When exactly is a related party debt statute barred?

For those that do not otherwise have access to the Weekly Tax Bulletin, a further recent article is extracted below.

The case of Re Breakwell and FCT [2015] AATA 628 (25 August 2015, reported at 2015 WTB 37 [1393]) highlighted a common trap in relation to the circumstances where a related party debt will be statute barred. The decision, which was upheld on appeal in Breakwell v FCT [2015] FCA 1471 (22 December 2015, reported at 2016 WTB 1 [27]) remains a timely reminder of the critical interplay between various legislative provisions that practitioners must be constantly aware of.

Breakwell

In Breakwell, the taxpayer argued that a $1.1 million debt owed by him to a family trust should not be included in the calculation of the trust's net assets under the maximum net asset value test for the small business CGT concessions under Div 152 of the ITAA 1997. The basis of the argument was that the debt had arisen prior to 1998 and was therefore outside the 6-year period provided for under the Limitation of Actions Act 1936 (SA).

In this regard, as noted by White J in the Federal Court decision, the relevant section in South Australia is not a bar to proceedings, rather, it creates a defence which bars the granting of a remedy. Similar legislation applies in every State and Territory except in New South Wales, where a creditor's right to the debt is effectively extinguished after the expiry of the limitation period.

Specifically, the taxpayer claimed that because no repayments had been made and he had not acknowledged the existence of the debt in writing, the debt had become statute barred meaning the family trust could no longer enforce repayment of the debt.

In finding against the taxpayer, the Administrative Appeals Tribunal noted that the taxpayer had signed the balance sheets for the family trust for the 2003 to 2008 income tax years (in his capacity as trustee). It was held that the signature on the balance sheets was sufficient to constitute an acknowledgement by him (as the borrower) of the existence of the debt.

This meant the debt was not statute barred and was required to be included in the calculation of the trust's maximum net asset value.

The taxpayer was unsuccessful in appealing the decision to the Federal Court, as previously reported by Jack Stuk and Danielle Gorman (see 2016 WTB 7 [181]). In brief, White J also raised a number of alternative methods by which the loan could effectively be recovered, including:

• the taxpayer as trustee of the family trust would face a duty-interest conflict in raising the limitation of actions defence; 
• the South Australian legislation (which differs from other States in this respect) allows for an extension of the limitation period; and 
• through an action by the trustee to recover trust property, which was again due to differences in the South Australian legislation as it has no limitation period in this regard. 

Why are the statute barred rules so important?

Determining whether a debt has become statute barred can be relevant in a number of areas, for example:

• From a commercial perspective, ensuring the lender has the ability to demand the repayment of the debt. 
• As highlighted in Breakwell, for determining whether or not a debt should be included in the maximum net asset value test under Div 152 of the ITAA 1997. 
• Under Div 7A of the ITAA 1936, which treats a debt that has become statute barred as being forgiven (and therefore potentially gives rise to a deemed dividend). 
• For determining whether a bad debt deduction can be claimed (see for instance TR 92/18). 
• Estate planning, particularly (for example) where there are debts owed by a trust to a will maker and certain beneficiaries are intended to control the trust, with others to benefit under the will. 
• Asset protection, particularly if the "gift and loan back" strategy has been implemented (see for example our article reported at 2013 WTB [1821]). 

The key issue – the start date

In this context, it is obviously important to determine the date on which a loan is deemed to begin.

Historically, there has been some support for the argument that the start date for limitation period purposes was the date that a demand was made for repayment of the debt or the last date a formal acknowledgement (including by way of part payment) was made.

This position was at least partially due to the fact that under the relevant limitation legislation, an acknowledgement must generally be made in writing by the debtor to the creditor, and be signed by the debtor.

The "acknowledgment" debate
Although the relevant legislation is slightly different in each State and Territory across Australia, the general test to determine if a debt has become statute barred is whether, within the relevant period (typically 6 years for unsecured debts and 12 years for secured debts) there has been either:

• a partial repayment by the borrower; or 
• a written acknowledgement of the existence of the debt signed by the borrower and addressed to the lender. 

Although these tests would seem fairly straight forward, there is some debate as to whether the written acknowledgement must be intended by the borrower to be an acknowledgement to the lender of the existence of the debt.

In VL Finance Pty Ltd v Legudi [2003] VSC 57 (13 March 2003) (in the context of the Victorian legislation), Justice Nettle (then sitting on the Victorian Supreme Court) held that any acknowledgement must be intended by the borrower to be an acknowledgement to the lender of the existence of the debt.

Therefore, the mere signing of financial statements by the borrower in their capacity as a trustee or director will not be sufficient to "refresh" the debt. Importantly, it was also held that the limitation period (at least for the purposes of Div 7A of the ITAA 1936) begins to run immediately on the date that an at-call loan is made; not from the time when the first call for repayment is made.

