy Act 1966 (Bankruptcy Act). Section 12-35 deals with payments of salary, wages, commission, bonuses or allowances paid to employees, section 12-85 deals with eligible termination payments, and section 12-90 deals with payments for unused leave. These sections place an obligation on the paying entity to withhold an amount from payments made to an individual.

In this Ruling, the phrase 'trustee under the Bankruptcy Act' means the trustee who holds the property or money of the debtor, or the proceeds of the debtor's property, on trust for distribution amongst the creditors.

Under the Bankruptcy Act, property of the bankrupt or insolvent debtor may vest in the trustee. This can occur: • when the debtor becomes bankrupt (paragraph 58(1)(a) of the Bankruptcy Act); • when a trustee is appointed by the creditors (section 132 of the Bankruptcy Act); • on execution of a deed of assignment (subsection 229(1) of the Bankruptcy Act); • under the terms of a deed of arrangement under Part X of the Bankruptcy Act; or • under a composition under Part X of the Bankruptcy Act.

Where the property or money of the debtor or the proceeds of the debtor's property do not vest in the trustee, but the trustee exercises its powers in the name of the debtor (for example, under subsection 190(4) of the Bankruptcy Act a controlling trustee exercises its powers in the name of the debtor), it is the debtor which is the entity that would have any withholding obligations in respect of payments made to employees or former employees. The trustee in making payments on behalf of, or in the name of the debtor, should ensure that the debtor's PAYG withholding obligations are complied with. As another alternative to bankruptcy, a debtor and creditors may enter a debt agreement, as provided for in Part IX of the Bankruptcy Act. This Ruling does not consider the debtor's obligations in these circumstances.

Former employees of a bankrupt individual may prove a debt to a trustee under the Bankruptcy Act for outstanding entitlements owing to them by the bankrupt individual. The Bankruptcy Act contains provisions for the trustee to make priority payments, including priority payments to former employees of the bankrupt, in respect of amounts (up to a statutory limit) due for services rendered to the bankrupt, [F1] and for amounts due for leave in respect of a period before the date of the bankruptcy. [F2]

These statutory priorities, with certain modifications, also apply to payments made by the trustee of a deed of assignment or a deed of arrangement under Part X of the Bankruptcy Act.

A trustee under the Bankruptcy Act can also make non-priority payments in respect of outstanding employee entitlements. For example, where part of the outstanding salary or wages exceeds the statutory limit for a priority payment to an employee, the excess amount will rank equally with other non-priority debts. A trustee of a composition under Part X of the Bankruptcy Act does not make priority payments, but may nonetheless make a non-priority payment in respect of outstanding employee entitlements.

This Ruling outlines the Commissioner's view on the application of the decision in Deputy Commissioner of Taxation v. Applied Design Development Pty Ltd (In Liq) [F3] to the PAYG withholding obligations of trustees under the Bankruptcy Act on priority and non-priority payments made to former employees of the debtor.

This Ruling applies to relevant payments made on or after the commencement of the PAYG withholding system on 1 July 2000. This Ruling does not apply to taxpayers, to the extent that it conflicts with the terms of a settlement of a dispute agreed to before the date of issue of the Ruling (see paragraphs 21 and 22 of Taxation Ruling TR 92/20).

Where the payer (in this case, a trustee under the Bankruptcy Act) has failed to withhold an amount under Division 12 of the PAYG withholding provisions an administrative penalty does apply. However, based on the surrounding circumstances and compliance history of the taxpayer, the Commissioner may remit that penalty. Law Administration Practice Statements PS LA 2000/9, PS LA 2002/8 and PS LA 2003/11 provide further information on the circumstances in which the Commissioner will remit penalties, including a remission to nil.

Since there may have been some uncertainty amongst trustees in bankruptcy regarding their PAYG withholding obligations and whether they could rely on the decision in Re Johnson and anor; Ex parte Law, [F4] the Commissioner considers that any failure to withhold was an honest mistake or misunderstanding of the New Tax System. Where trustees have put measures in place to ensure that they meet their future obligations, the Commissioner will remit any penalty for a failure to withhold prior to 1 January 2004.

Section 12-35 in Schedule 1 to the TAA 1953 only applies to payments made to individuals in their capacity as an employee. For section 12-35 to apply, the individual does not have to be an employee of the entity making the payment, nor does the employment relationship necessarily have to exist at the time of payment. The essential element is the character of the payment and not the identity or capacity of the entity making the payment.

