What is a Debt and When is One Incurred?

by Allan Topp of Sims Partners and Tim James

There is no definition of “debt” within the Corporations Act 2001 (Cth) ("the Act"). There is no “quick and fast” rule of what constitutes a debt as its meaning varies according to the type of transaction in question. This article discusses corporate debts and when they are incurred for the purposes of insolvent trading considerations.

Generally, a company incurs a debt when by its choice, it does or omits to do something which, as a matter of substance and commercial reality, renders it liable for a debt for which it otherwise would not have been liable.

“Debt” has been interpreted to bear its ordinary technical meaning as something recoverable by an action for debt and thus must be ascertained or capable of being ascertained. Therefore, a “debt” signifies an obligation for the payment of money or money’s worth. Many authorities suggest that the obligation must be for an ascertained liquidated sum.

The terms “incurs” and “debt” are words of flexible meaning. Their meaning changes in accordance with the context in which they are used. The words “incurs” and “debts” are not words of precise and inflexible denotation. Where they appear they are to be applied in a practical and commonsense fashion, consistent with the context and with the statutory
purposes.

The statutory purpose of the definition of “debt” is to encourage directors to focus on the overall management of their company’s financial affairs. In this sense, the central focus of the definition is to achieve an appropriate level of vigilance by directors for the overall financial affairs of their company. For this reason, what constitutes a “debt” has broad economic and social policy implications. Clearly, the meaning of “debt” in any situation requires a flexible consideration from the point of view of commercial reality.

At a fundamental level, the company must commit a positive act to bring a debt into existence. In this sense a debt can only be incurred by a positive, voluntary act that signifies the company’s willingness and intention to be bound. Its ordinary use implies that it is an obligation actually incurred.

General Checklist – Has a Debt Been Incurred?

The following general checklist may assist in determining whether or not a debt has been incurred:
  • Is the transaction for an ascertained sum of money?

  • Has the company committed a positive act to bring the "debt" into existence?

  • Does this positive act indicate the company's intention to be bound by the act or transaction?

  • Does the company have a choice to do (or omit to do) the act?

  • Is it the act (or omission) that renders the company liable for the debt?

  • Would the company have been liable for the debt in any event?

We now consider a number of forms of debt and outline when they are incurred for the purposes of insolvent trading considerations.

Uncommercial Transactions

A company incurs a debt for the purposes of the insolvent trading provisions when it enters into an “uncommercial transaction” (as defined under the voidable transaction provisions).

Broadly speaking, an uncommercial transaction is one that a reasonable person in the company’s circumstances would not have entered into having regard to the benefits and detriments to the company of entering into the transaction and respective benefits to other parties to the transaction. The liability of directors for insolvent trading therefore extends to
circumstances where the company has not actually incurred a debt at the relevant time but entered into an “uncommercial transaction”.

Leases

In Russell Halpern Nominees Pty Ltd v Martin ((1986) 4 ACLC 393), which was decided under the old section 556, the Court emphasised that a positive act must be committed in order to bring a debt into existence.

A lease represents a continuing or serial obligation. The only act that satisfies the “positive act” requirement in the context of a lease is the initial entering into of the contract of lease. Therefore, a company incurs a debt when they first enter into a contract of lease. The company does not incur a debt each and every time rent becomes payable under the lease because there is no positive act on the part of the company on these occasions. According to Burt CJ it would be unacceptable to decide otherwise:
    To hold otherwise would be to say that if a company when in all respects financially sound were to enter into a lease for a term of years and at some time thereafter and for reasons which could not be anticipated it were to fall on bad times and be unable to pay its debts, the directors would thereafter and on every rent day within the remainder of the term be guilty of an offence for the reason that on the rent day the company incurs a debt.
Where there is a periodic tenancy or a holding over after expiry of a term, it has been suggested that it is the failure of the tenant company to take steps to terminate the lease at the end of each period which would incur the debt for rent.

Workers’ Compensation Insurance and Other Features of Contracts of Employment

The company usually pays workers’ compensation insurance at the time of entering into the contract of employment with an employee. This initial contract of employment could be seen as a positive act by the company. In State Government Insurance Corporation v Pollock (1993) 11 ACLC 839 Seaman J held that a premium for workers’ compensation insurance is a debt, incurred at the time the insurance contract is entered into.

Following this line of reasoning, it is likely that salaries, wages and other incidents of the employment contract are debts incurred by the company at the time of entering into the initial contract of employment rather than on each and every pay day. Other incidents of the contract of employment may include liability for redundancy or retrenchment payment and obligations in relation to long service leave and holiday pay.

Interest and Financing

The key case which determined whether or not an agreement to pay interest constitutes a debt is John Graham Reprographics Pty Ltd v Steffens (1987) 5ACLC 904. In this case, Connolly J regarded the situation before him as resembling that in the Russell Halpern case and following the reasoning in that case. Thus, interest incurred under an agreement to pay interest is a debt incurred at the time of entering into the initial contract. In this way, failure to pay interest does not, of itself, constitute the incurrence of an independent debt.

