Inland Revenue is now ahead of liquidators and receivers in the queue for payment where cash is available in liquidation and PAYE is owed.
Industry practice has been that PAYE is paid to the Commissioner of IRD only after the insolvency practitioners’ fees and employees’ wages have been paid but the Court of Appeal has accepted the IRD's argument that the Commissioner has first claim.
The Commissioner has taken a new approach, which is to apply section 167 of the Tax Administration Act to say that available cash up to the value of PAYE deducted is held on trust for the Commissioner and forms no part of the company’s estate on liquidation. A majority in the Court of Appeal has accepted this approach. The result is that the Schedule 7 waterfall is bypassed.
Schedule 7 of the Companies Act sets out the priority of payments to preferential creditors and puts IRD behind fees and other expenses incurred by the liquidator and others, behind certain recoveries for creditors who fund the liquidator’s recoveries, and behind any monies owed to the employees.
But the Tax Administration Act (section 167) creates a trust over PAYE ‘deducted’ from payments to employees and certain contractors (section 167). There are two limbs to the section:
subsection (1), where PAYE has been dealt with properly by the employer, provides that the money is held on trust for the Commissioner and does not form part of the company’s estate on receivership or liquidation, and
subsection (2), where the employer has failed to deal properly with PAYE deducted, provides that the Commissioner ranks in accordance with Schedule 7.
The Commissioner accepted that the two limbs seem inconsistent, but argued that the PAYE owing was held in trust for her under section 167, so she was entitled to retain it. The liquidators argued that the Commissioner’s protection under section 167 is lost upon liquidation.
Overturning the decision of the High Court, the majority in the Court of Appeal found that where subsection (1) applies, the trust it creates is not extinguished on liquidation of the company, so the PAYE owing is paid straight to the Commissioner, as opposed to being subject to the Schedule 7 waterfall.
Whether an amount falls under the first or second limb of section 167 depends on whether the employer has ‘dealt properly’ with the PAYE deductions. The Court said that a company will have failed to deal properly with the PAYE if the money deducted is not paid to the Commissioner by the due date or is no longer held by the Company at the time of liquidation. Ellen France J gave a dissenting judgment, upholding current practice, finding that subsection (2) applies to PAYE in arrears at the time of liquidation.
The effect of the decision is that the status of PAYE deductions depends on whether the employer has a credit balance in their bank account at the time of liquidation. This is a surprising result given that there is no requirement for an employer to keep PAYE amounts separate, or to keep their bank account in credit with an equivalent amount.
A company that runs a perpetual bank account overdraft would automatically fall under subsection (2) as having failed to deal with the PAYE properly, despite the fact that it has not breached any obligations if the PAYE is not yet due.
Liquidators need to be aware that outstanding PAYE will be held on trust for the Commissioner where, upon appointment, the company has a credit bank balance. These funds cannot be applied to other creditors.
This decision impacts not only PAYE withheld from employees, but amounts of withholding tax deducted from “schedular payments” under the Income Tax Act 2007, including directors fees and payments made to non-resident contractors. Note however, that this decision does not extend to GST.
Receivers too will be affected by the decision. On appointment, funds held by the company will be subject to a trust for the Commissioner up to the value of the unpaid PAYE so the waterfall in section 30(2) of the Receiverships Act 1993 will, like schedule 7, be bypassed.
Chapman Tripp comment
The case signals the start of the Commissioner’s new approach to section 167. In our view it is regrettable that more guidance has not been offered as to the demarcation between dealing properly with PAYE deductions and failing to do so, and on the practicalities of assessing that demarcation by a bank account balance at the date of liquidation.
We consider that there is a workable approach to section 167, which allows the two limbs to work in tandem.
Subsection (1) applies to current PAYE. That is, PAYE that has been deducted but is not yet due for payment to IRD. On liquidation, the trust over that money remains in place, as the employer has not failed to deal properly with the amount.
Subsection (2) applies to PAYE in arrears. This is PAYE that the company has deducted but failed to pay to the Commissioner. In respect of recouping those amounts, the Commissioner ranks in accordance with Schedule 7.
We believe there is scope for the Supreme Court to engage with these issues. The liquidators have sought leave to appeal the decision to the Supreme Court. We will keep you informed of the outcome.