The Legal and Taxation Aspects of Asset Protection: Part 2
Irish Tax Review April 2010
CAVEAT This article does not deal with the additional creditor reliefs available to NAMA under the National Management Agency Act 2009
Aileen Keogan Solicitor and Tax Consultant
Introduction
Part 1 of this article was published in the January 2010 edition of Irish Tax Review, outlining why and how asset protection is dealt with. Part 2 now deals with the legal and taxation issues that arise out of asset protection.
Legal Issues to Consider
Declaration of solvency
Before the transfer of any asset into a company or trust or to a spouse or a child (“the asset protection structure”), the question of whether that transfer is valid or could be unwound needs to be addressed. Part 1 of this article already made reference to the fraudulent preference provisions of the Bankruptcy Act 1988.1These provisions apply to any transfers made at an undervalue, i.e. by way of gift or partial gift, unless made before and in consideration of marriage (in which case separate provisions apply). If assets are transferred into any of the asset protection structures mentioned in Part 1 of this article, care must be taken to ensure that the legislation will not apply to unwind the transfer and make it available to creditors or the Official Assignee in Bankruptcy of the client.
The legal practice to provide good title to the assets transferred is such that the client must swear a declaration of solvency stating that he or she is solvent without recourse to the assets proposed to be transferred. It would appear sensible for the client to back up that declaration with a statement of net worth that has been prepared and analysed critically by professionals. While this would not protect the transfer until the two-year cut-off period has passed (during which time, if the client becomes bankrupt, the transfer can be declared void, whether or not the client was in fact insolvent at the time of the transfer), it will assist the transferee to resist a claim made if the client becomes bankrupt within five years of the transfer (but after the two years have passed).
There is no requirement for an Official Assignee to prove a fraudulent intention in these cases. If the bankruptcy occurs within two years, no proof is necessary regarding fraud or solvency. If the bankruptcy occurs between two and five years, the burden is on the transferee to prove that the bankrupt was at the time able to pay his or her debts at the date of the transfer without recourse to the property transferred.
Nevertheless, where there is a conveyance of property made with the intent to delay, hinder or defraud creditors and others of their just and lawful debts, rights and remedies, such a conveyance is voidable unless the conveyance is bona fide for full consideration to a person not having notice or knowledge of the intended fraud.2There is no time limit on this provision, albeit in this case the intent to defraud would have to be proved by the creditor/Official Assignee.
Joint assets
Where a person holds an asset in joint names with another and that asset in itself is not subject to any debt, the share of the asset owned by the person, should he or she become bankrupt, is available to the Official Assignee in Bankruptcy. If the asset is held in joint ownership as tenants in common, it is usually clear who owns what share of the property so that the percentage open to attack is clear. In the case of joint tenancies, the presumption is that the asset is owned equally by the joint owners and the Partition Acts legislation will apply to make that property available to the Official Assignee.
Where there is a debt on the jointly owned asset itself, the asset must be used to pay off the joint debt first. If that debt is paid off and there is still value in the asset, then the remaining share of the asset is available to meet the debts of the joint owner who has been made bankrupt. Where the debt on the joint property is greater than the value of the joint property, the balance of the joint debt should be paid out proportionally out of the separate assets of the joint owners.3
Charged assets
A matter worthy of a separate article is the effect of assets being charged and how this affects the priority of payment of debts. The purpose of mentioning charged assets here is to highlight that, if a client wishes to carry out asset protection planning and were to seek to transfer assets that are already subject to bank security, the transfer would generally be ineffective unless consent is obtained by the chargor, typically the bank. It is unlikely that such consent would be available where the purpose of the asset protection transfer is to remove those assets from being available to that bank to pay off its loan. Therefore in practice it is only assets that are already free of debt and security that are available for transfer to an asset protection structure.
