By Philip de Haan, Partner and Aimee Riley, Lawyer, Thomson Geer Sydney
There are significant asset protection and tax advantages associated with discretionary trusts. However, these advantages will depend upon the circumstances associated with the trust.
Asset protection background
Discretionary trusts can provide significant asset protection advantages. However, these advantages, unlike superannuation, are not the result of thought out government policy. Rather, they are an “accident” of trust law.
So the trust law issues in relation to discretionary trusts need to be understood when evaluating the asset protection that is provided by discretionary trusts.
How does the protection arise?
The protection arises because the trustee of a discretionary trust is the owner of the assets. Accordingly, the starting point is that if a beneficiary goes bankrupt, that does not necessarily impact upon the assets owned by the trustee (see Dwyer v Ross (1992) 34 FCR 463). It is the beneficiary’s property that vests in a trustee in bankruptcy. Accordingly, the question is what is the beneficiary’s property in relation to the discretionary trust?
Most beneficiaries of discretionary trusts are “mere discretionary objects” (Gartside v Inland Revenue Commissioners  AC 553). That is, a trustee has the ability, if the trustee so determines, to distribute to those beneficiaries.
However, those beneficiaries themselves do not have interests in the assets of the trust. Rather, their legal rights are to see that the trustee administers the trust lawfully.
Accordingly, if a beneficiary of a trust who is only a mere discretionary object becomes bankrupt, and that interest in the trust is not a proprietary interest, it does not vest in the trustee in bankruptcy.
Attack on the trustee
If the trustee of the trust is a separate person to the beneficiary who becomes bankrupt (for example another person or a company acting as trustee), then the starting point is that it is not exposed to an action by a trustee in bankruptcy. Where the person becoming bankrupt is in fact the trustee, then the legal position is that the assets of the trust are not the individual’s personal assets (ie they are not owned by the trustee beneficially), and so they also do not vest in a trustee in bankruptcy (though the trustee of a trust does have an asset being the indemnity for liabilities incurred as trustee, which is a beneficial interest).
In practice, complicated issues arise if a trustee becomes bankrupt. For example, the assets of the trust will be owned by the individual who is bankrupt. There may be difficult evidentiary issues in showing that particular assets in the name of the bankrupt were in fact owned as assets of the trust. Accordingly, we would recommend that a person who has a potential of becoming bankrupt should not be the trustee of a discretionary trust.
Shareholders of a corporate trustee
A share is clearly property. Accordingly, if a person becomes bankrupt and they own shares, then those shares vest in the trustee in bankruptcy. Through this process, a trustee in bankruptcy could control a trust by, for example, controlling the trustee through being able to control the voting power associated with shares in the trustee company.
While there are complex trust law issues involved in relation to the trustee acting appropriately, we consider that if there is concern that a person may become bankrupt, then that person should not own a controlling interest in the company acting as trustee. Rather, we recommend a “safe” associate of the person be the sole shareholder, or the “unsafe” person own less than 10% of the shares in the trustee company.
As discussed above, a mere discretionary object does not have a proprietary interest in the assets of the trust. However, care needs to be taken when a person is a “default income” or “default capital” beneficiary. Those beneficiaries are entitled to the income or capital of the trust generally where the trustee does not make a decision by the due date to either distribute income or capital. Of course, the particular terms of any trust deed need to be considered to determine what, if any, other rights the default income and capital beneficiaries may have, and in fact whether there are such persons.
A default beneficiary, at least a default capital beneficiary, does have an interest in the trust. It may be property that may vest in a trustee in bankruptcy. While such property may not be worth much, we recommend that if there is any concern about an individual becoming bankrupt, that person should not be a default income or default capital beneficiary of a discretionary trust.
If a trustee of a discretionary trust has made distributions to a beneficiary and amounts have not in fact been paid, then the beneficiary has an interest in those unpaid distributions. The beneficiary would be able to demand immediate payment of whatever it is that the trustee has resolved to distribute to the beneficiary in the past. Accordingly, even if the beneficiary is a mere discretionary object, if the trustee of a discretionary trust has resolved to distribute amounts to that beneficiary, and those amounts have not been paid, then the outstanding distributions would vest in a trustee in bankruptcy if the beneficiary became bankrupt.
If a person funds a discretionary trust by way of loans, and the person becomes bankrupt, then those loans which are clearly property would also vest in a trustee in bankruptcy. Accordingly, any loans from individuals associated with a trust need to be carefully considered for their insolvency implications.
