ES­TATE PLAN­NING PIT­FALLS

Finweek English Edition - - Private Buy - PRO­FES­SOR PETER SUR­TEES

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.

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