Insolvency within the asset protection trust
To what extent is a trustee bound to be involved in the affairs of the underlying company? Case law4states that, if the only reasonable way to protect and preserve the trust assets is to have an insolvency practitioner appointed to the trust assets, then the trustee should do this. However, once an underlying company within the trust is insolvent, the trustee has the difficult problem that his or her duties as director will cease but the duties as trustee will not. The trustee therefore needs to protect the trust fund, albeit by working with the insolvency practitioner. Steps that could be taken to ensure that the control is not lost would include monitoring the liquidator’s conduct or securing a place on the creditor committee.
In the case of the insolvency of the actual trustee, the general rule does not automatically mean that a trustee must vacate office, although generally that would be the case. However, given that the right of an indemnity in respect of trustee expenses reasonably incurred is a personal asset of the trustee, any creditor of that trustee can exercise a right of subrogation to the trustee’s right of indemnity against the trust and get paid that way. However, the trustee must first discharge any prior indebtedness of his or her own to the trust before being able to exercise the right to indemnity.
Taxation
The following is a note of the taxation considerations that could arise on the creation, running and ultimately disbanding of each of the asset protection structures already discussed in Part 1 of this article. This is not intended to be a comprehensive discussion, as in many cases, for instance in the case of incorporation, whether a trade or an investment property should be incorporated or not is a subject worthy of a paper in itself. Suffice to say that, when a client wishes to undertake asset protection planning, his or her priority is not usually to save tax and, given that typically the asset protection structures are not tax-effective, the client needs to weigh up the risk of losing assets to creditors or finding assets tied up in tax-inefficient structures.
Creating the asset protection structure
On the creation of an asset protection structure, clients are disposing of their assets and effectively putting them out of their own (and their creditors’) reach. This means that, for tax purposes, they are disposing of their assets and, unless the disposal falls into any of the exemptions or reliefs or is a disposal of a non-chargeable asset, CGT and stamp duty will arise on the creation of the asset protection structure.
For this reason, the client usually limits the amount and type of asset put into the trust to cash assets and assets that will not trigger a hefty tax charge; otherwise the creation of the asset protection structure will create a further debt for the client (being a tax charge).
Incorporation
On the transfer of assets in a business from an individual to a company, specific reliefs are available under ss596 to 600 TCA 1997 so as to defer any CGT arising until the shares in the new company are disposed of.
Stamp duty will arise on the transfer of assets other than those that can pass by delivery5or where the transfer can “rest in contract”. Thus, stock in trade, plant and machinery (not fixed), cash and bank accounts can pass without documentation to avoid triggering a charge to stamp duty.
In the case of the transfer of non-business assets from an individual to a company, CGT and stamp duty will arise in the normal course.
Bare trust
As there is no change in the beneficial ownership of the assets passing from the client to the trustee/nominee of the bare trust,6no taxes (CAT, CGT or stamp duty) arise. However, as already highlighted in Part 1 of this paper, neither does any protection arise!
Interest in possession trust
On the transfer of assets from an individual client to a trust to hold on behalf of that individual for life or for any period certain, there is a deemed disposal for CGT, CAT and stamp duty purposes. The disposal is deemed to have occurred at the open-market value of the assets transferring.
For CGT purposes, the charge arises in the hands of the client transferring the asset. For this reason, it is best to transfer assets that on disposal will produce no gain or indeed will produce a loss (which loss would be available for the client against any other gains).
For stamp duty purposes, even if the trustee is a relative of the client, the consanguinity relief7is not available as the trustee is receiving the benefit in the capacity of trustee.
For CAT purposes, if the beneficiary of the interest in possession is in fact the disponer, no CAT will arise.8
Protective trust
On the transfer of assets from an individual client to a trust to hold on behalf of that individual for life or determinable on bankruptcy, similar to the interest in possession trust, there is a deemed disposal for CGT, CAT and stamp duty purposes. The disposal is deemed to have occurred at the open-market value of the assets transferring.
For CGT purposes, the charge arises in the hands of the client transferring the asset. For this reason, it is best to transfer assets that on disposal will produce no gain or indeed will produce a loss (which loss would be available for the client against any other gains).