Gifts to the trust
Very broadly, a transfer within five years of commencement of bankruptcy can be attacked where the transfer was not for full market value consideration. However, the transfer cannot be attacked if, where the transfer is to a related party, the transfer took place more than four years prior to commencement of bankruptcy and the transferor was solvent at the time of the transfer.
Where the main purpose of the transfer is to defect, hinder or delay creditors, the transfer can be attacked and there is no time limit.
So this means that gifts to a trust need to be carefully considered for their insolvency implications.
Most discretionary trusts have a position called an “appointor”, “guardian” or something similar. That person generally has the power to remove the trustee, and may have certain other powers (for example, to consent to amendments to the trust deed and in some circumstances consent to distributions of income and capital).
It is possible that such an interest may be a proprietary interest, and may vest in a trustee in bankruptcy, though case law suggests that it would not be a proprietary interest (Re Burton; Wily v Burton & Ors (1994) 126 ALR 557; Lewis v Condon; Condon v Lewis  NSWCA 204). If the appointor does have a proprietary interest, then extremely adverse consequences could arise as the trustee in bankruptcy would be able to remove the trustee and appoint another person who, again subject to complex trust law issues and restrictions (see Dwyer v Ross(1992) 34 FCR 463; Re Burton (1994) 126 ALR 557), may make distributions that have the effect of benefiting creditors of the bankrupt person.
We believe that the choice of the appointor and the drafting of the appointor clause in the trust deed need to be carefully considered. For example, the drafting of the trust deed should ensure as much as possible that the appointor’s powers are personal rather than proprietary.
Also, it may be worthwhile in certain circumstances to have two or more appointors (for example, one or more “safe” persons and a person who may become bankrupt), and the trust deed should provide that decisions of the appointors would only be valid if they are made by all appointors. In this way, even if the power of appointment in the circumstances is a proprietary interest and does vest in the trustee in bankruptcy, the trustee in bankruptcy would only have one vote out of two or more, and would not have the power, at least unilaterally, to remove a trustee.
Attack on the trust when beneficiaries control the trust
In the Federal Court of Australia decision of ASIC in the matter of Richstar Enterprises Pty Ltd (ACN 099 071 968) v Carey (No 6)  FCA 814, the court held that in the context of two orders sought under the Corporations Act, a beneficiary who is a trustee or who has the power to appoint a new trustee has ownership of the trust property. See also cases subsequent to this case, such as Deputy Commissioner of Taxation v Vasiliades  FCA 1250, which is a case in the context of freezing orders. This suggests that who are the appointors of the trust, or shareholders or directors of a corporate trustee should carefully be considered.
Based on the Richstar case, if the “controller” is also a beneficiary, the assets of the trust could possibly be exposed.
Attack on the trust under the Bankruptcy Act
- • the bankrupt supplied “personal services” to, or for or on behalf of, the entity when the bankrupt controlled the entity
- • the bankrupt received no remuneration or substantially less than arm’s length remuneration for those services
- • the entity acquired property as a result of the supply of those services
- • the bankrupt used or derived a benefit from the property when the bankrupt controlled the entity, and
- • the entity still has the property.
- • no act, omission or decision inconsistent with the person’s directions, instructions or wishes was done or made at that time, and
- • having regard to all the circumstances, it may reasonably be expected that no such act, omission or decision would have been done or made at that time, in relation to the matter, by or on behalf of the entity.
- • the bankrupt provided personal services to, or for or on behalf of, the entity when the bankrupt controlled the entity
- • the bankrupt received no remuneration or substantially less than arm’s length remuneration for those services, and
- • the entity’s net worth exceeds by a substantial amount what might reasonably have been expected to have been the entity’s net worth if those services had not been supplied.
The court can order a payment up to that excess.
Structuring discretionary trusts
In view of the above, careful consideration needs to be given about who should be the key persons associated with discretionary trusts. Care needs to be taken about who should be trustee (and directors and shareholders if the trustee is a company), beneficiaries (in particular, default income and capital beneficiaries) and appointor, and how the trust should be funded.
The following structure would offer asset protection advantages for an “at risk” person:
- • The trustee is a company that only acts as trustee of the trust.
- • The person is not a director, or is one out of two or more directors.
- • The person does not own shares in the trustee company, or owns less than, say, 10% of the shares.
- • The person is not an appointor, or is one out of two or more appointors whose decisions have to be unanimous before they are effective.
- • The person is not a default income or default capital beneficiary.
- • The person is not a general beneficiary (ie is not a mere discretionary object).
While the asset protection issues are very important, the tax and estate planning aspects also have to be considered. These may, of course, conflict with the asset protection aspects.