The expectation that assets held in a discretionary trust are out of the reach of creditors is not as bullet proof as some may believe.
In the case of Donnelly v Windoval1, a bankruptcy trustee was able to void a transaction that happened more than 10 years ago, on the grounds that it was conducted to defeat creditors. This was in spite of the fact that the bankrupt may have been solvent at the time of the transaction.
The decision highlights a number of potential risks for advisors to consider when assisting clients with structuring, restructuring or developing asset protection strategies.
Background
In September 1998 Mr Bonnell, a legal practitioner, received a private binding ruling from the Assistant Commissioner of Taxation. The ruling concluded that contributions Mr Bonnell proposed to make to his non-complying superannuation fund would be tax deductible. Importantly though, the ruling did not consider whether Part IVA (the anti-avoidance provisions within the tax law) would apply to the transactions.
In May 1999 the Commissioner of Taxation issued a media release declaring that contribution arrangements (in the same manner as those proposed to be made by Mr Bonnell) would likely be subject to the application of the anti-avoidance provisions and penalties.
In May 1999, after the ATO media release, Mr Bonnell contributed $5m to his superannuation fund and claimed tax deductions which gave him a tax saving of approximately $2.425m.
On 1 July 1999 the $5m was transferred from Mr Bonnell’s superannuation fund to his family trust (“Windoval”). The family trust was out of his direct control – a key feature in many asset protection strategies.
In 2004 the Deputy Commissioner of Taxation applied Part IVA and disallowed Mr Bonnell’s deductions from 1999 and issued an amended assessment in the amount of approximately $4.5m.
Due to his significant unpaid taxes, Mr Bonnell was made bankrupt on 10 September 2008 on the petition of the Commissioner.
Mr Bonnell’s trustee in bankruptcy applied to the Federal Court to void the $5m transfer to Windoval pursuant to section 121 of the Bankruptcy Act. The trustee argued that the transaction was conducted with the knowledge that Mr Bonnell would likely incur a tax debt and was therefore undertaken to defeat creditors.
Section 121 of the Bankruptcy Act and asset protection
Section 121 of the Bankruptcy Act provides bankruptcy trustees a means to claw back transactions that have been undertaken to defeat creditors. For this to be possible the following requirements must be met:
1. The transaction was undertaken by an individual who later becomes bankrupt and:
a) the property would probably have become part of the individual’s estate or would probably have been divisible by creditors if the property had not been transferred; and
b)The individual’s main purpose for undertaking the transaction was to prevent, hinder or delay the transferred property from becoming divisible by creditors; and
2. It can reasonably be inferred that the time of the transaction, the individual was, or was about to become insolvent.
In practical terms, any transfer of assets by an individual to a trust or other related party may be later scrutinised by a bankruptcy trustee. This is likely to be the case if there are grounds to believe the transfer was undertaken to defeat creditors and that individual was insolvent or on the cusp of insolvency at the time of the transfer.
For tax and accounting advisors, there is a need to understand the solvency and risk profile of a client before providing structuring or restructuring advice.
Issues considered in the Donnelly v Windoval case
At the heart of the argument was the timing of the transfer. It was established that Mr Bonnell was aware of the ATO media release shortly after it was published in May 1999, which declared that similar arrangements were a misuse of taxation policy and intent.
At the time of the transfer Mr Bonnell was not ‘balance sheet insolvent’ as there had not been an amended assessment issued by the ATO. However, Justice Foster found that Mr Bonnell knew there was a real possibility that the Commissioner would disallow the deductions by virtue of the media release and other published information, and that the ATO could therefore become a creditor.
It was considered likely that Mr Bonnell was aware that he would incur a tax debt and that by divesting himself of the cash assets he would have no means to pay an amended assessment, therefore defeating his creditors (the ATO).
Previous cases supported the judge’s reasoning that if there is at least some impending indebtedness, section 121 of the Bankruptcy Act can be satisfied2 and the transaction voided.
Orders made
In February 2014 the Court found in favour of Mr Bonnell’s bankruptcy trustee and voided the $5m transfer to his superannuation fund (and ultimately through to his family trust).
Implications for advisors
Although commonly used in asset protection, a discretionary trust does not always provide a safe haven in the event of bankruptcy. Where funds have been settled on the trust, or related party dealings have taken place for less than market value, these transactions can be scrutinised and potentially clawed back. Importantly, this scrutiny can happen many years later as there is no time limit on which certain transactions may become void.
When assisting clients with structuring, restructuring and asset protection strategies, advisors need to take into account factors other than the usual tax or stamp duty considerations. The other factors include:
- Is the transferor’s main purpose in undertaking the transfer (when viewed objectively by a reasonable person) to defeat creditors?
- How solvent is the transferor now?
- Are there contingent creditors which may not have crystallised claims (but it is reasonable to assume there may be a claim)?
- What effect will the transfer have on solvency?
William Buck’s Tax Services team works closely with our Business Recovery specialists to develop tax effective asset protection strategies for individuals, companies and trusts. Should you require assistance in structuring, restructuring or insolvency matters, please contact your William Buck advisor.
1 Donnelly (Trustee) v Windoval Pty Limited (Trustee); In the Matter of Donnelly (Trustee) [2014] FCA 80
2 Barton v Deputy Commissioner of Taxation [1974] HCA 43, Trustees of the property of Cummins (a Bankrupt) v Cummins [2006] HCA 6