For stamp duty purposes, even if the trustee is a relative of the client, the consanguinity relief9is not available as the trustee is receiving the benefit in the capacity of trustee.
For CAT purposes, if the beneficiary of the interest in possession is in fact the disponer, no CAT will arise.10
Discretionary trust
Again, on the transfer of assets from an individual client to a discretionary trust to hold on behalf of a class of beneficiaries including that client, similar to the interest in possession trust, there is a deemed disposal for CGT, CAT and stamp duty purposes. The disposal is deemed to have occurred at the open-market value of the assets transferring.
For CGT purposes, the charge arises in the hands of the client transferring the asset. For this reason, it is best to transfer assets that on disposal will produce no gain or indeed will produce a loss (which loss would be available for the client against any other gains).
For stamp duty purposes, even if the trustee is a relative of the client, the consanguinity relief11is not available as the trustee is receiving the benefit in the capacity of trustee.
For CAT purposes, CAT will arise only on the appointment out of assets from the trust and not on its creation. As the settlor is alive, no discretionary trust levies will arise.
Transfer to spouse
On the transfer of assets from an individual client to a spouse, any CGT, CAT or stamp duty that would normally arise will be exempt.12
Transfer to child
On the transfer of assets from an individual client to a child (or to a trust for the absolute benefit of a minor child), there is a deemed disposal for CGT, CAT and stamp duty purposes. The disposal is deemed to have occurred at the open-market value of the assets transferring.
For CGT purposes, the charge arises in the hands of the client transferring the asset. For this reason, it is best to transfer assets that on disposal will produce no gain or indeed will produce a loss (which loss would be available for the client against any other gains).
For stamp duty purposes, as the child is a relative of the client, the consanguinity relief13is available, so that, where ad valorem rates apply, these are discounted by 50%.
For CAT purposes, CAT will arise based on the value of the asset passing and the extent of prior benefits that the child has already received.14
Running the asset protection structure
Once the asset protection structure is created, it is a different entity from that of the client, and different taxes may arise in the new entity, which taxes might not have been a concern when the client held them in his or her own name.
The company
The income and gains arising from the assets are now in the regime of corporation tax and not income tax, and the client will now have to deal with the likes of close company surcharges, distribution of profits etc.
Bare trust
As there is no change in the beneficial ownership of the assets passing from the client to the trustee/nominee of the bare trust, the same taxes arise in the hands of the client as when the assets were owned legally in the client’s own name.
The trustees have power to recover from the trust assets if they are assessed to income tax.15This would normally arise in the case of the client becoming non-resident and Irish-source income arising.16
Interest in possession trust
If the client life tenant is in receipt of income that is mandated to him or her, the life tenant will be assessed to income tax as before.17If not, the trustees should pay income tax at the standard rate and pass over the net income to the life tenant, providing a certificate of income tax deducted.18The life tenant is then assessed to income tax on the income received from the trust as Schedule D Case IV income and is allowed a credit for the income tax paid by the trustees.
CGT on any gains arising in the trust is charged in the hands of the trustees, with no annual exemption available to them.
Protective trust
The life tenant and trustees are assessed to income in the manner of the interest in possession trust on the basis set out above but, once the trust is converted into a discretionary trust, the trust is assessed under the basis set out for discretionary trusts below.
If the trust is converted into a discretionary trust, there is an automatic trigger of CGT on any increase in the value of chargeable assets in the trust, even though no assets have been disposed of.19The chargeable assets are deemed to be disposed of by the trustees for their market value and reacquired by them at that value. This is a principal drawback of the protective trust compared to a discretionary trust.