Where a trustee under the Bankruptcy Act (the payer) makes a payment to an individual in respect of a provable debt for salary, wages, commissions, bonuses or allowances, the trustee has a PAYG withholding obligation. Such a payment, although paid under the statutory provisions of the Bankruptcy Act, retains its character as salary or wages for PAYG withholding purposes. This is because the consideration for the payment was the services the former employee rendered to the employer prior to the bankruptcy occurring. [F5] A trustee is required to withhold an amount from such a payment in accordance with section 12-35 of Schedule 1 to the TAA 1953 and to pay the withheld amounts to the Commissioner under section 16-70 in Schedule 1 to the TAA 1953.

Where a trustee under the Bankruptcy Act makes other payments in respect of provable debts for unpaid entitlements of former employees, these payments also retain their underlying character.

Accordingly, the trustee has an obligation under section 12-90 in Schedule 1 to the TAA 1953 to withhold an amount from payments it makes in respect of debts for unused annual leave and unused long service leave entitlements in consequence of retirement or termination of employment where the amount of the payment is assessable to the former employee under section 26AC or 26AD of the Income Tax Assessment Act 1936 (ITAA 1936).

Similarly, the trustee under the Bankruptcy Act is required to withhold an amount, in accordance with section 12-85 in Schedule 1 to the TAA 1953, from a payment it makes to a former employee of the debtor in respect of a provable debt for an eligible termination payment. [F6]

For an entity to be required to withhold an amount under section 12-35 in Schedule 1 to the TAA 1953, there must be: • a payment made by the 'entity'; • the payment must be made to an individual as an employee (whether of the payer or another entity); and • the payment must be a payment of salary, wages, commission, bonus or allowance.

For the purposes of the PAYG provisions, the definition of entity takes its meaning from section 995-1 of the Income Tax Assessment Act 1997 (ITAA 1997). [F7] Under that provision, an entity is defined by section 960-100 of the ITAA 1997 to mean an individual, body corporate, body politic, partnership, any other unincorporated association or body of persons, a trust and a superannuation fund. The trustee of a trust or superannuation fund is also taken to be an entity.

Where the property or money of the debtor, or the proceeds of the debtor's property, vests in the trustee under the Bankruptcy Act, the trustee is an 'entity' for the purposes of the section 12-35 in Schedule 1 to the TAA 1953.

Section 12-35 in Schedule 1 to the TAA 1953 only applies to payments made to individuals in their capacity as an employee. For section 12-35 to apply, the individual does not have to be an employee of the entity making the payment, nor does the employment relationship necessarily have to exist at the time of payment. [F8] The essential element is the character of the payment and not the identity or capacity of the entity making the payment. [F9]

Where the PAYG provisions refer to 'employees', the reference is to employees at common law. Taxation Ruling TR 2000/14 Income Tax: Pay As You Go - withholding from payments to employees, discusses the meaning of 'employee' for the purposes of section 12-35 in Schedule 1 to the TAA 1953. In the context of this ruling, an individual must have been an employee of the bankrupt individual for the provisions of section 12-35.

As salary, wages, commission, bonuses or allowances are not defined terms in PAYG provisions they take their ordinary meaning. At common law, salary or wages denotes money payable to an individual for work or services. [F10]

When a trustee makes a payment under the provisions of the Bankruptcy Act to a former employee who has a provable debt for unpaid salary, wages, commission, bonuses or allowances, it is necessary to establish whether the payment retains its character as a payment of salary, wages, commission, bonuses or allowances.

In Deputy Commissioner of Taxation v. Applied Design Development Pty Ltd (In Liq) [F11] it was held that a priority payment, made under paragraph 556(1)(e) of the Corporations Act 2001 (Corporations Act) to an employee who had proved a debt for wages, retained its character as salary or wages for the purposes of section 12-35 in Schedule 1 to the TAA 1953. It was found that the consideration for the payment was the services rendered by the former employee to the company before its liquidation. The nature of the payment remained unaltered by the liquidation process. It was also found that the payment was made to the taxpayer in his capacity as an employee as required by section 12-35 notwithstanding that he was also a creditor of the respondent.

