Critically analyse the place of discretionary trusts in our legal system or society
Introduction
Trusts are legal arrangements most commonly found in legal systems that are influenced by British common law, members of British Commonwealth, or territories that were earlier British colonies. Trusts are commonly used for holding assets, running small / family business and distributing income in the defined / equal proportions among certain group of people. A trust essentially separates the legal ownership from the benefits associated with ownership such that one party (“the trustee”) has legal title to the assets and uses it for the collective benefit of one or more other parties (“the beneficiaries”). Consequently, in a trust both trustees and beneficiaries hold certain aspects of ownership. Discretionary trusts allow the allocation and distribution of income among the beneficiaries in the manner stated in the trust deed. This allows unequal but predefined allocation of income among the beneficiaries often preferred for charitable purposes and in family situations / bequest or will. A beneficiary of discretionary trust cannot quantify his / her value in the trust property but obtains benefits therefrom.
Through providing a means to split incomes without splitting assets, discretionary trusts offer numerous benefits to the society, such as: providing a vehicle for preferred type of pooling of assets, protection of minor or unwise beneficiaries from their own poor judgment, possibility to minimize income and estate taxes in several jurisdictions and providing protection to estate property against bankruptcy or settlements pursuant to divorce.
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Asset protection and division of property u/ Family Law Act, 1975 (“FLA”)
Asset protection strategy is one of the most common uses of discretionary trusts. These trusts provide protection to the trust assets from beneficiary’s creditors in case of bankruptcy, as the trust assets are not generally classified as personal property for the beneficiary or the trustee and therefore not divisible in such circumstances. However, this strategy often fails to provide protection from ex-spouses or ex-domestic partners post-divorce in the disputes brought before the family courts. Such disputes are dealt under the FLA, rather than common law.
Under Section 79(1)(a) of the FLA power is vested in the Family Courts to alter the property interests of the disputed parties in the property. These interests may include, for example, specific investments and business assets, property inherited by either of the parties and the property owned before marriage. This allows courts to decide on and settle disputes relating to the claims over property including properties held in trust, and to which a party may be entitled, whether in possession or reversion. Implications may therefore arise in case of division of trust property which includes financial and non-financial contributions from both spouses.
Traditionally, there has been a strong chain of case laws that view a certain property held in a discretionary trust as if it belonged to one of the spouses and brought to the marital pool under the family trust. This has further been confirmed by the famous and controversial case law Kennon v Spry (2008) which has arguable widened the scope of the powers of the family courts. Accordingly, the courts are said to have disregard the existence of family trusts when dividing pool of marital property on a property settlement case. In case of Spry Trust, the majority judges held that the property in trust can be treated as “property of the parties to the marriage” within the meaning assigned under section 79 of FLA because the property held in discretionary trust has no equitable interest in those assets. The summary of decision by French J is that trust property may be covered under the martial pool if: (i) property is held by one of the spouses under the non-exhaustive discretionary trust without any obligation or restrictions to apply those assets in a particular way; (ii) either of the spouses is trustee in the discretionary trust; (iii) property was acquired through financial or non-financial contributions of that person or his/her spouse; and (iv) such property was acquired before or during the marriage.
Extending the control of property owners beyond their death
One of the issues in the family financial matters is how the distribution of income or allocation of assets should be done after the death of the owner parent, since no beneficiary has a particular defined interest in the property. Discretionary trusts help in resolving this issue by creating fixed entitlements for each beneficiary and achieve a reasonable degree of certainty that a particular beneficiary would be able to have distributed their share of the trust capital after a particular period or upon happening of a particular contingency and require the trustee to consider their request. In addition, the trust deed could also be framed to vary the amendment provision in a way to not allow the variation in ‘estate planning amendments’ after the death of the owner. However, disputes relating to distribution of income and property often become unavoidable even in the presence of the trustee, for example, questions over the fulfillment of fiduciary duties vested int eh trustee, and his exercise of discretion properly. This is when the courts will interfere to settle the disputes. In a famous case law Sinclair v Moss, certain guiding principles are established that can guide a court’s approach in dealing such situations. These include:
- Onus of establishing that discretion has been wrongly applied lies on the plaintiff.
- Intervention is warranted only where real and genuine consideration of the matter was missing on the part of the trustee in the application of his discretion.
- Intervention is warranted when the trustee failed to account for relevant matters.
- Courts will take into account the material available on record, the inquiries made or not made by the trustees.
- Errors in the evaluation of facts will not warrant court intervention.
- Two types of discretions exist: 1. Absolute and unfettered discretion, and 2. Discretion that requires the court to form an opinion about something.
In another case, Karger v Paul the Court refused to interfere in the trustees decision where it was exercised in good faith. In this case a wife left her life interest to her Husband with the power to the trustees to pay some or all of the interest in the trust capital to the husband upon his request, with the residuary interest passing to her cousin. The husband requested the trustees to transfer the entire capital to himself and very soon got engaged and later died and leaving the entire estate to his new fiancée. The cousin sought to set aside the transfer made by trustees to the husband. The court held that the trustees did not fail o give due consideration of the facts in exercise of their discretion and an intervention was not warranted.
Discretionary trusts as separate vehicles for taxation
One of the major reasons for creating discretionary trusts is the flexibility it affords in the distribution of income and capital among the beneficiaries. Whilst this income splitting strategy comes with several benefits it may be seen by the tax authorities as tax aggressive arrangements aimed at avoiding or evading the ta consequences for certain brackets of income groups. These aggressive arrangements may aim at reducing the tax liability of beneficiary or a participant in a tax avoidance scheme to reduce their taxable income, obtain benefit of enhanced tax deductions and rebates against their taxable income, and/or avoid paying tax on their income entirely.
Since the trustees of discretionary trust have the power to ascertain and allocate the income earned by property under the trust to certain beneficiaries, it may result in diversion of accumulated income in the hands of various persons and consequently result in selective taxation rather than defined taxation in the hands of the true beneficial owner of the trust property. Since the trusts do not generally pay tax on their incomes like the corporations, the distributions of that income become taxable in the hands of the beneficiaries. This allows families to distribute their assets and incomes in a way that reduced the overall taxation of the family.
Many jurisdictions take this opportunity to offer benefits and tax discounts to trustees in a way that makes these benefits appealing and encourage registration of trusts and filing of returns by the beneficiaries rather than merely use of trusts as a vehicle for tax saving.
