- Impediments to Immediate Gifts of Entire Net Worth/All Assets to a Family Trust
Contrary to what many think, the abolition of gift duty on 1 October 2011, while undoubtedly making estate planning easier, does not necessarily mean that all and sundry should make an immediate gift of their entire net worth or all their assets to a family trust. There are numerous impediments and restrictions on such a course of action, and they require careful navigating in order to minimise the chances of the gift later being set aside. Some of the restrictions and impediments represent "grey areas" of the law, and it is impossible to lay down in advance what gifts will be ineluctably safe and which will not. Each case must be carefully considered on its merits, and then a judgment call needs to be made as to whether a client's entire net worth can be immediately gifted to a family trust or not. The judgment call may not always be the correct one, because circumstances will inevitably change for many clients, and the Courts may change their interpretations on the relevant statutes. What we can do is identify potential hazards in the way of making immediate "safe" gifts to family trusts, and reduce the risks associated with them. The impediments and restrictions of making immediate gifts of one's entire net worth or all ones assets to a family trust include:
2.1 Sections 344-350 Property Law Act 2007
These sections are the successor to the old Section 60 of the Property Law Act 1952, which provided that gifts with intent to defraud creditors could be set aside. The new sections considerably extend Section 60 of the PLA 1952, because it is no longer necessary to prove intent to defraud - it is sufficient now if a gift has the effect of prejudicing a creditor. And by virtue of Section 346(2)(a) of the PLA 2007, a gift is liable to be set aside if the donor/debtor was insolvent at the time of the gift, or became insolvent as a result of making the gift. By virtue of Section 345(1)(d) of the PLA 2007, "a debtor must be treated as insolvent if the debtor is unable to pay all his, her, or its debts, as they fall due, from assets other than the property disposed of". Suppose a debtor has assets of $500,000, and his only liability is a guarantee of $10,000 he has given in respect of his business (owned by a company). If this debtor makes an immediate gift of $500,000 to his Family Trust, then by virtue of the foregoing definition he is regarded as "insolvent" (seeing as he has no assets left to meet the $10,000 guarantee), and therefore the entire $500,000 gift could later be set aside if a creditor claims he or she or it has been prejudiced by the gift. I have not at this stage had time to properly consider the effect of the Limitation Act, but it seems plausible and reasonable to assume that the Limitation Act would only start to run when the creditor actually suffers loss in respect of the gift, which might be years after the gift is actually made. The sections of the PLA 2007 therefore arguably have a very long reach in terms of time, and any gifts should be carefully structured to properly and fully allow for any liabilities (especially contingent liabilities like guarantees) which may exist at the time of the gift. These sections will be further dealt with in paragraph 3 and subparagraphs below.
2.2 Insolvency Act 2006
Sections 192-205 of this Act can render void or voidable certain gifts made within certain time periods preceding bankruptcy. More specifically:
2.2.1 Section 204 of the IA 2006 means any gift by a bankrupt can be set aside by the Official Assignee if the gift was made within two years preceding adjudication as a bankrupt. The Official Assignee may exercise this right irrespective of whether the bankrupt was solvent at the time of the gift within that two years.
2.2.2 Under Section 205 of the IA 2006, a gift by a bankrupt within the period between two years and five years preceding bankruptcy may be set aside by the Official Assignee if the bankrupt was then unable to pay his or her debts, and the onus of proof is on the donee of the gift to prove that the bankrupt was immediately after the gift able to pay his or her debts without the aid of the property that the gift is composed of.
Any gift within two years preceding bankruptcy will be set aside by the Official Assignee, whether the bankrupt was then solvent or not. Any gift made between five years and two years preceding bankruptcy may be set aside by the Official Assignee if the gift would have left the bankrupt then insolvent, with the onus of proof being on the donee of the gift to prove that the bankrupt was solvent immediately after making the gift. It follows that if the bankrupt gifted their entire net worth to a family trust within five years and two years preceding bankruptcy, and the bankrupt at that time owed even a relatively small guarantee, then the gift is likely to be set aside as the donee of the gift will be unable to prove that the bankrupt was solvent immediately after the gift.