Mansfield J looked to the fact that the consideration for the payment was services rendered by the individual to the company in liquidation as the factor that would lead to its characterisation. His Honour said: Nothing turns in the present case on the fact the payment was made to [the former employee] by way of a dividend pursuant to his statutory right to receive it. The consideration for the payment was the services [the former employee] rendered to the company prior to its liquidation. But for that consideration, the proof of debt lodged by [the former employee] would not have been admitted to rank as a liability... It is that consideration that leads to the characterisation of the payment as a payment in the nature of salary and wages. The nature of that consideration is not only unaltered by the winding up process under the Corporations Law, but expressly acknowledged as the criterion under which [the former employee's] entitlement to the priority payment under s556(1)(e) arose. The priority accorded to [the former employee's] debt was because his debt constituted wages...payable by the respondent in respect of services rendered by him as an employee to the respondent. [F12]

In making a priority payment under paragraph 556(1)(e) of the Corporations Act in relation to a debt for wages, the liquidator applies the property of the company in discharging the company's liability. However, in the case of a bankrupt, the bankrupt's property vests in the trustee for distribution among the creditors of the bankrupt. While there is that difference, a parallel can be drawn with the decision in Deputy Commissioner of Taxation v. Applied Design Development Pty Ltd (In Liq) in the circumstances where a trustee makes a priority payment under paragraph 109(1)(e) of the Bankruptcy Act to a former employee who has a provable debt for salary or wages: • the consideration for the payment is the services rendered by the former employee to the debtor; • the nature of this consideration is not altered by the process under the Bankruptcy Act even though the former employee's personal contractual right to enforce his or her debt is in effect compromised when the employer enters into bankruptcy (section 60 Bankruptcy Act) and is replaced by a statutory right to participate in the estate of the bankrupt; • the proof of debt lodged by the former employee is admitted to rank as a liability (section 82 Bankruptcy Act) because of that consideration; and • the nature of that consideration is expressly acknowledged as the criterion under which the former employee's entitlement to a priority payment under paragraph 109(1)(e) of the Bankruptcy Act arises - that is, because the debt constitutes wages due to the former employee in respect of services rendered as an employee to the debtor.

A payment made under paragraph 109(1)(e) of the Bankruptcy Act by a trustee in bankruptcy to a former employee of the bankrupt retains its character as a payment of salary, wages, commission, bonuses or allowances paid to an individual as an employee for the purposes of section 12-35 in Schedule 1 to the TAA 1953.

Where a part of the salary or wages outstanding at the date of bankruptcy exceeds the amount payable to a former employee as a priority payment (as specified in Regulation 6.02 of the Bankruptcy Regulations), the excess amount ranks equally with other non-priority debts. There are also other circumstances covered by the Bankruptcy Act whereby former employees of the debtor are paid a non-priority dividend under sections 140 and 145 of the Bankruptcy Act. For example, a trustee of a deed of composition does not make a priority payment under paragraph 109(1)(e) of the Bankruptcy Act to employees, but may nonetheless make a non-priority payment to a former employee in respect of outstanding salary or wages. It follows that where a trustee makes a non-priority payment to a former employee for outstanding salary or wages, that payment would also survive the process under the Bankruptcy Act to retain its character as a payment of salary, wages, commission, etc for the purposes of section 12-35 in Schedule 1 to the TAA 1953.

The Commissioner considers that the reasoning in Deputy Commissioner of Taxation v. Applied Design Development Pty Ltd (In Liq) in finding that the character of salary and wages survive the insolvency process is broad enough to apply equally to other payments representing unpaid entitlements of employees.

Section 12-90 in Schedule 1 to the TAA 1953 states: An entity must withhold an amount from a payment it makes to an individual if the payment is included in the individual's assessable income under: (a) section 26AC (payment for unused annual leave); or (b) section 26AD (payment for unused long service leave); of the Income Tax Assessment Act 1936.

The wording of this provision can be differentiated from section 12-35 in Schedule 1 to the TAA 1953 in that it does not rely on an individual receiving the payment 'as an employee'. Rather it relies on the nature of the payment in the hand of the recipient as assessable income under sections 26AC or 26AD of the ITAA 1936.

Section 26AC of the ITAA 1936 includes in an individual's assessable income amounts received in consequence of the retirement or termination of employment of that individual from any office or employment in respect of unused annual leave. Section 26AD of the ITAA 1936 includes in an individual's assessable income amounts received in consequence of the retirement or termination of employment of that individual from any office or employment in respect of unused long service leave. Where an amount is assessable income to an individual under these provisions, section 12-90 in Schedule 1 to the TAA 1953 requires a payer to withhold a PAYG amount.

