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We have been asked whether a taxpayer is entitled to carry forward pre-bankruptcy losses where the loss arises from the taxpayer paying the debts owing (as opposed to the debts being remitted).
Tax Information Bulletin Vol. 9, No. 9 (September 1997), at page 20, included an item under the heading "Losses released on discharge from bankruptcy - inability to carried forward". The item concerned an enquiry on the ability of a bankrupt to carry forward income tax losses that had arisen as a result of debts incurred in a previous year. The bankrupt was released from payment of these debts during the bankruptcy process, and as a result had not made any payment towards the debts that made up the losses. She was not entitled to carry the losses forward to offset against post bankruptcy income, as she had been released from the obligation to pay the debts. Because she had made no payment of the debts, the amount of the debts could not be taken into account in calculating the losses available to carry forward.
This item considers the situation where the bankrupt has paid the debts.
A taxpayer was made bankrupt as a result of a farming business affected by severe flooding. Up to the time of the floods, the farming business had operated reasonably successfully and all business debts to the end of the previous income year had been paid in full. However, due to large depreciation claims, accumulated income tax losses were available to be carried forward at the time the farmer was adjudged bankrupt.
At a meeting of creditors it was agreed that the Official Assignee (the "Assignee") would continue to operate the business, as there was every prospect of the farm trading successfully once it had recovered from the floods. The farmer obtained work in a nearby town and derived salary and wages for the period of the bankruptcy. The farmer has asked about his income tax obligations and whether he is entitled to carry forward the pre-bankruptcy accumulated losses.
In the situation described above, where the Assignee is carrying on the former business of the bankrupt, there are two "taxpayers":
The income tax responsibilities of each follow.
The bankrupt will be required to file two income tax returns for the year in which he was adjudged bankrupt.
Under section 44(1)(f) of the Tax Administration Act 1994, the first return will cover the period from the beginning of the income year to the date the farmer was adjudged bankrupt. This return is an "interim" return that enables Inland Revenue to lodge a proof of debt with the Assignee for any tax owing at the date of adjudication. From the income derived during this period, the farmer is entitled to deduct the pre-bankruptcy losses against any farming profit earned during the period to date of bankruptcy and other income (such as salary and wages) derived during that period. See Subpart IE of the Income Tax Act 1994 (the ITA). If there is an overpayment of income tax resulting from credits of PAYE tax deductions or provisional tax paid, the refund will pass to the Assignee.
At the end of the income year in which the farmer is adjudged bankrupt, he must file a return of income for the full income year.
This second return will include any income or (loss) already declared in the earlier return of income to the date of bankruptcy, but not any income or loss resulting from the farming business now carried on by the Assignee. Any adjustments necessary to take account of PAYE credits already refunded to the Assignee as a result of the "interim" return of income will be made when the tax assessment for the full year is made.
Under subpart IE of the ITA, the farmer will be able to offset against that full year's income the accumulated pre-bankruptcy losses to the extent of the income derived. Any remaining losses can be carried forward to future years.
Any of the pre-bankruptcy losses remaining after the bankruptcy is discharged can be used by the farmer to offset against future income derived.
Under section 42 of the Insolvency Act 1967, when a person is adjudged bankrupt all property of the bankrupt vests in the Assignee. This property includes the farm business assets, but not the accumulated losses as these are not "property" as envisaged by that Act. The Assignee carries on the farming business as trustee for the creditors. As trustee, the Assignee is a new taxpayer and will be liable to income tax on any gross income derived from the business. As section IE 1(1)(a) of the ITA only permits losses to be carried forward by "the taxpayer", the Assignee, as another taxpayer, cannot utilise the farmer's pre-bankruptcy losses against any income derived as trustee of the farming business.
Under section HH 4 of the ITA the Assignee, as trustee, is required to furnish income tax returns for each income year, or part thereof, during the bankruptcy period while carrying on the former business of the bankrupt. Income tax is payable on any trustee income derived during the period. Any losses incurred by the trustee can be carried forward from year to year to offset against subsequent trustee income. However, any accumulated "trustee losses" remaining at the end of the bankruptcy period are not available to the farmer to offset against his post-bankruptcy income.