Promissory notes a ‘last resort’ for gift and loan back arrangements

Gift and loan back arrangements can still work if implemented correctly despite some recent court decisions that challenge their effectiveness, according to Cooper Grace Ward Lawyers.

Senior associate Keeghan Silcock said the arrangements, which are essentially an asset protection strategy, involve an individual gifting an amount of money to a related lower risk entity, usually a discretionary trust.

That entity then lends the same amount of money back to that same individual and takes security over one or more assets of that individual for the loan.

“There have been some recent decisions out of the courts which are putting these gift and loan back arrangements at some additional risk,” said Ms Silcock at the CGW Annual Adviser Conference.

However, accountants and their clients can minimise some of the risks with these arrangements by following the right steps, said Cooper Grace Ward Lawyers partner Clinton Jackson.

“The number one tip is to avoid using promissory notes. Find a way to get the cash. Scrimp and save or take a little from somewhere else, do what you need to do and transfer the cash,” said Mr Jackson speaking in the same session.

In the decision Re Permewan (No 2), handed down the Queensland Supreme Court last year, the gift and loan back arrangement was invalidated by the court because the transaction was implemented using a promissory note.

“A promissory note involves the individual gifting the amount of money to a related entity, using a document that specially prepared promising to pay that amount to the entity rather than actually cash flowing that transaction using money,” said Ms Silcock.

“In Re Permewan (No 2), the way that the promissory note was prepared didn’t satisfy the technical requirements of the Bills of Exchange Act [1909].”

These arrangements should therefore be implemented using cash with the use of a promissory note substantially increasing the risk.

One way that clients might be able to get the cash for the arrangement is by talking out a short term loan with their bank.

“If you’ve got a great relationship with your banking manager, potentially, you could get a same day loan. So the bank could transfer the money into [the client’s] bank account and then from their personal bank account into a personal bank account that’s been set up for a trust,” said Ms Silcock.

“That money then needs to be lent back from the trust to [the client] so there will be another transfer from the trust to back to the personal account. That way we can see that the cash flow has actually happened.”

Once that money has hit the client’s personal bank account, the money can then be immediately repaid to the bank.

“So if you’ve got a great bank manager, they can do that transaction in the same day [as a] short term loan.”

Ms Silcock said it is also vital that any documents prepared in respect of the arrangement satisfy all the technical requirements, are signed properly and where appropriate, are registered.

Proper legal documents should be in place for the deed of gift, the loan agreement and the mortgage.

“We need to have the paperwork to prove what the transaction is,” said Mr Jackson.

“[Also] when we have that cash transfer go across from the bank account to the trust account, we prefer it to say ‘gift’ in the transaction history. It’s not the end of the world because we’ve got the piece of paper to support it but it’s great to have everything match up.

“When we transfer it back from the trust to the personal account, we then want the transaction to say ‘loan’.”

This will ensure that alongside the legal documents, there will also be an independent record of what has actually happened with the bank statements showing the movement of cash.

Mr Jackson said the gift and loan back arrangement should also include commercial terms to prevent it being considered a sham arrangement.

“Often when we see these arrangements implemented, there is a loan agreement with no fixed repayment date and no repayment requirements. We should consider having some commercial terms in that loan such as interest being charged or periodic payments to actually prove to third parties that there is a genuine loan there,” he said.

“This will be an important plank of what we do in the future.”

Ms Silcock said there should also be a valuation or an appraisal in place to support the amount that is being gifted and loaned back.

Considering the impact of these arrangements on eligibility for the Age Pension is another critical step. 

“If a [client] was in receipt of the age pension, their main residence doesn’t get taken into account as part of the assets test for eligibility for the Age Pension. [However], if they’re gifting $2 million into a related trust and then getting it back, that could impact upon their eligibility for the Age Pension,” said Ms Silcock.

“So make sure you ask clients if they’re receiving the Age Pension before you implement this and consider whether these transactions will affect their eligibility.”