A trust is not a separate legal entity in the same way as an individual or a company. Rather, a trust is a relationship between a person, persons or entity (called the trustee) and other persons or entities (each a beneficiary), in which the trustee holds property in its own name (the legal interest) for the benefit of the beneficiary or beneficiaries, or for some other object or purpose permitted by law.
The nature of the relationship and the terms upon which the trustee holds the trust property for the beneficiaries are usually set out in a deed (Trust Deed) and the terms of the Trust Deed will determine whether the trust is a so called discretionary trust or unit trust.
A discretionary trust is constituted by the payment to the Trustee of an amount called the settled sum which the trustee agrees to hold, together with any other money paid or property transferred to it, in accordance with the terms and conditions of the Trust Deed executed by the person making the initial donation (settlor) and the trustee at the time that donation is made.
For tax purposes the Settlor should not be a person who may benefit under the trust. The reason for this is Section 102 of the Income Tax Assessment Act (“ITAA”) which provides that where a Settlor has created a trust that can be revoked or altered so that the Settlor acquires a beneficial interest the Commissioner may at his discretion tax the Trustee.
In Truesdale v FC of T 70 ATC 4056 the High Court held that the payment of money (by the parent) to a Trustee to be held on the terms of a pre-existing trust (established for the benefit of the children) did not amount to the creation of a trust. Accordingly, Section 102 could not apply where moneys were gifted to a pre-existing trust.
Ideally the Settlor should be a family friend. In the event that the accountant or solicitor for the client acts as the Settlor then it is critical that they do not bill the settled sum as a disbursement. That is, the settled sum should be a true gift made by the Settlor.
Once the Settlor executes the trust deed and provides the initial settlement, the Settlor has no further role in the administration of the trust and is not subject to further legal obligations. The Settlor cannot be held responsible for any actions of the trustee in conducting the trust, even if the trustee later breaches the terms of that trust.
A major issue is who should be the Trustee. Given that transactions entered into in respect of the trust are in fact entered into by the Trustee in a personal capacity then it is preferable to use a specific
purpose company as Trustee. This is particularly important where obligations or liabilities may be incurred (such as in a trading situation).
Where the trust is merely a passive investor then the importance of having a specific purpose Trustee is much less.
The law imposes upon a Trustee a duty to act in good faith for the benefit of Beneficiaries named in the Trust Deed establishing the trust, and the Trustee must administer the trust in accordance with the terms, conditions and powers enumerated in the Deed and implied by law.
Provided that a Trustee acts in accordance with the terms, conditions and powers contained in the Trust Deed and implied by law, the law will protect it from any liability in respect of those actions or any claim by any beneficiary, despite the result of those actions.
Beneficiaries of a Discretionary Trust
It is important to distinguish between the two forms of beneficiaries under a discretionary trust – discretionary beneficiaries and default beneficiaries.
A mere discretionary beneficiary can only benefit under the trust if the Trustee exercises a discretion to apply income or capital, as the case may be, in favour of that beneficiary.
On the other hand, a default beneficiary has a contingent interest in the trust assets since if the Trustee does not exercise a discretion then, in default, the income or capital is applied automatically to the default beneficiary.
The appointor of a trust is the person who has ultimate control of a discretionary trust since they have the power to replace the trustee.
Issues to consider when deciding whether to establish a Trust
When considering how to structure a business enterprise or an investment, three high level issues are typically traversed:
(a) ease and costs of setting up and operating the structure during its existence;
(b) ease and costs of exiting the structure; and
(c) asset protection.
The importance that one places on each of these issues differs depending on whether a business or investment structure is desired. Asset protection and exit costs (such as the ability to claim various capital gains tax (“CGT”) concessions) are foremost for an investment structure. In contrast the robustness of a business structure is likely to be judged via the ease of operation, and the ability to minimise running costs and maximise after tax profit for the principals of the business.
The various issues which should be considered in selecting an appropriate structure include:
(a) Is the proposed activity a new enterprise or an existing enterprise?
A change to a more appropriate business structure entity may entail significant change-over costs. For example, stamp duty on the transfer of assets; the possible impact of CGT; and the possible loss of income taxation benefits (tax losses).
