27 July 2010

Bequest of a loan - the vexing question of how to avoid triggering Capital Gains Tax?

Two recent tax cases have highlighted the need for clients to have their wills reviewed by their attorneys periodically.

In the past, in what was in effect an advance on an inheritance and an attempt to reduce the estate duty payable on their death, individuals advanced monies to their heirs on loan or sold assets on loan, and then proceeded to waive payment of the loan in their will. Alternatively, testators or testatrixes sold assets to their family trust on loan and then proceeded to bequeath their loan accounts owed by the trust to the trust. Unfortunately, the favourable consequences of doing so changed with the introduction of Capital Gains Tax (CGT) with effect from 1 October 2001.

In terms of paragraph 12(5) of the Eighth Schedule to the Income Tax Act, CGT is triggered when a creditor reduces or waives payment of a debt for no consideration, or for a consideration which is less than the face value of the debt which has been reduced or discharged. As a result, a deemed capital gain is created in the hands of the debtor.

In the first of the two tax cases, ITC 1793, the testatrix had sold shares to a family trust on loan and subsequently bequeathed the aforesaid debt to the trust. The court held that the situation through which set-off could occur was created by an act on the part of the testatrix, and that it was the drawing of the will which rendered the result of the set-off taxable in the hands of the debtor.

The court further held that paragraph 11(1) of the Eighth Schedule expressly included any operation of law which resulted in the extinction of an asset, and the estate's asset was extinguished by the operation of law, namely the set-off. Accordingly, the testatrix's provision in her will discharging the trust's debt constituted a deemed disposal in terms of paragraph 12(5) of the Eighth Schedule and hence CGT was payable by the trust on the amount of the discharged debt.

In the second case, ITC 1835, the appellant, an inter vivos trust, was the sole heir of the residue of the estate of the testatrix. At the time of the testatrix's death, the appellant was indebted to the testatrix on a loan account which fell into the residue of the estate. The executor in the estate did not demand and/or receive payment of the claim, but rather reflected same as a claim awarded to the appellant as sole heir to the residue in the liquidation and distribution account.

The judge found that the circumstances were different from those in the first case. It was held that it was not the intention of the testatrix to specially bequeath the claim (ie. her loan account) to the appellant, and thus the claim of the testatrix under her loan account formed part of the residue of the estate, and that it was not her intention to dispose of this claim in favour of the appellant for no consideration as contemplated in paragraph 12(5) of the Eighth Schedule to the Act. It was further held to be relevant that the trust was at all times financially able and in a liquid position to repay the loan had the testatrix demanded payment before her death. It was also found by the court that it is not how the executor deals with the estate (in this case he had awarded the loan account to the trust) but what the creditor intended when disposing of the debt, that is relevant.

The question then is how to draft your will so as not to fall foul of paragraph 12(5) of the Eighth Schedule?

At this stage, until the issue is further clarified by further cases or amendments to existing legislation, several options appear to be available:

  1. Leave the residue of the estate to the creditor as sole heir.
  2. The claim could be rolled over to the surviving spouse (if relevant), and be bequeathed to him or her.
  3. Leave the claim to a third party and bequeath a cash amount to the debtor so that he or she can repay same.
  4. Quantify the loan and leave a specified amount to the debtor, but preferably not the exact same amount of the loan. Ideally, the executor should call up the loan, and once same has been repaid, then distribute the legacy.

As always, it remains essential to consider your will every few years, and especially every time a life changing event such as marriage, birth of a child, or a change in financial circumstances occurs.

What the cases especially emphasise, however, is the importance of regularly having your will reviewed by your attorney to ensure that any recent changes in the law are taken into account.

Fiona McKend, Director, Trusts and Estates

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