by John Wojtowicz (Director - Law Central Legal)

“Before borrowing money from a friend decide which you need most.” (American Proverb)

A debt is usually a legal obligation for a natural person or entity (the Debtor) to pay a certain amount of money to a person or entity (the Creditor) by a certain date. This obligation is usually created as a result of a contract (verbal or written) being entered into. It can also arise from other circumstances such as from a court order or in certain circumstances from unpaid trust distributions that have been lent back to the trust.

Debts are considered to be property and therefore an asset of the Creditor. They are a “legal chose in action” that can be forgiven or assigned.

Particular issues relating to debts

1. Loans/unpaid trust allocations

A family/discretionary trust may resolve to distribute certain income/capital to a beneficiary. That beneficiary may not physically receive the monies in his or her bank account but nonetheless be recorded in the trust book of accounts as the beneficiary having been entitled to the funds distributed to him or her.

It is common for many accountants when preparing the accounts for a family trust not to distinguish between an unpaid trust allocation to a beneficiary and a loan from a beneficiary to the trust.

A point of difference here, is that a loan is subject to a limitation period (i.e. proceedings must be brought within 6 years of the loan being due to be repaid) whereas an unpaid trust allocation is not subject to the Limitation Act/Limitation of Actions Act in certain States of Australia, therefore allowing for demand for payment to be made much later. Each State has a Limitation Act/Limitation of Actions Act stating what time period an action must be commenced within to recover monies from a breach of trust. For instance the position in Victoria is different to Western Australia where the limitation period is 6 years.

It is common when a loan account exists for it to be payable on demand by the creditor.

Where the beneficiary of a trust is a Creditor and one of the following situations arise:

1. a dispute between the beneficiary and the trustee;

2. a dispute between the beneficiary and other beneficiaries to the trust;

3. a dispute between the beneficiary and his/her spouse;

4. the beneficiary, being an individual, goes bankrupt;

5. the beneficiary, being a company, goes into liquidation;

6. the beneficiary loan account being subject to the control of a receiver or agent as a result of the beneficiary providing a security interest over the beneficiary loan under the PPSA to a third party;

7. the beneficiary loan account being assigned or sold to a third party who may wish to recover the debt,

then there is a strong likelihood that a demand for repayment of the loan will be made against the trust.

2. Family court proceedings

Should a Creditor be involved in Family Court proceedings, then the debt will in all probability form part of the asset pool subject to the Family Court proceedings. In particular, the Family Court has powers to deal with the family trust loan accounts. Our Gold and Platinum members should read our platinum content to see an example of this.

How is a debt forgiven?

Primarily, Debts are forgiven in 2 ways:

1. Deed of debt forgiveness;

2. Where the Creditor is a natural person, he may elect to do so through his Will.

Often debts are forgiven due to the relationship between the Creditor and Debtor. The term often used is that the debt is forgiven on the grounds of “natural love and affection”. This term is also used in section 245-40(e) of the Income Tax Assessment Act 1997 (the Act) relating to the forgiveness of commercial debts provisions of the Act.

Natural love and affection as consideration for forgiving a debt may not always constitute sufficient consideration to support a promise. The case of DPP v Le [2007] HCA 52 discusses this point.

Interestingly, the Australian Taxation Office, in ATO Interpretative Decision 2003/589, holds the view that a Creditor is not required to be a natural person to forgive a debt for reasons of natural love and affection.

The entering into of a Deed of Debt Forgiveness dispenses with the consideration issues as no consideration is required when the parties enter into a Deed.

The situation where a beneficiary has an unpaid trust allocation as opposed to a loan being owed to him from the trust needs to be dealt with differently. It may be the case that the beneficiary, if he has not accepted the distribution, will need to ‘disclaim’ his entitlement. How and when this can be done and the tax ramifications of a disclaimer of gift will be looked at in a future newsletter.

Bankruptcy Act 1966 (Bankruptcy Act)

If a person forgives a debt and that person subsequently goes bankrupt, then the debt could be clawed back as an asset of the bankrupt’s estate. The trustee administering the bankrupt’s estate could form the view that the forgiving of the debt was  an undervalued transaction which may be subject to the claw back provisions of the Bankruptcy Act.

Tax Implications

There may be tax consequences as a result of a debt being forgiven. The tax areas that may arise:

1. deductibility of interest;

2. capital gains tax;

3. fringe benefits tax – where the Debtor is an employee of the Creditor;

4. commercial debt forgiveness provisions;

5. other provisions of the tax legislation; and

6. stamp duty/transfer duty.

These tax issues will be discussed in more detail in future newsletters.

Gold and Platinum Members read on for more information of how the Family Court has powers to deal with the family trust loan accounts.

Disclaimer: The content of this Bulletin is general information only. It is not legal advice. Law Central Legal recommends you seek professional advice before taking any action based on the content of this Bulletin.