To the extent a payment by the trustee to a former employee is in respect of a provable debt for unused annual or long service leave entitlements in consequence of the retirement or termination of employment, the payment retains that underlying character. The amount is assessable income to the former employee under section 26AC or 26AD of the ITAA 1936. Accordingly, a trustee under the Bankruptcy Act is required to withhold an amount from such payments in accordance with section 12-90 in Schedule 1 to the TAA 1953.

Section 12-85 in Schedule 1 to the TAA 1953 requires an entity to withhold an amount from an eligible termination payment it makes to an individual. Eligible termination payments are certain payments made in consequence of the termination of any employment and are defined in subsection 27A(1) of the ITAA 1936.

Where a former employee's entitlement to a termination payment arises as a consequence of the termination of employment, there is a sufficient causal connection with the termination of employment, even though the amount is paid by a trustee under the statutory provisions of the Bankruptcy Act. The payment retains its character as being in consequence of the termination of employment.

Accordingly, a trustee under the Bankruptcy Act is required to withhold an amount, under section 12-85 in Schedule 1 to the TAA 1953, from payments it makes to any former employee in respect of a provable debt for an eligible termination payment.

An alternative view is that trustees under the Bankruptcy Act are not required to withhold amounts from payments to former employees of the debtor. Under this view, a payment by a trustee under the Bankruptcy Act is claimed to be a dividend to meet a debt owed to a creditor, and is not a payment made by an employer to an employee of salary or wages or of other unpaid entitlements of the former employee. This view relies on the decision in Re Johnson and anor; Ex parte Law [F13] (Re Johnson).

This case determined that a trustee under a deed of arrangement under the Bankruptcy Act was not required to make deductions under the former Pay As You Earn (PAYE) provisions of the ITAA 1936 from payments made to persons proving for wages owing by the debtor prior to the deed of arrangement. The former PAYE provisions required employers to make tax instalment deductions from salary or wages paid to employees. Under section 221A of ITAA 1936 'employer' was defined to mean a person who pays or is liable to pay any salary or wages; and 'employee' was defined to mean a person who receives, or is entitled to receive, salary or wages.

The emphasis in Re Johnson was on the lack of an employer/employee relationship between the trustee and the creditor receiving the payment. However, more recently there have been a number of cases that have held that at common law and under subsection 221A (1) of ITAA 1936, 'salary or wages' may be payable to an employee by a person who, at common law, is not the employer of the employee. [F14]

This later interpretation under the case law is now reflected in the current PAYG Withholding provisions that apply to payments made after 30 June 2000. The current PAYG system requires withholding under section 12-35 in Schedule 1 to TAA 1953 from payments of salary or wages made to an individual as an employee (whether of the payer or another entity).

The emphasis is on the character of the payment, and it is quite clear that the payer does not need to be the common law employer of the employee. Therefore, it is considered that the decision in Re Johnson cannot be relied upon as support for a contention that withholding is not required where the trustee is not the common law employer.

On 15 March 2002, John entered into official bankruptcy. At the date of bankruptcy, John owed Sam, an employee, outstanding wages in the sum of $1,500. In consequence of the termination of his employment, Sam also had an entitlement to a payment for unused annual leave of 2 weeks. On 1 April 2002, Sam lodged with the official trustee in bankruptcy a proof of debt for the wages outstanding in the sum of $1,500 and unused annual leave in the sum of $1,000. On 15 April the proof of debt was admitted by the trustee in bankruptcy. On 10 May 2002, the trustee in bankruptcy declared a dividend in the amount of $2,500 payable to Sam. The payment is to be made pursuant to paragraphs 109(1)(e) and 109(1)(g) of the Bankruptcy Act.

The trustee in bankruptcy is required to withhold a PAYG amount under section 12-35 and paragraph 12-90(a) of Schedule 1 to the TAA 1953 from the payment made to Sam, and to pay the withheld amounts to the Commissioner (section 16-70 of Schedule 1 to the TAA 1953).

Below is a detailed contents list for this Taxation Ruling: Paragraph What this Ruling is about 1 Date of effect 9 Ruling 12 Payments to employees - section 12-35 12 Payments for unused annual leave and long service leave - section 12-90 and eligible termination payments - section 12-85 14 Explanation 17 Payments to employees - section 12-35 17 Payment to be made by an entity 18 Payment to an individual as an employee 20 Payment of salary, wages, commission, bonuses or allowances 22 Payment retains its character 24 Payments for unused annual leave and long service leave - section 12-90, and eligible termination payments - section 12-85 29 Unused leave - section 12-90 30 Eligible termination payments - section 12-85 34 Alternative view 37 Examples 42 Detailed contents list 44