Establishing a Discretionary Trust


Trust instruments range from serviceable for simple tax affairs to comprehensive for complex tax and succession planning.

A discretionary trust is often selected as an investment or business structure to provide asset protection, family law protection and tax planning flexibility.

The terms of the trust instrument is central to the administration of a discretionary trust and the trustee is obliged to ascertain the terms of the trust (Hallows v Lloyd (1888) 39 Ch D 686).

Discretionary trust can be relatively complicated structures to administer.  Selecting the appropriate discretionary trust instrument is important to achieve these desired objectives.

Legislative references are to the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) and the Corporations Act 2001 (Cth) (CA 2001).

Nature of a discretionary trust

An express discretionary trust is established when a trustee holds legal title to a settlement sum (e.g. $10) or property gifted by the settlor on the terms of a trust instrument for the benefit of a class of beneficiaries with the power to retain and accumulate as corpus or distribute income (e.g. rent), capital (e.g. bonus shares) and accretions to corpus differentially amongst the class of beneficiaries (In re Gulbenkian’s Settlement [1970] AC 508).

Beneficiaries of a discretionary trust

Generally, the class of beneficiaries includes primary beneficiaries (e.g. mum, dad and descendants) and general beneficiaries consisting of relatives, related eligible companies and related eligible trusts of the primary beneficiaries, eligible charities and specifically nominated persons, but excludes the settlor and persons that derive any rights of the settlor  and sometimes notional settlors (e.g. persons who transfer property to the discretionary trust for less than market value consideration), the trustee and other persons.

In more comprehensive trust instruments, relatives of the primary beneficiaries include adopted and ex-nuptial children, half-blood relatives (Re Marstella [1989] 1 Qd R 683) and same sex couples.  Some relatives are beneficiaries only while a relationship to the primary beneficiary remains, so upon divorce or death of the relevant primary beneficiary, the relative ceases to be a beneficiary of the discretionary trust.  More comprehensive trust instruments will address these issues by including the estate of a former beneficiary and the continuation as a beneficiary despite death of or divorce from another beneficiary.

Any power of the trustee to nominate or appoint additional beneficiaries will be construed strictly (Idlecroft P/L v FCT [2005] FCAFC 141 at [47], [49] & [72]) so these procedures should be clear, uncomplicated and simple to document.

Excluded persons

The settlor, and sometimes notional settlors, are excluded so the revocable trust taxation rules do not apply.  The exclusion of notional settlors is now irrelevant (Truesdale v FCT [1970] HCA 27 at [7] and [12]), but has been retained in some trust instruments.

Where a person created a trust in respect of income or property (including money) and has the power to revoke or alter the trusts to acquire a beneficial interest in the income or property or the income is accumulate for or payable to the child of that person who is under the age of 18 years, the ATO may assess the trustee to tax rather than the beneficiaries who received the distribution (sec. 102 ITAA 1936).

If the settlor is also the trustee and is empowered to vary the trust so the settlor can become a beneficiary, the ATO may assess the trustee to tax rather than the beneficiaries who received the distribution.

If a child of the settlor under the age of 18 is a beneficiary under the discretionary trust, the ATO may assess the trustee to tax rather than the beneficiary who received the distribution, unless the benefit of the child of the settlor is contingent (e.g. on turning 25 years old: Hobbs v FCT [1957] HCA 58).

The trustee may be excluded to avoid a conflict of the trustee’s personal interest and the trustee’s fiduciary obligations to administer the discretionary trust for the benefit of the class of beneficiaries.

Other persons (e.g. former spouses or wasteful relatives) that may otherwise be within the class of beneficiaries may be expressly excluded to achieve trust purposes.

The class of excluded persons should be carefully considered, because purported distributions to excluded persons are ineffective and may have adverse taxation consequences.

Distribution flexibility

The class of beneficiaries is usually expansive to maximise flexibility in differentially distributing income, capital and corpus to achieve trust purposes and tax planning objectives.  Since 2010, managing the legal and tax distinction between income, capital and corpus has assumed greater important in administering a discretionary trust (ATO Ruling TR 2012/D1).

The flexibility of a discretionary trust arises because no beneficiary has a vested or contingent interest in the trust fund, but rather has an equitable chose in action carrying with it, or involving, a right to call for the due administration of the discretionary trust (Lygon Nominees P/L v CSR (Vic) [2007] VSCA 140 at [77]).  The nature of a beneficiary’s rights generally make trusts relatively effective asset protection and family law protection structures.

