Abolition of Gift Duty – Should You Make A ‘Lump Sum’ Forgiveness of Debt?

The much heralded abolition of gift duty has now been passed into law and took effect on 1 October 2011. This news has evoked an enthusiastic response from those of us who are currently engaged in slow and tedious gifting programmes. Surely this means that we can enter into one final gift on or after 1 October 2011 and be done with our pesky gifting programmes forever? Maybe not.

History

Gift duty was introduced in 1885, originally to prevent people from gifting their assets prior to their death in an attempt to avoid estate duty. Gift duty was retained after the abolition of estate duty, as it was considered, amongst other things, to provide:

• protection for creditors;
• protection in respect of relationship property claims; and
• protection against abuses in social assistance targeting, such as the residential care subsidies.

However it’s the current government’s view that the existing regime of legislation and case law provides sufficient protection to justify the abolition of gift duty. So, how does this legislation and case law affect you, your trust and your gifting programme?

Protection for Creditors

The Insolvency Act 2006, the Property Law Act 1952 (insofar as it still applies) and the Property Law Act 2007 allow for certain gifts and transactions to be set aside where:

• the debtor was either unable to pay their debts at the time of the disposition; or
• the disposition was made with the intent to defraud creditors; or
• the disposition prejudiced the creditor.

But what does this mean?

In the 2009 case of Regal Castings Limited v Lightbody, the Court found that an intent to defeat creditors could be established where a gift of property was made that might ‘hinder, delay or defeat creditors’ recourse to that property’. This means that, if you are planning on making a large lump sum gift, that gift may be successfully challenged at some stage in the future by any of your existing creditor(s) at the time of the gift who you later fail to pay. Strictly speaking, to best protect your personal assets against future claims by creditors, you need to be solvent at the time of making such a lump sum gift.

Relationship Property Claims

The Property (Relationships) Act 1976 (‘PRA’) provides for some dispositions of property to be set aside by the Courts, or for compensation to be paid, where those dispositions were made “in order to defeat the claim or claims of any person”. However, those statutory remedies are very limited.   As a result, in recent times the Courts have been developing & applying some novel remedies in an attempt to provide ‘justice’ for partners who the Courts consider have been disadvantaged by the limited application of those statutory remedies. In particular, the Family Court has been applying & developing a number of ‘trust busting’ principles in order to get at the assets of a trust and distribute them as if they were the personal assets of the couple. Currently, the Family Court has been willingly applying & developing 2 ‘trust busting’ approaches – namely, the doctrine of ‘sham or alter ego trusts’ and the ‘bundle of rights’ doctrine.

Now that gift duty has been abolished, it is likely that more claims will be made through the Family Court in respect of trust assets following the breakup of a relationship. The extent to which the Courts will apply these ‘trust busting’ principles is uncertain, but momentum and support amongst the judiciary continues to build for the breakdown of trusts in this manner. If you are in a relationship with someone who is not a beneficiary of your trust, and you plan to make a large lump sum gift to that trust, we would strongly recommend that (if you have not already done so) you enter into a Property (Relationships) Contracting Out Agreement which protects your trust’s assets and your ‘separate property’ from any future relationship property claims.

Residential Care Subsidies & Other Social Welfare Benefits

The Social Security Act 1964 (‘SSA’) provides for ‘means testing’ to determine whether a person is eligible for certain social welfare benefits – such as subsidies for people in long-term residential care. For many of us, the transfer of the residential home into our family trust has meant that we were likely to benefit from that care subsidy.   However, the likelihood of this being the case will be severely compromised if you make a large ‘lump sum’ gift.

Despite the repeal of gift duty, the SSA still imposes a limitation on gifting for the purposes of determining eligibility for a residential care subsidy and certain other social welfare benefits.

Under the SSA, it is possible to give up to $27,000 in any 12 month period without threat of that gift being ‘clawed back’ for the purposes of the benefit ‘means testing’, provided that the gift was made at least 5 years prior to the donor applying for the subsidy or benefit.    However, the SSA provides that any gift made over the sum of $27,000 can be ‘clawed back’ and there is no limitation on the time period in which that ‘claw back’ can be applied. Given the abolishment of gift duty, it seems inevitable that this discretion will be used more widely by the Ministry of Social Development in assessing whether or not a person is entitled to a residential care subsidy or other social welfare benefit.

If one of your primary purposes for maintaining your trust moving forward is the preservation of your right to a residential care subsidy or some other social welfare benefit, then it will be necessary for you to continue your annual gifting programme at the rate of $27,000 a year.

Future Cash Flow Considerations

For reasons other than those stated above, it may be beneficial for you to preserve the debt owed to you by your trust. For instance, you may benefit from the ability to call up all, or part, of any debt owed to you by your trust, as a means of obtaining cash flow, free from tax. We would therefore suggest that you speak with your accountant before making any decision about your gifting programme.

Identity of Beneficiaries of a ‘Lump Sum’ Forgiveness of Debt

The common practice in the past was for personally owned assets to be transferred into a family trust by way of a sale and debt back mechanism to avoid gift duty.

A loan that is interest free and repayable upon demand (which is the usual case in such a sale & debt back arrangement) is an exempted financial arrangement to the lender under the financial arrangements rules of the Income Tax Act 2007. This means that no income accrues to the lender from that arrangement.

However, from the perspective of the borrower (ie. the family trust in this case), the loan is still subject to the financial arrangement rules. In particular, those rules provide that, where a debt is forgiven, income can be accrued to the trust borrower. There is an exemption to this rule, however – namely, where the debt is forgiven ‘in consideration of natural love & affection’.

A debt owed by a trust may be forgiven without income tax consequences, if the trust was established mainly for the benefit of ‘a natural person for whom the creditor has natural love & affection’ and/or a charity that is registered with the Charities Commission.

However, if any debt owed by a trust has been forgiven and the trust subsequently makes a distribution to a beneficiary outside that scope (eg. a company), then all or part of that distribution may be deemed trust income and taxable accordingly.

Summary of Key Issues

In a ‘nutshell’, the 5 key issues that need to be determined when deciding whether to make a ‘lump sum’ forgiveness of debt are:

1. Your solvency at the time of the forgiveness, and your intention regarding the forgiveness.
2. The ‘relationship property’ status of the debt you are proposing to forgive.
3. Whether you wish to preserve eligibility to a residential care subsidy or other social welfare benefit.
4. Whether you wish to maintain the right to be repaid all or any part of the debt at any time in the future.
5. The identity of the beneficiaries of the trust debtor.

‘Lump Sum Gifting’ Assessment Process

We have developed a unique assessment process that addresses each of the above key issues, and which provides our clients with some comfort & guidance regarding any decision by them to make a ‘lump sum’ gift. It is also a robust evidence based process, which will help clients to counter any future questioning of a ‘lump sum’ gift made by them.

Disclaimer

We really must emphasise that the law is dynamic and always changing and we expect that this will be particularly the case in the areas of law described above. All we can do is provide you with information based on the current situation and to keep you informed of developments as they take place.

What Now?

We recommend that you think carefully about your current primary purpose for maintaining your trust. We also suggest that you contact your accountant or financial advisor to talk through the options with them.

We will be contacting our ‘trust clients’ over the coming months to discuss the best way forward for them.

In the meantime, if you have any questions please do not hesitate to contact us on (04) 970 3600.