With gift duty to be abolished from 1 October 2011, many clients will be wanting to make a one off forgiveness of debt for the amount owed to them by their trust. We discuss the tax and non-tax issues that should be considered before any such gift is made:
The debt is an asset for the lenders and often it is used as a means by which to control the trust. Clients need to understand that once the debt is forgiven they may lose the most effective way to control the trust. This can particularly apply to loans by parents to trusts for their children.
It is often easier for disappointed beneficiaries to establish a claim against wills/estates than against the trustees of a discretionary trust. Many clients will be wanting to extinguish the debt so that potential claimants against the estate are not able to access the debt back, which is an asset of the estate. Any clients wanting to exclude a person inheriting from their estate will most likely see the abolition of gift duty as an opportunity to make a one off gift to a trust, and control the inheritance “from the grave”.
Relationship Property claims often focus on the debt back from the family trust. If there is no debt back, PRA claims against the trust are that much harder. We are therefore likely to see more debts forgiven for PRA reasons.
A one-off forgiveness of debt will not give rise to any added advantages in terms of entitlement to rest-home subsidies or other WINZ benefits. The rules only allow a certain level of gifts for the five years preceding the application (currently $6,000 p.a), and for periods beyond that at only $27,000 per year. If there is a one-off gift, all but the annual exemption amounts will be clawed back in the calculation. This suggests it may well be appropriate to continue with a regular gifting programme if WINZ considerations are going to be relevant to the client in the future.
For tax purposes, if there is a distribution from a trust to a beneficiary for whom the creditor would not have natural love and affection, remission income can arise in the trust under the accrual rules. This applies where there has been a debt forgiveness programme, not where there were cash gifts to the trust.
This claw back on distribution is most likely to apply where there is an investment trust looking to distribute income or capital to say, a company (that may or may not have tax losses). The general rule is where there has been debt forgiveness, do not allow the trustees to make any distribution to a non-natural love and affection beneficiary.
Insolvency and the timing of any debt forgiveness is relevant. Many readers may be well aware of Section 346 of the Property Law Act and the Regal Castings case, as well as the relevant sections of the Insolvency Act. These sections need to be addressed and full information of a client’s financial position is required. It may be that it is appropriate for clients to ask their accountants to provide a solvency certificate at the time of any one-off forgiveness of debt. We note that there are differing views as to whether the relevant solvency test is a cash flow test or balance sheet test.
Many clients with trusts will also be the shareholders in a Look Through Company (“LTC”) which will own a geared investment rental property. A potential issue arises with the shareholders forgiving the debt owed to them by the trust, where the trustees are also guaranteeing the debt. Forgiveness of the debt can affect the “equity” for the shareholders and lead to the application of the loss limitation rule whereby they are not able to claim all of the losses arising from the LTC.
Written by Keith Turner NSA Tax
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