2.3 Property (Relationships) Act 1976
Section 47 of the PRA 1976 means that relationship property agreements with intent to defeat the creditors of one spouse are void, and again this provision is potentially far reaching in terms of time. Where there is no intent to defeat creditors of a spouse, a property relationship agreement that has the effect of defeating creditors is void against such creditors and the Official Assignee for a period of two years following the property relationship agreement. Section 44C of the PRA 1976 means that the Court can order compensation where one party to a marriage or defacto relationship or civil union has disposed of assets to a family trust during a relationship, and the disposition has the effect of defeating the claim or rights of one of the spouses or partners under the PRA 1976.
2.4 Consent of Secured Creditors
Where a secured creditor has a security over an asset or property that is about to be gifted to a family trust, then the securities are inevitably worded in such a way that the consent of the secured creditor is required, although this is usually only a formality when the client is not in default under the security. The secured creditor will often require that the security be redocumented in the name of the family trust to which the asset or property is to be transferred.
2.5 Social Security Act 1964
Section 74(1)(d) of this Act enables the cancellation or reduction of social welfare benefits where "the applicant has directly or indirectly deprived himself of any income or property which results in his qualifying for that or any other benefit or an increased rate of benefit". This is the section which WINZ relies on when refusing rest home subsidies to persons who may have gifted their entire net worth to a family trust in old age. This section is potentially far reaching, eg someone who at the age of 40 spends $20,000 on a round the world trip could be said to have deprived themselves of assets or income which resulted in them qualifying for a rest home subsidy 40 years later; as this is obviously absurd, WINZ have introduced a "rule of thumb" that they only look at gifts made within the last five years when deciding on eligibility for rest home subsidies. The "rule of thumb" is however just that - a rule of thumb - and if an elderly couple gift their entire net worth to a family trust six years before going into a rest home, then we could be sure that WINZ would look long and hard at whether they should extend the five year period to six years in this particular case. There is nothing in the legislation to prevent WINZ from extending the five year period in a proper case.
2.6 GST Implications
In the case of in specie gifts of assets to a family trust, and in the case of a sale of those assets to the family trust at full market value with an immediate gift of the sale price, there may be GST implications of the transfer. These are addressed in greater detail in paragraph 4 and its subparagraphs below.
2.7 Income Tax Implications
There may be income tax implications associated with gifting or selling any assets to a family trust, whether or not a sale at full market value is accompanied by an immediate gift of the sale price. The income tax implications are discussed at further length in paragraph 5 and its subparagraphs below.
- Allowing for Contingent Liabilities
We have seen in paragraph 2.1 above that there can be significant risks for a client who elects to gift their entire net worth (on the assumption that contingent liabilities such as guarantees are regarded as zero) to a family trust without properly allowing for the contingent liabilities in some way. Where a client who owes contingent liabilities (eg guarantees) elects to gift assets to a trust, the following precautions should be observed:
3.1 Do not gift the client's full net worth, on the basis contingent liabilities are valued at nil, to a trust as otherwise the whole gift is at risk of being set aside under Section 348 PLA 2007 and/or Sections 194, 198, 204, and 205 Insolvency Act 2006.
3.2 Always sell assets for the full market value to the trust for a debt back (as opposed to gifting the assets in specie), and then gift off the debt. That way, any capital appreciation of the assets arguably falls outside what can be "clawed back" as in general only the debt can be "clawed back": Section 348(2)(a) PLA 2007, Sections 204 and 205 Insolvency Act 2006.
3.3 If contingent liabilities are small in amount, leave assets outside the family trust sufficient to cover them, eg, personal furniture and effects, personal bank account, personal vehicles, etc. The assets left outside the family trust should be documented, so that the client can if necessary prove that he was solvent at the time of gifting the bulk of his assets to a family trust.
