Gift and loan-back strategy – interesting comments by the Supreme Court of Queensland

Re Permewan [2021] QSC 151

The gift and loan-back-strategy is widely employed in estate planning and asset protection scenarios. The essence of the strategy is as follows:

• The principal (who wishes to protect their assets) gifts a substantial sum, equivalent to the net value of the asset they are trying to protect to a safe entity; typically a discretionary trust established just for this purpose.
• The gift is not cash-flowed but is made by way of a promissory note or cheque.
• Contemporaneously with the gift, the safe entity lends the value of the gift back by loan agreement.
• The safe entity takes security over the principal’s assets by way of a mortgage over real property or PPSR security interest over personal property in order to protect its position as lender.
• The outcome is the principal has retained their assets, but now has net equity of $0 and has a secured debt to the safe entity which they control. This reduces the likelihood of claim against the principal.

There have always been detractors of the gift and loan-back strategy. It has been described as a “sham” or a “legal fiction” concocted by persons who wish to obtain the asset protection features of giving away their property without actually giving away their property. This is an unconsidered and uninformed view of the arrangement. Case law is quite clear that this arrangement could not be described as a sham or legal fiction and does not have any of the essential characteristics of those arrangements. Shams and legal fictions are arrangements where the parties never intended them to be legally binding. It is quite clear that the parties to a gift and loan-back strategy intended the arrangement to be binding.

The detractors next attack the gift by saying that it is not effective at law because value is not truly passed to the safe entity. Such criticism is certainly not valid if the gift is cash-flowed. At times it is appropriate for the principal to borrow the funds from an external source, cashflow the gift, receive the loan back, and then repay the external party.

The use of promissory notes to transfer the value of the gift to the safe entity is open to more criticism because promissory notes are an ancient legal and financial instrument and are not well understood. Our view and the view shared by practitioners who endorse the strategy, is that the use of a promissory note is perfectly enforceable as a means of transferring value. Promissory notes have a very long history and case law attests to their effectiveness.  Of course it is important that arrangements comply with the Commonwealth Bills of Exchange Act 1909 which regulates the use of promissory notes in Australia. There is no set form of a promissory note but there are some essential characteristics ^[1]; namely:

A promissory note is an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay, on demand or at a fixed or determinable future time, a sum certain in money to or to the order of a specified person, or to the bearer.

The statutory rules for a promissory note are:

• The promissory note must be endorsed by its maker.
• A promissory note must be delivered to the payee or to the bearer.
• The note must be presented for payment within a reasonable time of the endorsement.

Atia -v- Nusbaum

The gift and loan back strategy was considered in the Supreme Court of Queensland in the case of Atia -v- Nusbaum [2011] QSC 44. In this case the plaintiff had entered into a gift and loan-back strategy with his mother. The Supreme Court examined the strategy in detail. In that situation the security was a registered mortgage. The plaintiff pleaded that the arrangement was a sham and that he had not intended to be legally bound by it when he entered into the strategy.

The Supreme Court was not convinced and found it was binding. It is notable that the Court made no adverse comments about the fact that the strategy was quite plainly set up for asset protection purposes.^[2]

Bankruptcy Act

One vulnerability of the strategy relates to claw-back periods under the Bankruptcy Act. The principal who makes the gift is entering into a transaction which is subject to the claw-back periods under the Bankruptcy Act. Section 120 provides that a transfer to a related party for less than market value is subject to being clawed back for a period of 4 years after the date of transfer if the transferor becomes a bankrupt. Therefore, the gift and loan-back strategy is subject to the principal remaining solvent for a period of 4 years.

Section 121 of the Bankruptcy Act provides that a transfer of property by a person who later becomes bankrupt is void against the trustee-in-bankruptcy if the main purpose in making the transfer was to prevent, hinder or delay the property becoming payable to their creditors. There is no time limit to how far back in time the trustee-in-bankruptcy can seek to have a transaction overturned under this section. Therefore, if a gift and loan-back strategy is undertaken with a particular debt or creditor in mind that the principal is trying to defeat, then it is likely that the transaction is susceptible to being undone by the trustee-in-bankruptcy if the principal later becomes bankrupt. Therefore, once someone has received a claim from a particular creditor, and at that time the person’s solvency is dubious, attempting to avoid the debt by entering into a gift and loan-back strategy may not be effective, even if it is some years later that the creditor finally seeks to enforce the debt.

The situation is different where the principal undertakes the strategy having no reasonable expectations of becoming insolvent or a bankrupt in the foreseeable future. In such a case, the gift and loan-back strategy is not being entered into for the purpose of defeating any particular creditor but instead is being entered into as prudent asset protection arrangements. It is akin to paying dividends out of a company regularly to ensure that if a claim ever comes against the company in future, the losses are limited to what is in the company at that date.

The Courts have recognised that parties are able to undertake prudent asset structuring and estate planning in order to provide asset protection for themselves in the event they later become a bankrupt. This is permissible and, indeed, advisable.  The issue only arises if someone does so with a particular claim in mind they wish to defeat.

Permewan

Turning to the comments made by the Supreme Court in Permewan, in this case Prudence Permewan entered into a gift and loan-back strategy. Part of that strategy was a promissory note in the amount of $3M payable to its bearer.

A company of which Ms Permewan was director, Zalerina Pty Ltd, signed receipt of the note as trustee for the Lotus Trust. Zalerina Pty Ltd lent the money back to Ms Permewan on the same day by a loan agreement. The loan was secured by a mortgage over real property and security interest over shares.

The first thing to note is that the parties alleged that the promissory note did not meet the definition of the Bills of Exchange Act. We recommend that when using promissory notes they meet the Bills of Exchange Act

The Court described the arrangement as “an elaborate web of documents” with “no commercial purpose but were designed only to avoid the existence of a fund from which a family provision application could be made“^[3]. These comments do not inspire confidence that the Court will take an impartial view of the arrangement. In discussions with Counsel, his Honour emphasized that the executor, at least arguably, had an obligation to consider attempting to set aside the gift and loan-back strategy which had been made by the deceased.

The Court did not have cause to consider whether the strategy was effective or not, and was instead commenting on it in the context of an application for removal of an executor of the estate, who had an interest in the strategy being upheld.

Despite the obviously adverse comments by Davis J, the decision is not a precedent for the enforceability or otherwise of the gift and loan-back strategy. However, it will be interesting to see if litigation continues and the Court is required to make any final decision on the strategy.

Our view remains that the strategy is valid and enforceable. The Bankruptcy Act will not apply in the case of a family provision claim in any event because the trustee-in-bankruptcy is not involved.  There is no creditor at the table; it is instead a child, or other relative, making an application for provision out of an estate which is not bankrupt but instead has modest assets.

We recommend now, as we always have, that the gift in the gift and loan-back strategy be cash-flowed wherever possible as it removes the perhaps slightly weaker link of the promissory note.

[1] Section 89

[2] The amounts given and lent in this arrangement appear to have been cash-flowed rather than by use of a promissory note.

[3] At paragraph 43