Key Points: A Tax Sharing Agreement can help manage tax consolidation risk, but only if it's valid.

The GFC has increased lender sensitivity to the effectiveness of security taken in financing transactions. Concerns centre around managing risks and ensuring that documentation properly reflects (i) the credit requirements to be met; and (ii) the ability to enforce the security in a timely fashion.

In this edition of Banking & Financial Services Insights, we revisit tax consolidation risk for secured financiers, and ways to manage it.

Why do corporate groups consolidate for income tax?

Tax consolidation rules allow a head company and its wholly-owned subsidiaries to be treated as a "single entity" for income tax purposes. All intra-group transactions within the corporate group are ignored for income tax purposes, notwithstanding that a legal transaction has taken place.

Financiers beware: consolidation risk

The law provides that, in the absence of a tax sharing agreement, a head company of a corporate group and each of its "contributing members" are jointly and severally liable to pay the group tax liabilities where the head company of the group defaults in making a tax payment to the Australian Tax Office (ATO) by its due date.

A demand for payment of the tax debts can have a serious impact on the security of a financier lending to particular members within a tax consolidated group. The challenges that tax consolidation poses for a secured financier include:

  • the risk that the ATO may be able to recover in priority to a secured financier;
  • the risk that the ATO may recover disproportionately against the secured assets of the financier, because of the possibility that joint and several liability may result in an uneven recovery against the group members; and
  • this risk is not factored into a financial model that underpins credit approval.

ATO's competing claim

The ATO has the power to issue notices that require a debtor to pay their tax debts. Some notices create a statutory charge in favour of the ATO (eg. a "garnishee" order).

The ATO is increasingly turning to these notices as a means of obtaining an advantage in corporate insolvencies. The security will compete with other secured creditors, however the service of a notice can take priority over existing floating charges that have not crystallised.

Financier's competing claim

The two key concerns for the financier are to ensure that its interest takes priority over other secured rights, or at least coincides with that of the ATO. The cases recognise that in order for the financier's security interest to take priority, the floating charge must crystallise before the ATO issues a notice.

Managing consolidation risk: Tax Sharing Agreements

It is therefore necessary to consider effective ways to mitigate the tax risk posed by the joint and several liability.

One way is for a secured financier to ensure that the consolidated group members have entered into a valid Tax Sharing Agreement (TSA).

A TSA is a written agreement between all members of a consolidated group that provides that each group member is liable to the ATO for its "contribution amount" as determined under the TSA (rather than being jointly and severely liable for the whole group's tax liabilities) should the head company default in making a tax payment. The Tax Act (Income Tax Assessment Act 1997) requires that the member's contribution amount is determined on a reasonable basis. Two reasonable bases of allocation are: (i) "Notional tax" – the member's tax contribution as a percentage of the total group tax liability; or (ii) "Accounting profit" – the member's accounting profit as a percentage of the overall group accounting profit.

TSA validity checklist for financiers

If a TSA is invalid, each member of the corporate group will be jointly and severally liable for the tax debts of the entire group should the head company default. This poses an ongoing risk to a financier of the members within a tax consolidated group.

Proactive document mitigants

  • Obtain a Condition Precedent that the TSA is in a form acceptable to the financier;
  • Obtain a tax opinion on the validity of the TSA, particularly in structured finance transactions where such whole of group tax liabilities would ordinarily not be contemplated;
  • Ensure that the consolidated group commits to updates to the TSA as circumstances change (eg. changes in corporate structure), including regularly reviewing and updating (as required) the allocation methodology;
  • Include notification covenants if the head company either defaults in making a tax payment or where the Commissioner asserts that the TSA is invalid; and
  • Obtain representations, warranties and undertakings reaffirming that the TSA is valid and will remain valid, and that it provides for a risk-free allocation to the lender. This includes commitments from the head company that it will comply with obligations that ensure the TSA remains valid.

Reactive document mitigants

In the case that a TSA is rendered invalid, should consider whether documentation should include a clause stipulating Payment Acceleration in order to match the timing of the ATO's claim.

Security crystallisation triggers should also be carefully drafted to ensure the priority of the financier's claim. The events listed below are examples of crystallisation triggers:

  • Distress is levied or a judgment, order or encumbrance is enforced, becomes enforceable, or would become enforceable by the giving of notice or following a lapse of time or fulfilment of a condition; or
  • Any person takes a step, or attempts to, or agrees to do anything which may result in the assets of the lender being dissipated; or
  • The TSA becomes invalid, void or unenforceable or ceases to be a valid tax sharing agreement (within the meaning of section 721-25 of the Tax Act);
  • Head company fails to pay any taxes to the Commissioner when due and payable.

To further mitigate the risk, particularly in structured finance transactions where such tax liabilities would ordinarily not be contemplated, the following could be considered:

  • Obtain an indemnity from the other corporate entities that make up the tax consolidated group to cover any excess of the ATO's claim over and above any "reasonable allocation", and for any tax funding payment made to the head company that is not ultimately paid to the ATO.
  • If the credit risk on the balance of the consolidated group is unacceptable, some form of credit support in an amount equivalent to the group's likely tax liability could be obtained.