(b) What entities, if any, are currently utilised? What are the existing entity structures?
The choice of what entity to use may be influenced in part by what existing entities and group structure a client has. In this situation it is possible that the appropriate entity is either the existing entity or a new entity of the same or a different nature.
If the existing entity is a company, in certain circumstances it may be appropriate to use the existing company or a new company despite the fact that, for tax purposes, a company acting in its own right is not an ideal structure for acquiring appreciating assets. While a trust is a more appropriate entity to hold appreciating assets, it may be more important to maintain consistency in the structure of entities in certain cases. In the case of a tax consolidated group of companies, profits and losses may be distributed with ease amongst the group. Further, a more significant advantage may be that clients are probably more knowledgeable about companies than say trusts if they already use companies. This may provide commercial advantages such as lower transaction costs.
(c) Does the activity involve the acquisition of an appreciating asset? Does it involve the conduct of a trade or business? What is the form of the income to be generated (dividends, interest, business income, foreign source income, capital gains)?
(d) Who are the participants/principals? – Will there be arm’s length participants or is the activity to be pursued within the “family group”? Will new participants be sought in future?
(e) What are the financing requirements, and how is the security to be provided?
In selecting the appropriate entity the response to the above questions will generally be considered in light of the following factors:
(a) control of the business;
(b) asset protection (protecting personal and business assets from third party creditors);
(c) family law issues;
(d) CGT issues;
(e) stamp duty issues;
(f) income tax issues;
(g) goods and services tax issues;
(h) land tax, payroll tax, and other state taxes;
(i) estate planning and succession issues;
(j) professional/industry requirements; and
(k) commercial knowledge/complexity/administrative and compliance costs.
What are the characteristics of a good structure?
The characteristics of a good business or investment structure are:
(a) flexibility so that the structure can accommodate changing circumstances with minimum consequences;
(b) the structure provides adequate asset protection to the principals of the business;
(c) the structure minimises costs, particularly tax; and
(d) the structure allows for the efficient distribution of profits.
For these reasons it is common always to include a discretionary trust in a structure to represent the interests of an individual.
Does a discretionary trust provide asset protection?
Asset protection involves protection against unsecured creditors since secured creditors are usually assured of their pound of flesh. The guiding principle for asset protection is identifying where risk lies and to the extent possible separating valuable assets from such risk.
Generally speaking assets owned by a discretionary family trust are not considered assets of the principal. The ownership of the assets of the trust usually lies with the trustee. Provided that the
discretionary trust deed is worded so that the principal has no default interest in the trust, then the principal is a mere discretionary beneficiary and has no proprietary interest or right to the assets of the trust. All that the principal has, as a mere discretionary object of the trust, is a right to be considered as a beneficiary and to require the trustee to duly administer the trust but no more. Accordingly, generally speaking, the creditors of the principal have no rights to the assets of the discretionary trust in the event of a claim only upon the principal.
Whilst the assets of the discretionary trust are not owned by the beneficiaries, beneficiaries must be concerned about the ownership of loan accounts to the discretionary trust, which may reflect the value of the underlying assets. The existence of such loan accounts can undo the asset protection advantages of holding assets in discretionary trusts. This is because on bankruptcy, the individual’s trustee in bankruptcy will become the owner of that loan account and may call on the trustee of the discretionary trust to repay the loan.
Recent family law cases (Kennon v Spry  HCA 56 (“Spry”) being the most prominent example) and corporate law cases (ASIC: In the Matter of Richstar Enterprises Pty Ltd (ACN 099071968) v Carey (No 6)  FCA 814 (“Richstar”)) have eroded the protection provided by a discretionary family trust.
In Spry the High Court expanded the concept of matrimonial property for the purposes of divorce property settlement proceedings to include assets of a discretionary family trust. The reason why the High Court included the trust’s assets in the couple’s matrimonial property was because the husband was the original trustee of the trust, the husband was for a period of the marriage a beneficiary of the trust and the wife was a beneficiary of the trust for the entire period of the marriage. The High Court considered that the assets of the trust were matrimonial property because during the marriage the husband could have appointed the whole of the assets of the trust to the wife. Spry means that assets of a discretionary trust established during the course of a marriage (whether the trust was established by one spouse or both spouses) where one spouse has the power to control income and capital distributions and the other spouse may benefit from such distributions, are likely to constitute matrimonial property which can be directly subject to Family Court property settlement orders.
