ESTATE PLANNING PITFALLS
INTER VIVOS TRUSTS are commonly used as estate planning tools. Typically, the trust is funded by interest-free loans from the founder of the trust, who bequeaths the loan to the trust on death so that the loan is extinguished. However, two recent court decisions may affect that practice. Where a debt owed by a person is reduced or discharged by the creditor for no consideration or for less than face value, the debtor will be subject to capital gains tax on the benefit. That’s commonly called forgiveness of debt.
In a recent tax court case: ITC 1793, a testatrix had sold shares to an inter vivos trust on a loan account during 2000. On her death in 2002 the loan account was bequeathed to the trust. The court found the bequest amounted to a discharge of the debt for no consideration and the trust was liable for CGT on the value of the loan.
That judgment failed to con- sider adequately the wording of the relevant paragraph in the legislation in relation to testamentary bequests. Further, it seems the executors didn’t use all the legal arguments available. As the decision wasn’t appealed it stands as it is for the time being.
However, a testator who wishes, upon death, to terminate a family trust’s obligation in respect of an interest-free loan can still achieve that without triggering the CGT consequence. A testator should bequeath to the trust an amount in cash at least equal to the value of the loan on the date of death, rather than bequeathing the loan to the trust. Thus the trust is a normal legatee and can then repay the loan, possibly using the cash that was bequeathed. In effect, there’s a bequest and, separately, repayment of a debt.
That doesn’t amount to forgiveness of the debt because two distinct obligations are settled by due performance by each debtor. Of course, the clause in the testator’s will would necessarily be carefully phrased and the bequest can’t be made on condition that the bequest is used to repay the loan.
The SA Revenue Service has indicated that parties wishing to adopt this strategy should act carefully, as an exchange of cheques may constitute a forgiveness of a debt.
The use of interest-free loans in general was recently considered in the now notorious Brummeria case, where it was found that an interest-free loan had a commercial value. The loan in that case was between the occupants of a retirement village and the developer. The occupant received a right to lifetime occupation in return for making an interest-free loan to the developer. The Supreme Court of Appeal found the loan had a value in the hands of the developer, based on its interest-free nature.
Unfortunately, the judgment was cryptically worded and it’s uncertain whether or not the receipt of an interest-free loan gives rise to a taxable benefit in the hands of the recipient only where the interest-free loan is in consideration for a supply or in all cases, irrespective of the facts. It does seem the court had in mind an interest-free loan that takes place in a business or trading environment where there was a quid pro quo such as a barter transaction. (See article by Tenk Loubser, Finweek, 27 September 2007.)
Most family trusts have received interest-free loans not as quid pro quo or consideration but as a loan granted on favourable terms by the lender. Accordingly, the right to interest-free use of the funds would be a receipt of a capital nature. Based on the reasoning in Brummeria that would exclude it from the definition of “gross income” in section 1 of the Income Tax Act.
Therefore, in the bulk of estate planning scenarios that involve trusts the use of interest-free loans shouldn’t give rise to the problem.