By contrast, Lonsdale Sand & Metal v FCT [1998] FCA 155 (5 March 1998) (in relation to the South Australian legislation) and now Breakwell have both concluded that the mere signing of the financial statements by the borrower will be sufficient to "restart the clock" on the recovery period.

Conclusion

The differences between the outcomes in relation to acknowledgments in VL Finance on one hand and Lonsdale and Breakwell on the other are hard to reconcile.

While it could be argued that VL Finance provided a far more robust analysis of the issue and reached a more reasoned conclusion, practitioners should be cautious relying on the decision given the conflicting judgments.

Nonetheless, some common themes can be identified from all 3 cases, including:

• An oral acknowledgement by the borrower by itself will be insufficient to "refresh" a debt, unless accompanied by some written acknowledgement. 
• The inclusion of a debt on the borrower's signed financial statements should be insufficient to "refresh" the debt, unless it can be shown that those financial statements were subsequently provided to the lender with the intention of acknowledging the existence of the debt. 
• Where the debts are owed between entities with common directors, the signing of the lender's financial statements by a director who is also a director of the borrower will likely be seen by the ATO to be sufficient to "refresh" the debt. 

Ultimately, practitioners should be wary of advising clients that debts have been statute barred where the debts are between related parties.

This issue is generally most relevant if a client wishes to rely on PS LA 2006/2 (GA), which provides administrative relief from Div 7A where loans which arose prior to the introduction of those provisions in 1997 become statute barred. In this factual situation, it is critical to review the financial statements for each relevant financial year. The analysis must focus on whether it could be argued that the debt has at any time been "refreshed" by virtue of the borrower signing the financial statements in their capacity as a trustee or director.

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The Blues Brothers and protecting family trust assets

As set out in earlier posts, and with thanks to the Television Education Network, today’s post considers the above mentioned topic in a ‘vidcast’ at the following link - https://youtu.be/kOMhiXHR-5A

As usual, an edited transcript of the presentation for those that cannot (or choose not) to view it is below –

The case of Morton & Morton (email me if you want a copy of the decision) is one we often refer to as the Blues Brothers’ case.

The structure was a corporate trustee where there were two shareholders. Those two shareholders were brother 1 and brother 2.

The percentage share that they each had was 50%. The two brothers were the two directors. There were two primary beneficiaries, being the two brothers. You might start to see a pattern with this one.

There were two appointors – again, brother 1 and brother 2. The one point of distinction was there was one bucket company, so one corporate beneficiary. That bucket company was owned by the family trust itself.

Brother 1 was busting up with his wife. Her argument was ‘everything is 50-50 here. Clearly, my husband is entitled to 50% of the trust assets because he’s got 50% of the control, got 50% of the appointorship, got 50% of the shareholding, got 50% of the distributions.’

‘My husband is entitled to 50% of everything and therefore I'm entitled to a percentage share of his 50%.’

The court said no. The court said because all relevant aspects are 50-50 for each brother, then this is in fact analogous to each brother effectively having 0%, because it was the same as nothing. Thus, the assets of the trust were protected.

Ultimately, the Blues Brothers case is a really important decision. It is a decision that should give everybody confidence that structured properly, trusts can be a very powerful instrument in the context of matrimonial breakdowns.

Inside Stories - latest View book release

One of key goals at View is ensuring that we have ‘written the book’ for every aspect of the law we specialise in.

Following the successful launch of books in estate planning, tax, trusts, entity structuring, testamentary trusts, SMSFs and business succession, we have now developed and launched another book – Collection of Inside Stories (Reference Guide).

This is the 6th edition of the book and contains all posts over the last seven years, edited to ensure every post is current and organised into chapters for each key area.

There are chapters on topics including estate planning, trusts, asset protection, superannuation, structuring and powers of attorney.

All of the View books (over 15 at last count) can be accessed via our website – see - https://viewlegal.com.au/product-category/books/

Anyone who likes or shares this post over the next week will go into the draw to win a free copy of the latest edition of Inside Stories.

Changing trustees of trusts – Simple in theory … not so simple in practice

For those that do not otherwise have access to the Weekly Tax Bulletin, a further recent article is extracted below.

The decision in Balcaskie Investments Pty Limited v Chief Comr of State Revenue [2017] NSWCATAD 19 ("Balcaskie") was reported at 2017 WTB 4 [120].

The case is a timely reminder of the critical issues that can arise from a revenue perspective in relation to the superficially simple area of changing the trustee of a trust.

The starting point for any change of trusteeship is always the terms of the trust deed. In this regard, the 'read the deed' mantra has been regularly highlighted by us.