Even without Spry’s expansion, the Family Court already has extensive powers in Part VIIIAA of the Family Law Act 1975 (Cth) (“FLA”) which can effectively break down the protection of a discretionary trust. Section 90AE of the FLA allows, inter alia, the Family Court to alter the rights, liabilities or property interests of a third party as part of a matrimonial property settlement. Additionally, even if the Family Court does not treat discretionary trust assets as matrimonial property, it may adopt a financial resource approach which in substance factors in the worth of trust assets in a property settlement: see Goodwin Alpe v Goodwin (1990) 14 Fam LR 801 at 806. The Family Court usually undertakes a 4 step process when dividing matrimonial property between ex-spouses, namely:
(a) the Court identifies and values the net matrimonial property of the parties – this step is affected by Spry;
(b) the Court determines the financial and non-financial contributions of parties to the marriage;
(c) the Court considers various statutory factors outlined in subsection 75(2) of the FLA, including, the income, property and financial resources of each party and the physical and mental capacity of each of them for appropriate gainful employment; and
(d) the Court considers whether the proposed property division order is just and equitable.
Where one party to a marriage has the ability to benefit from a discretionary trust, even if the trust’s assets are not included in the concept of matrimonial property, the Family Court may decide that the trust is a financial resource of that party and allocate less matrimonial assets to the party under the property settlement. In that way the assets of the discretionary trust are indirectly taken into account in the property settlement.
The approach that the Family Court adopts in property settlements and its wide property powers mean that a discretionary trust will not protect a principal against an ex-spouse. If such protection is desired then the principal would need to enter into a binding financial agreement with their spouse.
Richstar suggests that in certain contexts a discretionary beneficiary may be considered to have a proprietary interest in the trust where they control the trust. In Richstar ASIC sought court orders to appoint a receiver over assets which were held by discretionary trusts which benefited certain officers and former officers of the failed Westpoint Property and Finance Group. Justice French (as he was then) held that such orders could be made under the Corporations Act 2001 (Cth) (“CA”) where the discretionary trust is controlled by a trustee who is the alter ego of a Westpoint officer beneficiary. This was because such a beneficiary would have some proprietary interest (over which a receiver could be appointed) because it would be “as good as certain” that the beneficiary would receive income and/or capital distributions from the trust.
Richstar created great consternation when it was first handed down since potentially it expanded the range of assets which a bankrupt beneficiary’s trustee in bankruptcy could access. Later cases, however, appear to confine Richstar to its particular facts and receiver context. In Public Trustee v Smith  NSWSC 397 the traditional view that a beneficiary of a discretionary has no proprietary interest in trust assets was upheld. There a disappointed beneficiary to a will sought to apply Richstar in another context. The beneficiary was gifted a property under the will, however, the gift failed since it turned out that the testatrix did not actually own the property but rather her discretionary family trust did. The beneficiary argued that because the testatrix controlled the family trust the testatrix should be regarded as the owner of the property and hence the property should devolve to the beneficiary. Justice White rejected the argument confining Richstar to its particular context under the CA.
Where a discretionary trust is intended to be a safe harbour nest egg vehicle, Richstar indicates that care needs to be taken in determining who “controls” that trust. Ideally the principal of a business who is at risk should not have such control. This will affect who one chooses to be the appointor of
the trust and the trustee of the trust (or the directors of the corporate trustee). In a perfect world the principal would not hold any of these positions, but rather an independent person would act as appointor and trustee. In reality it may be difficult to find a trust worthy independent person and the business principal may have to have some involvement in these roles.
The upshot of the above discussion is that whilst discretionary trusts provide a measure of asset protection they do not provide complete protection, particularly in relation to hostile former spouses. Despite this a discretionary trust is probably still the best asset protection vehicle in the market place apart from superannuation and at the very least should provide one with time to negotiate.