The position is somewhat different in relation to bill financing. In contrast to the decision in John Graham Reprographics, the case of Standard Chartered Bank v Antico has decided that interest on a principal debt may be considered an independent “debt” in relation to bill financing. According to Hodgson J, where a loan is for a fixed term the borrower incurs interest for the term of the loan as a debt:
    (i) when the loan agreement was entered into, when early repayment of the principal is not a realistic option for the borrower; or
    (ii) from day-to-day, when early repayment is a realistic option for the borrower.
However, where the loan is not for a fixed term, or the fixed term has expired, the borrower incurs interest as a debt:
    (i) when the loan was entered into, when repayment is not a real option for the borrower; or
    (ii) from day to day, when repayment is a real option for the borrower.
Where re-financing occurs, and the borrower enters into a new agreement to pay interest on a loan that is due or overdue for repayment, the borrower incurs interest as a debt:
    (i) when the new loan agreement is entered into; or
    (ii) when the original loan agreement was entered into, when the borrower is unable to repay the existing loan and the new loan agreement is in substance merely an extension of time for repayment of the principal.
This clearly establishes that re-financing does amount to incurring a debt under the insolvent trading provisions where there is an entry into a new agreement that is not a mere extension of the existing finance facility. In order for a new independent debt to be created as a result of re-financing, the new loan agreement must be different in substance from the existing loan agreement.

In general terms, the more of an option repayment is, the stronger is the case for saying that the debt for interest is incurred by entering into the new agreement. Similarly, the more different the new agreement is from the original agreement, the stronger is the case for saying that the liability for interest under the new agreement is not the same liability as it would otherwise have been.

It is not clear when repayment will be a “real option” for the borrower, but the court is likely to look at the financial affairs of the company and the assets and funds available to it to repay the loan. What is clear is that at the time of re-financing, directors must turn their mind to the financial position of the company and examine its ability to repay the interest in the principal.

Guarantees and Other Contingent Liabilities

Guarantees and other contingent liabilities are considered “debts” for the purposes of the insolvent trading provisions. In the case of a guarantee, whilst the liability of a guarantor arises at the time of entry into the contract, the primary debt does not arise until the primary debtor defaults. However, the Court has held that a debt is incurred at the time of entry into the guarantee.

There is little authority dealing with the goods and services tax in an insolvent trading context. However in practice, GST is a debt which is incurred at the time of sale of a good or service. According to the reasoning and decision in Commissioner of Taxation (WA) v Pollock (1993) 11 ACLC 16, a debt is "that which is owed or due' anything which one person is under an obligation to pay or render to another". On this basis, GST is a debt for insolvent trading purposes.

Similarly, in the case of Powell v Fryer held that sales tax was a debt for the purposes of the insolvent trading provisions.

Payroll Tax

When a company employs an employee, the employer becomes liable to pay payroll tax under the Payroll Tax Assessment Act 1941 (Cth). Payroll tax becomes owing when it is ascertainable, and this is usually the end of each month. The Court has held that payroll tax only becomes a “debt” upon the expiry of the month in which it was incurred but remains a contingent liability until that time.

It should also be noted that a company’s liability to remit PAYE deductions deducted from employee’s salaries is a debt and is incurred when the deduction was made.

Penalties

It is not clear whether a penalty is debt for the purpose of the insolvent trading provisions. Under the approach of Hodgson J in Standard Chartered Bank v Antico a penalty would not be a debt as there is no positive act to bring it into existence. However the approach of Prior J in Powell v Fryer suggests that the Courts may consider penalties for the failure to pay taxes or other obligations imposed by law as a "debt".

Judgment Debt

A debt requires an ascertained or liquidated sum. In Jelin Pty Ltd v Johnson (1987) 5 ACLC 483 the Court held that damages could not be a debt because there was no ascertained sum at the time the action arose. In addition, there is no act on the part of a company that can be considered as the requisite positive act.

Supply of Goods

There is no hard and fast rule that a company incurs the debt for goods sold and delivered at the time when the goods are delivered to the company, and not at any earlier time.

The terms of trade, the nature of the goods, and their marketability will be considered.

The act or omission may be the order itself or the acceptance of delivery of the goods, depending on the facts of the case. If the goods are readily saleable by the vendor, it is more likely that the debt is incurred by the acceptance of delivery. On the other hand, if the goods are not readily saleable to another purchaser, it is more likely that the debt is incurred at the time of placing the order for the goods. This article is an excerpt from an AAR Paper: Insolvent trading - risks and benefits for liquidators, creditors and ASIC. To read the rest of the paper, please visit www.aar.com.au/pubs/insol/cirfeb04.htm


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