Assuming the trust deed creates the relevant power and the change of trustee documentation follows the procedure mandated by the trust instrument, there are 2 key revenue issues to be aware of, namely

1. Capital gains tax ("CGT");
2. Stamp duty provisions in the relevant jurisdiction (in the case of Balcaskie – NSW). 

Each of these issues is considered in turn below.

CGT consequences

Arguably the most commonly triggered CGT event is the disposal of a CGT asset (being CGT event A1).

A question that regularly arises, particularly in estate planning and asset protection exercises, is whether a change of trustee triggers CGT event A1.

Relevantly, s 104-10 of the ITAA 1997 provides as follows:

1. CGT event A1 happens if you dispose of a CGT asset; and 
2. you dispose of a CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law. However, a change of ownership does not occur: 

1. if you stop being the legal owner of the asset but continue to be its beneficiary owner; 
2. merely because of a change of trustee. 

Therefore, it is generally accepted that CGT event A1 does not occur as a result of a change in the trustee and the ATO acknowledges this position in Tax Determination TD 2001/26.

Similarly, there are numerous private binding rulings ("PBRs") that confirm the same outcome, such as PBR 1011623239706.

Stamp duty consequences

Unfortunately, while there are generally no stamp duty consequences for changing a trustee, the rules to gain access to the relevant exemption are different in each state.

Generally however, an exemption should be able to be accessed to mirror the revenue neutral CGT position, with the requirements likely to include at least the following:

1. the dutiable transaction was undertaken for the sole purpose of giving effect to a change of trustee; 
2. the transaction is not part of an arrangement: 

1. involving a change in the rights or interests of the beneficiary of the trust; 
2. terminating the trust; and 

3. transfer duty has been paid on all trust acquisitions for which transfer duty is imposed for the trust before the transaction. 

It is important to note that each state adopts its own approach in this area, and (for example) in New South Wales, additional requirements must be met including that the new trustee cannot be a beneficiary of the relevant trust.

Section 54(3) of the Duties Act 1997 (NSW) limits the nominal duty exemption for a change of trustee to trust deeds that contain provisions ensuring that:

1. none of the continuing trustees remaining after the appointment of a new trustee are or can become a beneficiary under the trust; 
2. none of the trustees of the trust after the appointment of a new trustee are or can become a beneficiary under the trust; and 
3. the transfer is not part of a scheme for conferring an interest, in relation to the trust property, on a new trustee or any other person, whether as a beneficiary or otherwise, to the detriment of the beneficial interest or potential beneficial interest of any person. 

This prohibition is relevant for trusts established in NSW obviously. It is however also relevant in other jurisdictions as well because many trust deed providers are based in NSW, or rely on precedents originally sourced from NSW.

In addition, the NSW requirements will need to be satisfied where a trust which has been established in another jurisdiction owns dutiable property in NSW.

As noted in Balcaskie, prior to the case, there had not been a reported decision interpreting the way in which the stamp duty exemption on changing a trustee under the NSW rules operates.

The trust deed in Balcaskie had a specific clause (inserted by a deed of variation some years after the deed was originally settled) that required any change of trustee to comply with the NSW stamp duty rules to ensure access to duty relief.

In particular, the relevant clause stated –

"The Original Trustee and the New Trustee and any future and past trustees are absolutely prohibited from being a beneficiary under the Trust Deed or from otherwise directly or indirectly benefiting under the Trust Deed and this clause will not be capable of amendment or revocation."
The separate power of variation clause in the trust deed was very widely crafted, and on the reading adopted by the NSW Office of State Revenue ("OSR"), created the power for the trustee to amend (and potentially remove) the above mentioned prohibition.

This apparent power of variation meant (in the view of the OSR) that the duty exemption on changing the trustee was not available.

The NSW Civil and Administrative Tribunal decided the conflict solely on the basis of a fundamental rule of construction.

That rule being that a specific provision must be read as prevailing over a provision of general import.

In this case, the rule meant that the specific prohibition had priority over the general power of variation. In turn, the OSR was therefore required to grant the duty exemption on the change of trusteeship.

The case may also impact on the OSR's interpretation of the law in other areas – for instance, the NSW OSR has historically adopted the view that a trust will not qualify as a 'fixed trust' for land tax purposes if there is a power for the trustee to amend the trust deed in a manner which alters the fixed entitlement. The Balcaskie decision arguably means the OSR should be considering the terms of the fixed trust deed as they exist at a particular point in time, regardless of any power the trustee may have to subsequently amend those terms.

Conclusion – always start by reading the deed

As explained regularly in this Bulletin, given the range of significantly adverse consequences that can result where a purported change to a trust is subsequently found to be invalid, advisers should proactively invest in processes and systems to minimise the risk of such an outcome.

Invariably, best practice dictates that the starting point must be to read the trust deed.

There must then be a methodical analysis of all potential revenue consequences.

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