A bitter inheritance dispute between siblings has caused a light to be shone on the efficacy of 'gift and loan back' arrangements to protect assets. The popular strategy involves transferring the value, rather than the title, of assets between high-risk and low-risk entities to shield wealth from creditors or other claimants.

The Supreme Court of Queensland recently ruled one such arrangement at the centre of a will dispute was unenforceable, raising concerns about whether it is still an effective strategy. In my opinion, it is still a viable option, but with some important caveats that accountants should be aware of.

How do gift and loan back arrangementss work?

Let’s use an example. John Jones is a company director concerned about the risk of being sued for insolvent trading, or pursuant to personal guarantees. He owns a $3 million home that he still owes $1 million on the mortgage and wants to protect the remaining equity.

To effect a gift and loan back John gifts $2 million to the Jones Family Trust; then the Jones Family Trust loans John $2 million and secures the debt, by holding a mortgage over the house (that ranks behind the bank’s mortgage).

Once the arrangement’s in place, if a creditor sues John and the house is sold, the proceeds would be divided between the bank and the Jones Family Trust first, with none (or little, if the equity has increased over time) remaining to be distributed to other creditors. And because the title to the assets never changes hands – just the equity – these transactions generally don’t incur tax and stamp duty. However, best laid plans can come undone, particularly when it comes to asset protection.

A battle of wills

A recent decision of Justice Cooper of the Supreme Court of Queensland in Re Permewan No. 2 [2022] QSC 114 should prompt careful reconsideration of how gift and loan back arrangements are structured.

The case centres on a widowed matriarch who wanted to exclude her adult daughters from her will and leave her entire estate to her son.

The mother was concerned her daughters may challenge any will, so she entered into a gift-loan-back arrangement to put her assets beyond their reach. Before she died in 2019, the mother gifted $3 million – the total value of her assets – to a trust that was to be controlled by her son. The trust then `loaned’ $3 million back to her and took security over her assets – a house and company shares.

However, there was never any transfer of cash between the entities. The initial $3 million gift was made by way of a `promissory note’ – essentially a legal IOU.

Promissory notes are not commonly used and have exacting rules governing how they are executed. During the case it was conceded the promissory note was not `delivered’ as required and therefore never took effect. Despite this technicality voiding the arrangement, the court went on to consider whether it would have been enforceable, had the promissory note been valid.

Justice Cooper found the arrangements would also have been unenforceable on two grounds:

1. The arrangement was a sham, because the mother never intended to pay $3 million to the trust pursuant to the promissory note and

2. It was deceptive and contrary to public policy because its sole purpose was to thwart a potential challenge to the will under the family provision application regime of the Succession Act 1981 (Qld).

The takeaways

The decision has significant wider implications for anyone considering similar arrangements to protect assets.

The use of a promissory note is likely to be considered a sham. This issue can be overcome by actually transferring cash between the relevant bank accounts. If assets are illiquid, parties could consider a temporary loan to cover the to-and-fro transfers. While a traditional loan may not be obtainable, your client’s banker may be able to arrange a bespoke short-term facility involving an immediate successive round robin of funds transfers.

There is still a risk this arrangement could be ruled void against public policy in the case of deceased estates. But it remains to be seen whether it would be void against public policy in the case of bankruptcy. I think there is a good argument to say that it would not be, because the Bankruptcy Act contains specific provisions to “undo” transactions entered into that seek to defeat the policy of the Act. For example, Section 120 provides that where property of a person is transferred at an undervalue less than five years before they became bankrupt, the transfer is void. Section 121 provides that a transfer of property to defeat creditors is void if it was entered into at any time. Both of those sections could be used to undo the arrangement.

There are also issues of the client lacking capacity, being the victim of unconscionable conduct or being unduly influenced. Any of those matters may result in the arrangement being unenforceable. Accountants should be alert, especially with elderly or vulnerable clients, for a lack of capacity, or of taking instructions from a relative or other third party. Documenting the advice and the client’s understanding is important.

Pictured: Michael Morris

“This judgment is a timely reminder to consider how any such arrangement would be viewed if tested in court.”

The terms of any gift and loan back need to stand up to scrutiny. So, ensuring the loan back is made on commercial terms (with interest payable and a payment schedule) will help legitimise the arrangement.

Gift and loan back arrangements are not dead, but the use of promissory notes to facilitate them certainly is. More broadly, this judgment is a timely reminder to consider how any such arrangement would be viewed if tested in court. There may be other solutions for your clients to consider, taking into account their business structure and objectives.

While some options may have tax or duty consequences, that needs to be weighed against the risk of the arrangement coming undone and exposing assets to a claim.