3.4 If the contingent liabilities are large in amount (eg the client owns a substantial company and has given very large personal guarantees in respect of its liabilities), arrange for the trust to indemnify the donor in respect of the contingent liabilities, on the following basis:
3.4.1 Indemnities should be limited to the amount of the contingent liabilities after the guarantor has exhausted his rights of subrogation. The guarantors right of subrogation is to stand in the shoes of the guaranteed creditor, after paying out the guaranteed creditor, and enforcing the guaranteed creditor's securities and rights to recover what the guarantor can. In the case of, for example, a relatively low mortgage on a valuable property, the guarantor's rights of subrogation mean that the guarantor effectively has no personal contingent liability on his or her guarantee. This should be reflected in the wording of the indemnity of the trust in favour of the guarantor.
3.4.2 The indemnity should be carefully limited to only those contingent liabilities existing at the date of the gift. This means that if the guarantor/client later refinances elsewhere, the indemnity will not extend to the replacement guarantees, ie refinancing later may well have the effect of reducing the indemnity from the family trust to zero. Similarly, if the borrowings personally guaranteed are later increased, the indemnity should not apply to the increase unless of course the secured creditor makes it a condition of the increase that the family trust's indemnity will increase in tandem.
3.4.3 The indemnity should be on a reducing value basis, so that as guaranteed term liabilities are paid off, the indemnity reduces in tandem.
3.4.4 A speculative possibility is that a family trust indemnity of a guarantee of a bank overdraft could reduce as credits are made to the overdrawn bank account, on the basis of Clayton's case, ie the indemnity would not apply to the overdraft limit but would only apply to the amount outstanding at the date of gift which amount would reduce to zero as credits are made to the overdrawn account. I personally would regard this as quite a high risk strategy, and I would make sure that any client who wished to embark down this track was well aware of the risks involved should he or she get into difficulties later.
3.4.5 If the client goes bankrupt, then the indemnity from the family trust should be worded to be limited to the lesser of:
(a) The limit established under 3.4.1-3.4.4 above, and
(b) The Official Assignee's estimate of contingent liabilities under Section 251 of the Insolvency Act 2006, less dividends from the bankrupt's estate. Under that Section, the Official Assignee can estimate a claim in the bankrupt's estate that is subject to a contingency or is otherwise uncertain. Under Section 252 of that Act, the Official Assignee's estimate can be appealed to the High Court. The Courts have traditionally been quite generous in discounting contingent claims eg Poulgrain & Others v Stirling (1981) 5 NZTC 61, 331, where the Court of Appeal fixed a contingent liability for estate duty at a mere $8,500 in respect of assets of $90,000 where the estate duty could have been a substantial sum. This reflects the fact that the Courts tend to take a very "broad brush" and even generous approach to valuing contingencies, and this could have the effect of reducing the family trust's exposure on its indemnity to a generously low sum in at least some circumstances.
3.5 Can the Property (Relationships) Act 1976 be used to transfer half of the marital assets to a spouse where say the husband owes contingent liabilities? The answer, in general, is "no": Sections 25(2) and 47 of the Property (Relationships) Act 1976.
- GST Implications
4.1 If our recommendation of transferring the assets at full market value is followed, then there will be no change in GST implications from previous practice. That is, the effect and incidence of GST needs to be allowed for. This may require the input of chartered accountants, and in fact it will be good practice to always involve the client's accountant, especially if income producing assets are to be transferred to a trust.
4.2 If the assets are gifted to a family trust in specie (ie in kind), then GST will be generally assessable on the current market value of the property gifted: Sections 5 and 10(3) of the GST Act.
- Income Tax Implications
5.1 If our recommendation of transferring at full market value is followed, followed by an immediate gift of the sale price, then the income tax implications will be as per previous practice. In particular, it is necessary to watch for depreciation recoveries - if they are likely to be high, consider vesting the asset in the family trust by Court Order under the Property (Relationships) Act 1976, although this process will now be a lot easier as we no longer have to worry about gift duty implications (which meant that the process of getting a Court Order to vest the family trust was formerly quite complicated). If shares are to be transferred, ensure that you discuss the implications of this with a Chartered Accountant, as it may be necessary to take steps to ensure (for example) that unused imputation credits are not lost.