Discretionary trust
The trustees of an Irish discretionary trust should pay income tax at the standard rate and pay an income tax surcharge of 20% on any income not paid out of the trust to a beneficiary within 18 months (the discretionary trust income surcharge). If the trustees pass over the net income to a beneficiary, they should provide the beneficiary with a certificate of income tax deducted.20The beneficiary is then assessed to income tax on the income received from the trust as Schedule D Case IV income and is allowed a credit for the income tax paid by the trustees. If that income is paid over after the surcharge has arisen, however, the surcharge is not available as a credit. If the trust is held offshore,21the “transfer of assets abroad” legislation applies to the income earned in the trust.22
The trustees need to take care in deciding to pay over the income on a regular basis to a beneficiary as, if it appears that the trustees are automatically treating a beneficiary as being entitled to the income, Revenue (or indeed other creditors) may seek to claim that the trust is not in fact discretionary. However, where the beneficiary is the original settlor, there is no advantage to Revenue to argue this, as no CAT arises.
CGT on any gains arising in the trust is charged in the hands of the trustees, with no annual exemption available to them. On the appointment of any capital to a beneficiary in the form of an asset, a charge to CGT could arise as there would be a deemed disposal for CGT purposes. If the trust is held offshore,23when gains are made by the trustees in managing the trust, anti-avoidance legislation can trigger CGT in the hands of an Irish beneficiary24whether or not the beneficiary receives benefits (in the case where there has been an Irish settlor)25and otherwise on the payment of capital benefits to that beneficiary.26
The advantage to this trust over the protective trust is that the automatic change in status of the trust from a life interest trust to a discretionary trust would trigger CGT (as outlined above), but where the trust is always discretionary, such tax would not arise on the beneficiary becoming bankrupt.
If the settlor dies, discretionary trust levies may arise, depending on the trust documentation and who the beneficiaries are. Where the discretionary element of the trust does not cease on the death of the settlor, if the trust does not include principal objects27of the settlor, a 6% initial levy28will arise, together with an annual 1% levy as long as the trust remains discretionary. Where the discretionary element of the trust ceases on the death of the settlor, the levies will not arise. If the concern for protection was merely for the settlor, there seems little need to continue the discretionary element of the trust beyond the settlor’s death. However, if the settlor’s dependants are young at the time that the trust is created, the settlor may wish to keep the trust discretionary beyond death to ensure that the dependants do not come into assets at too young an age.
Transfer to spouse
The same taxes arise in the hands of the spouse as had arisen in the hands of the client when the client had owned the assets.
Transfer to child
The same taxes arise in the hands of the child as had arisen in the hands of the client when the client had owned the assets.
Winding up the asset protection structure
The client’s circumstances may improve or the perceived threats may dissipate and the client may then wish to unwind the asset protection structure and get the assets back into his or her own hands. However, in many asset protection cases, the client is not entitled to demand this and will have to persuade the trustees/spouse/ children to get the assets back, as they are no longer in the client’s control. If successful in persuading the relevant party(ies), taxes can arise on the undoing of the structure.
The company
Here the client has the control as shareholder to wind up the company. If there is an uplift in value in the company arising from assets in the company (e.g. a property gain) and if the client wishes as shareholder to take the property out of the company and into his or her own name, there may be a double charge to CGT (the gain on the property in the hands of the company and the gain on the shares in the hands of the shareholder).
Unless the assets are distributed in specie to the client, stamp duty will arise on the taking out of the assets from the company.
Bare trust
As there was no change in the beneficial ownership of the assets passing from the client to the trustee/nominee of the bare trust, there is no change in getting it back into the client’s own name, and so no taxes arise.
Interest in possession trust
On the winding-up of a life interest trust, the trustees would need to ensure that they have been given power to appoint all of the capital back to the life tenant. In such a case no CAT should arise, as the disposal is made to the original disponer. However, CGT and stamp duty will arise.
For CGT purposes, the trustees are deemed to dispose of the chargeable assets in the trust for their market value29and so CGT may arise.
The disposal of the assets to the client may trigger stamp duty unless it is exempt as a disposal to a person entitled under the trust instrument. Even if the assets include shares, which are normally subject to the 1% rate, as a disposal of trust assets it will still come under the ad valorem rates. Again, no consanguinity relief will be available as it is a disposal from persons in their capacity as trustees, even if they are relatives of the client.
