Weekend Money: Taxwise by Denham Martin

Forgiving debt works only for your loved ones

People considering transfering assets into a trust should be pleased by the proposed legislation addressing some income tax concerns over the forgiveness of debts owed by trustees.

Those concerns stem from the earlier draft of this proposed legislation and a draft ruling released by Inland Revenue late last year, which were discussed in this column at the time.

By way of background, significant amounts of wealth cannot simply be transferred into a trust without incurring a large gift duty liability. Consequently, what is typically done is that an asset is sold to the trustees for its market value with the purchase price being left outstanding as a debt. If that debt is then forgiven over time, gift duty can be avoided.

While the adoption of a debt forgiveness programme removes the concern over gift duty, it gives rise to a separate concern over income tax. This is because the forgiveness of a debt as a general rule constitutes taxable income of the debtor.

However, the general rule does not apply if the debt is forgiven in consideration of "natural love and affection. This raises the issue of whether the natural love and affection exemption applies to the forgiveness of debt owed by trustees.

The position adopted by Inland Revenue in its draft ruling is that the exemption does not apply if the beneficiaries of the trust include entities for which the forgiver cannot have natural love and affection.

Inland Revenue considers that natural love and affection is normally only felt for close relatives and lifelong friends - people are supposedly unable to have natural love and affection for companies and charitable organisations.

As most family trusts include charities within the class of beneficiaries that may receive distributions at the discretion of the trustees, any debt forgiveness made to such trusts would not be covered by the natural love exemption and, consequently, would be exposed to income tax.

The revised draft of the proposed legislation ameliorates the practical problem. It provides that the trustees would not be disqualified from being able to claim the exemption if the trust had charitable beneficiaries.

Further, debt forgiveness made in respect of trusts with other types of beneficiaries, such as companies, is to only give rise to taxable income to the extent that distributions are actually made to those beneficiaries.

The position under the proposed legislation is not ideal, however, for the following reasons:

* The legislation is to apply only to debt forgiveness made after it is enacted, so trustee debts that have already been forgiven remain exposed to possible assessment by Inland Revenue.

* Uncertainty still surrounds the tests to be applied in order to determine whether natural love and affection exists.

* Uncertainty also surrounds the requirement that the trust is to have been established "primarily to benefit
natural persons for whom the forgiver has natural love and affection, together with charities.

* The necessity to maintain records of debts forgiven and distributions made for the entire life of the trust is an onerous practical requirement for trustees.

The proposed legislation is almost at enactment stage and it is unlikely that further significant changes will be made.

Therefore, those involved with family trusts that have charities within the beneficiary class and who had suspended their gifting programmes in light of the draft ruling look set to be able to resume those programmes in the near future.

However, people must still consider these matters when establishing a trust and the transfer of wealth into that trust by way of debt forgiveness.

* Denham Martin is the principal of Denham Martin & Associates, lawyers specialising in advice on taxation and related matters.