5.2 It appears not to be an option to transfer depreciable property for nil consideration to a trust as an in specie transfer, because the trust will generally be unable to claim a depreciation deduction on the depreciable asset as it will have been acquired at a nil value: Section EE40(7) Income Tax Act 2007.
5.3 It is essential to seek advice from the client's chartered accountant before transferring financial arrangements (including shareholder loans and shareholder current accounts), livestock, company shares, and depreciated property. There is or may be taxation implications associated with transferring these assets, especially for a nil consideration. Again, it will be good practice to always involve the client's accountant, especially if income producing assets are to be transferred to a trust.
- Some General Implications of the Abolition of Gift Duty
6.1 Trusts should be created, and net worth (subject to contingent liabilities) transferred to them, before signing personal guarantees or going into business.
6.2 Lack of gift duties provides a new mechanism to extend the life of trusts. If a trust expires, and the beneficiaries desire to continue on the trust, but it is not possible without breaching the rule against perpetuities, then the entire property of the trust can be distributed to one of the beneficiaries who has no contingent liabilities, and then the beneficiary can resettle all that property on a brand new trust for the same class of beneficiaries as before, all without paying gift duty. Before the abolition of gift duties, it was extremely difficult to extend the life of the trusts which reached the end of their life, but which could not be extended without breaching the rule against perpetuities. This effectively means that assets like family farms can be sheltered in a succession of family trusts of potentially indefinite duration.
6.3 The lack of gift duties enables proper protection of personal assets before relationships begin - Section 44C of the Property (Relationships) Act 1976 only applies to gifts made during the relationship. Hence clients can divest all their assets, before a relationship begins, to a family trust where the assets will generally be immune from claims under the Property (Relationships) Act 1976 as the gift was made before the relationship began. There will also be increased scope to gift assets to family trusts during the first three years of a marriage, civil union, and de facto relationship, although to be absolutely safe the gift should occur before the relationship begins.
6.4 Can companies now gift company assets to a family trust of the shareholders? A gift by a company to a shareholder's family trust will generally be a taxable dividend (Sections CD4, CD5, and CD6 of the Income Tax Act 2007) unless the gift can be fitted within a non-dividend return of capital - eg an off market cancellation of shares, etc. It will also be necessary to meet the solvency test of the Companies Act 1993 and otherwise comply with that Act.
6.5 Prior to the abolition of gift duty, it was necessary to do the conveyancing steps in a very precise and technical order when reserving a life interest in a family home where the reversion was being gifted to a family trust - if one got the order wrong, then one could create a dutiable gift and even income tax liabilities in some circumstances. The abolition of gift duty means that reserving life interests will now be much easier, and much less fraught with peril for the conveyancer involved.
6.6 As will be apparent from the above, for many clients one cannot just simply make an immediate gift of their entire net worth to a family trust. Even the immediate completion of the gifting programme requires care and requires observation of the principles in paragraph 3 above in particular.
6.7 There will still need to be an annual round of gifting for many clients e.g. where the family home is gifted to a trust, and the client advances funds to the trust each year to meet the mortgage, rates, insurance, and repairs and maintenance - in these types of situations, the client advances to the trust should be written off by way of gift at regular intervals, and once a year seems a good frequency to attend to this.
6.8 Even where there is no need to have such an annual gifting program, it will still be good practice to convene a meeting of the trustees annually to review the trust investments, sign the annual financial statements, and sign the annual trust resolutions, as doing these things will reduce the likelihood of the trust failing through becoming a sham.
- Conclusion
For some clients, the abolition of gift duty means they can gift their entire assets immediately to a family trust without fear of potential adverse repercussions. For many and perhaps even most, however, the abolition of gift duty will not allow an immediate gift of the client's entire net worth to a family trust - it is still necessary to navigate many traps and potential pit falls, the most important of which have been set out above.
Written by Dennis J King - Director www.denniskinglaw.com
Disclaimer: This newsletter discusses its topic in general terms and should not be relied upon as legal advice