Protective trust
On the winding-up of the protective trust while it is still in the form of a life interest trust, the trustees would need to ensure that they have been given power to appoint all of the capital back to the life tenant. In such a case, the provisions outlined above with regard to interest in possession trusts would apply.
On the winding-up of the protective trust while it is still in the form of a discretionary trust, the provisions outlined below for discretionary trusts would apply.
If the trust has already become discretionary, the death of the beneficiary who was the original life tenant does not trigger a charge to CGT if the discretionary element continues beyond the death of the client. However, if the trust deed provides that the discretionary element ceases automatically on the death of the original life tenant, CGT would arise on a deemed disposal by the trustees, as they would then hold the assets absolutely for named individuals, e.g. the spouse and children.30
Discretionary trust
On the appointment out of all the assets in a discretionary trust to the beneficiary, CGT may arise. For CGT purposes, the trustees are deemed to dispose of the chargeable assets in the trust for their market value.31
As with the protective trust, if the trust deed provides that the discretionary element ceases automatically on the death of the original life tenant, CGT would arise on a deemed disposal by the trustees, as they would then hold the assets absolutely for named individuals, e.g. the spouse and children.32
Transfer to/from spouse
On the transfer back of assets from the spouse to the client, any CGT, CAT or stamp duty that would normally arise will not be due.33
Transfer to/from child
On the transfer back of assets from the child to the client, there is a deemed disposal for CGT, CAT and stamp duty purposes. The disposal is deemed to have occurred at the open-market value of the assets transferring.
For CGT purposes, the charge arises in the hands of the child transferring the asset.
For stamp duty purposes, as the client is a relative of the child, the consanguinity relief34is available so that, where ad valorem rates apply, these are discounted by 50%.
For CAT purposes, CAT will arise based on the value of the asset passing and the extent of prior benefits that the client has already received within the Group B threshold.35
Conclusion: Practical Concerns
The main difficulty for a client is that, under any effective asset protection structure, such as a discretionary trust, by and large the client, as provider of the funds, expects to be the principal beneficiary and controller of what goes on in the trust. Clients are used to giving instructions and being in charge. The very idea that they have to appoint somebody else (and indeed pay them) to take charge of their assets and who could ignore their instructions is not something that clients can easily accept. In addition, the idea that there are other beneficiaries who might have rights under the trust might not sit well with the client.
However, the more the settlor controls, the less likely the trust is to be genuine - whatever type of trust and whatever jurisdiction is chosen - as it will be a sham and liable to be set aside.
In addition, if settlors become insolvent, how do they access monies in the trust so that those monies are not then subject to a claim by the creditors? It is not easy to benefit an insolvent beneficiary! It may be that the trustees will have to pay for out-of-pocket expenses of the settlor (beneficiary), if the settlor can get credit to pay those expenses in the first place.
There is also the question of what type of trustee should get involved in cases such as this. The trustees themselves are very vulnerable to cases taken against them if they seek to make any remedies charged against the trust assets difficult to enforce.
Given the fact that these structures are intended to protect and not to be tax-efficient, it is crucial that clients are aware of what they are getting into. Is it worth running the risk that they might not become insolvent in the next two (or five) years as against running a structure knowing it is not the most tax-efficient way to deal with their assets?
Finally, the time limits imposed by legislation that seeks to unwind the transfer of assets into protective structures means that this sort of planning is not something that can be done on the eve of bankruptcy. Careful planning is required.
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Footnotes
1. Section 59 Bankruptcy Act 1988. If the transferor of assets at an undervalue becomes unable to meet debts as they fall due within two years of the transfer, the transfer can be set aside without any proof required by the creditor or the Official Assignee regarding solvency at that time. If the transferor of assets at an undervalue becomes unable to meet debts as they fall due between two and five years of the transfer, the transfer can be set aside unless the transferor (or the transferee on his or her behalf) proves that the transferor was in fact able to meet the debts without recourse to the property transferred at the time of the transfer.
