Gift and Loan Arrangements – There is more you should know
Gift, loan and mortgage arrangements can be an important component of an asset protection strategy. Typically, the arrangement involves at risk individuals gifting equity in assets to a related, lower risk entity, such as a discretionary trust (Protected Trust). The Protected Trust then loans an equal sum of money back to the at-risk individuals and takes security, by way of registered mortgage or other appropriate security (e.g. a security interest) over one or more assets of the at-risk individuals. The purpose being to provide a legal right to reclaim the funds advanced, protecting assets of the at-risk individuals from claims by third parties.
Effectiveness against bankruptcy claims
In the context of bankruptcy of the at-risk individuals, it is key that the Protected Trust, under the loan and mortgage documentation, has the right to call on the assets as payment for the secured loan. The right to the equity in the secured asset thereby becomes an asset of the Protected Trust and in turn, is no longer an asset of the at-risk individuals’ asset pool, which may be exposed to unsecured creditors.
The arrangement, however, does not come without risks. Each transaction, namely, the gift, loan and mortgage, need to be separately considered and implemented correctly to ensure that the overall transaction is successful in achieving the asset protection sought. Particularly, in considering the gift component, in the context of bankruptcy of the at-risk individual, the provisions of the Bankruptcy Act 1996 (Cth) (Bankruptcy Act) can apply to render the gift void against the trustee in bankruptcy. In such circumstances, the timing of the gift and the date of the bankruptcy event are key under the anti-avoidance provisions contained in section 120 of the Bankruptcy Act.
Section 121 of the Bankruptcy Act should also be considered. This section of the Bankruptcy Act requires the gift to be a ‘genuine transaction’, examined on a case-by-case basis, as to whether the main purpose of the arrangement was to prevent assets from being available to creditors. Therefore, it is critical that there is a clear record of funds exchanging hands.
When considering the loan component of the arrangement, the loan must operate to provide the Protected Trust with the right to call on the debt owed by the at-risk individuals. It must also allow for security to be taken by way of registered mortgage. The effectiveness of the arrangement has over time been considered by the Courts. It has been held that the loan term must be clearly definable and certain, repayment must be due shortly after the Protected Trust calls for repayment.
The final step in the arrangement is that of the mortgage. The mortgage must have the ability to be, and should be, registered. In circumstances where there is an existing mortgage is registered over the property, consent is required from the existing mortgagee to the registration of a second ranking mortgage. Security interests are registered on the Personal Properties Security Register and generally rank in priority based on the time of registration, making early registration critical.
From a commercial perspective, it is also important to consider:
Liquidity of funds, or the ability to borrow funds, to ensure funds are exchanged the arrangement is not held to be invalid.
Equity can change over time and should be regularly reviewed. Only existing equity at the time of the transaction is protected and fluctuations in market value can impact on the level of asset protection provided.
Use in the context of family dealings
For parents who advance funds to their children, and those children then become involved in family law proceedings, if implements correctly, the arrangement has the ability to protect the funds advanced from being considered part of the ‘pool’ for a property settlement between the parties. In such circumstances, the arrangement must be formalised and appropriately documented so that the parents, advancing the funds, can call upon the amount advanced. A clear delineation must be able to be established between the fund advanced being classified as a loan, rather than a mere gift.
The Courts approach
The Queensland Supreme Court decision of Re Permewan (No 2) declared that a gift and loan arrangement was invalid. In this decision, the arrangement was signed using a promissory note, where an individual promised to pay a related entity by document, rather than a physical exchange of money. The Court, in their finding that the arrangement was unenforceable, considered three key elements of the transaction:
Firstly, the Court was ‘almost certain’ the arrangement was a ‘sham’ as there appeared to be no intention to pay back the loan to the trust in question, and the trust never intended to call on payment of the loan.
Secondly, the transaction was considered ‘contrary to public policy’ as it was an attempt to circumvent the family provision proceedings under the Succession Act 1981 (Qld).
Finally, there was no evidence that the promissory note had been delivered by the trustee of the trust to the individual, and therefore, the transaction was technically never completed.
Key takeaways
Gift and loan arrangements can be effective in providing asset protection for at risk individuals, or parents wanting to advance funds to their children. In considering the effectiveness of the arrangement, care must be taken to document the transactions correctly and to take the appropriate security over assets to mitigate the risk of the arrangement being deemed unenforceable if ever brought before the Court.
Appropriate legal and financial advice should be obtained prior to entering to this type of arrangement.
For further information please contact:
Alasdair Woodford
Principal
T: 03 5225 5217 | M: 0436 456 144
E: awoodford@ha.legal
Joseph Flanagan
Senior Associate
T: 03 5226 8504 | M: 0491 307 550
E: jflanagan@ha.legal
Tayla Berger
Senior Associate
T: 03 5226 8559 | M: 0407 825 365
E: tberger@ha.legal
Madeline Thompson
Law Clerk
mthompson@ha.legal
