Dale Boccabella

There is currently a review of the way discretionary trusts have become all pervasive in Australia. And yet it is clear they will grow in number.

Discretionary trusts are a category of trusts. A trust involves a relationship whereby a trustee holds property or conducts a business for the benefit of beneficiaries. They are an alternate business or investment vehicle to the company, partnership or fixed trust.

In addition to discretionary trusts being set up by living persons (principals), it has become common practice for many assets passing on death to be housed within a discretionary trust (testamentary trusts/discretionary will trusts). And, wealth that will pass to future generations in Australia over the next 20-years or so will be unprecedented.

So what makes discretionary trusts popular? To answer this we need some understanding of this “entity”. It is a trust. But unlike many other trusts (e.g. listed property trusts, listed share trusts), the potential beneficiaries do not have fixed entitlements to capital or income. Whether a beneficiary gets a distribution of capital or income is at the discretion of the trustee (legal owner of trust property) and/or those behind the trust. Accordingly, a beneficiary does not legally own anything until the trustee decides to make them a distribution.

The trustee is the legal owner of trust property, but trust property does not belong [beneficially] to the trustee. The trustee is often a “$2 company”. A $2 company means that the share capital subscribed by shareholders for shares is only $2. Often, trust property will have been transferred to the trust for no money by the people behind the trust (usually Mum and Dad). These people are likely to be potential beneficiaries along with the children, and a family company.

As well as being the only shareholders in the $2 trustee company, Mum and Dad may also be the appointers of the trust. Appointers have power to remove a trustee if they are not satisfied with the way the trustee is exercising his/her/its discretion.

What flows from all this?

First, assets held within a discretionary trust are generally beyond the reach of creditors of the beneficiaries, and creditors of the principals who set up and transferred assets to the discretionary trust. This also means the trustee in bankruptcy of a beneficiary or the principals usually cannot access those discretionary trust assets. Further, the principle that creditors of a trust (e.g. suppliers of goods to trust) can, in certain circumstances, access the assets of beneficiaries of the trust, does not apply to a discretionary trust.

In terms of “divisible property” for the purpose of a family law proceeding (relationship breakdown), the Family Court can take into account assets held in a discretionary trust, but this is less likely where the discretionary trust assets existed before the failed relationship commenced.

Secondly, the discretionary trust allows the trustee flexibility to make income (and capital) allocations to beneficiaries based on their differing needs and capacities. For example, one of the children might currently be unemployed or sick and therefore a greater income allocation can be made to him/her for the current year. The discretionary trust also allows the trustee to defer or stagger a particular child’s entitlement because there is concern about the child’s big spending habits (spendthrift). It should be said though that it is rare that the flexibility of the discretionary trust is sought to deal with the differing capacities and needs of beneficiaries. Other less sophisticated legal arrangements can more than adequately deal with the differing needs and capacities scenario.

Thirdly, and this is usually the most important advantage sought, the discretionary trust allows for tax minimization; substantial minimisation. The flexibility that has a genuine non-tax basis to it (see above) also provides the means to minimize tax by, for example, allocating a given taxable income across a number of taxpaying units (simple income splitting). In addition, the DT allows income allocations across tax years to take account of beneficiaries’ other tax profile that can change over years. There is also the advantage of streaming different income types to beneficiaries who can make best use of certain items of income, a technique the government has recently re-endorsed.

There are many other tax advantages from a discretionary trust including allowing income allocations to children under 18-years of age to be taxed at the adult tax rate schedule where the discretionary trust arose under a will (testamentary trust). Normally, under-18s are taxed at a penalty rate of tax.

The advantages of discretionary trusts are quite substantial. No other entity comes close to offering all the advantages of the discretionary trust; some offer one or two advantages of the discretionary trust. And of course, one person’s advantage is another person’s disadvantage. For example, suppliers to discretionary trusts may have trouble getting payment for debts, and minimized tax through discretionary trusts, must be made up by other taxpayers or government services must be reduced.

Are there any disadvantages to those using a discretionary trust? The main one is the danger of a “rogue trustee”. That is, the trustee might exercise their discretion in a way contrary to the wishes of the principals who set up the discretionary trust. With careful legal drafting, including wise selection of appointers, safeguards against this can be provided.

It is one of life’s twists that discretionary trust can also breed suspicion and “distrust” amongst “beneficiaries” who would otherwise (in a fixed trust) expect an entitlement. The reason is that entitlements under a discretionary trust are contingent on the trustee’s discretion so that a beneficiary may be at the whim of the trustee, and those controlling the trustee.

The cost of financial planners, tax advisors, lawyers, etc, in setting up a discretionary trust and properly maintaining it can also become expensive as an effective discretionary trust must be kept-up-to date with changes in the circumstances of relevant parties. Indeed, these professionals are doing, and will continue to do, a solid trade in discretionary trusts.

By and large though, the disadvantages to those who can avail themselves of a discretionary trust are not significant and are overwhelmed by the advantages. And, no other entity (e.g. fixed trust, company) comes close to offering the same or similar tax and non-tax advantages.

As far as tax goes, various government inquiries have endorsed the current tax treatment of discretionary trusts. Indeed, the Assistant Treasurer, the Hon Bill Shorten MP told a Tax Institute conference last year: “We don’t believe trusts are any form of tax avoidance. We see trusts as a legitimate feature of how Australians conduct their financial affairs.” The tax advisors listening must have had a quiet chuckle; they need to be quiet because a loud chuckle may prompt the Assistant Treasurer to actually check the basis for that ridiculous statement.

Equally, important are the non-tax advantages. To my knowledge, there has not been a systematic and comprehensive inquiry on the asset protection aspects (code for not paying debts), property division aspects, etc, of discretionary trusts. However, there has been isolated reform in various areas that has reduced the abusive use of the discretionary trust (e.g. pensioners cannot house assets in a discretionary trust and avoid having those assets counted for asset and income testing purposes).

The pervasive use of the discretionary trusts has snuck up on society. The time for a comprehensive review of the advantages and disadvantages of discretionary trust has come. At the moment, many Australians are gorging themselves on the advantages of trusts, and similar advantages are not available to others.

Dale Boccabella is an Associate Professor of Taxation Law at the Australian School of Business