2. Section 74(3) Land and Conveyancing Law Reform Act 2009.
3. Section 34 Bankruptcy Act 1988.
4. Bartlett v Barclays Bank Trust Company Limited [1980] 1 Ch 515.
5. Section 59 SDCA 1999 provides that certain chattels are liable to stamp duty at contract stage if included in a contract for sale.
6. See Part 1 of this article (Irish Tax Review, 23/1 (2010)).
7. Schedule 1 SDCA 1999, para. 15, “Conveyance or transfer on sale of any property other than stocks or marketable securities or a policy of insurance or a policy of life assurance”.
8. Section 83(2) CATCA 2003.
9. Schedule 1 SDCA 1999, para. 15, “Conveyance or transfer on sale of any property other than stocks or marketable securities or a policy of insurance or a policy of life assurance”.
10. Section 83(2) CATCA 2003.
11. Schedule 1 SDCA 1999, para. 15, “Conveyance or transfer on sale of any property other than stocks or marketable securities or a policy of insurance or a policy of life assurance”.
12. Stamp duty (assuming not a sub-sale) under s96 SDCA 1999; CGT, provided that the spouse is living with the client, under s1028 TCA 1997; CAT under s70 CATCA 2003.
13. Schedule 1 SDCA 1999, para. 15, “Conveyance or transfer on sale of any property other than stocks or marketable securities or a policy of insurance or a policy of life assurance”.
14. If the child has received no prior benefits, he or she can receive €414,799 in value of assets before CAT at 25% will arise (current rate and threshold for calendar year 2010). Credit may be available for CGT paid by the client disponer provided that the child does not dispose of the assets within two years ( s104 CATCA 2003).
15. Section 1046 TCA 1997.
16. Section 890 TCA 1997.
17. Williams v Singer 7 TC 411 [1921, but the trustee must file a return under s890 TCA 1997.
18. Form R185.
19. Section 577(3) TCA 1997.
20. Form R185 – note that this does not include the surcharge, which cannot be credited against the income of the beneficiary.
21. The trustees are not resident or ordinarily resident in the State.
22. Sections 806 and 807A TCA 1997; for further discussion on this, see A. Keogan, J. Mee and J.C.W. Wylie, The Law and Taxation of Trusts (Dublin: Tottels, 2007), paras 30.049 et seq.
23. Where the trustees are not resident or ordinarily resident in the State.
24. Beneficiary must be domiciled and either resident or ordinarily resident in the State.
25. Settlor must be domiciled and either resident or ordinarily resident in the State at the time of the creation of the settlement or in the year of the gain.
26. Sections 579 and 579A TCA 1997.
27. See definition in s14 CATCA 2003.
28. Reduced to 3% if the trust is wound up within fi ve years; see s18(3) CATCA 2003.
29. Section 576 TCA 1997 applies as it is an enlargement of a life interest and not a termination of a life interest; see also Revenue CGT manual, para. 19.3.5.8(c).
30. Section 576 TCA 1997 and the exemption under s577(3) are not available as the interest that expires is not a life interest.
31. Section 576 TCA 1997 applies as it is an enlargement of a life interest and not a termination of a life interest; see also Revenue CGT manual para. 19.3.5.8(c).
32. Section 576 TCA 1997 and the exemption under s577(3) are not available as the interest that expires is not a life interest.
33. Stamp duty (assuming not a sub-sale) under s96 SDCA 1999; CGT, provided that the spouse is living with the client, under s1028 TCA 1997; CAT under s70 CATCA 2003.
34. Schedule 1 SDCA 1999, para. 15, “Conveyance or transfer on sale of any property other than stocks or marketable securities or a policy of insurance or a policy of life assurance”.
35. If the client has received no prior benefits, he or she can only receive €41,481 in value of assets before CAT at 25% will arise (current rate and threshold for calendar year 2010).