Should the trustee not make an effective distribution, the distribution is either accumulated and retained by the trustee as an accretion to corpus or automatically distributed to specified default beneficiaries (Pearson v IRC [1981] AC 753; cf Queensland Trustees Ltd v CSD (Qld) [1952 HCA 52).  If accumulated, the trustee is taxed at the highest marginal tax rate.  If distributed to the beneficiaries, the beneficiaries are taxed at their relevant tax rates.

Accumulation of ineffective distributions may be preferred for asset protection purposes, so that the trustee and not the beneficiaries, suffer any adverse taxation consequences.

Trustee Liability

The trust instrument usually expressly provides a trustee indemnity, limits the beneficiaries’ obligation to indemnify the trustee and excludes the trustee’s liability for loss, other than for breach of trust and fraud.  There are some limitation on this protection from liability.

The trustee is personally liable for the debts of the trust, but is granted indemnity and exoneration from the trust assets (Octavio Investments P/L v Knight [1979] HCA 61).  Accordingly, a corporate trustee is often used for limited liability.  The limited liability of a corporate trustee is not absolute.

A director, a public officer, a shareholder or a beneficiary is generally not liable for the debts of the corporate trustee (sec. 252 ITAA 1936), unless liability is imposed by contract, statute or common law (Edgington v Fitzmaurice (1885) 29 Ch D 459).

A director is jointly and severally liable to discharge the debt of a corporate trustee where the corporate trustee had not and could not discharge that liability and was not entitled to be fully indemnified against the liability out of the trust’s assets, even if the trust does not have enough assets to indemnify the corporate trustee (sec. 197 CA 2001).

The corporate trustee and each director are jointly and severally liable for the family trust distribution tax (sec. 271-20(2)(b) ITAA 1936), trustee beneficiary non-disclosure tax (sec. 102UK(2)(a)(2) & (3) ITAA 1936), and unremitted Pay-As-You-Go Withholding and Superannuation Guarantee Charge amounts (sec. 271-20(2)(b) ITAA 1936).

A director is generally not liable to the shareholders or beneficiaries, unless liability is imposed by contract or common law (e.g. Part IVA Federal Court of Australia Act 1976 (Cth).Collie v Merlaw Nominees P/L [1998] VSC 203; Barnes v Addy (1874) LR 9 Ch App 244).

Trust protectors

Traditionally, an appointor has the power to appoint and remove the trustee and a guardian has the right to veto the otherwise wide powers of the trustee (e.g. such as to appoint and remove beneficiaries, to make corpus distributions or to vary the trust terms and vest the trust) to supervise the operation of the discretionary trust, to avoid breaches of trust or ensure compliance with trust purposes. 

The positive power must be exercised for the benefit of the beneficiaries while the veto or consent power may be exercised without any fiduciary restriction (Montevento Holdings P/L v Scaffidi [2012] HCA 48; Re Internine and Intertraders Trusts [2005] JLR 236). 

Sometimes the separate offices of appointor and guardian may be held by different people providing checks and balances to safeguard the trust and sometimes the offices are combined.

Distinguishing between the trust protector’s fiduciary positive powers that may be challenged and non-fiduciary veto/consent powers that may not be challenged may assume important in trust disputes to obtain control of or wind up discretionary trusts.

Duration of the discretionary trust

In States and Territories, other than South Australia, the discretionary trust must vest a maximum of 80 years after establishment of the trust or 21 years after a life in being at the creation of the trust.  Since different States and Territories have different remoteness of vesting rules, the correct vesting date clause must be included in the trust instrument.

In Australian jurisdictions, other than South Australia where the vesting obligation has been abolished, a trust is effectively invalid if it does not vest all trust property in beneficiaries not acting as trustees within the perpetuities period. 

The perpetuities legislation requires a trust to vest under the terms of the trust instrument no later than 80 years from the date of execution of the trust or no later than 21 years after some life in being at the creation of the trust interest (sec. 8 Perpetuities and Accumulations Act 1985 (ACT); sec. 8 Perpetuities Act 1984 (NSW); sec. 187 Law of Property Act (NT); sec. 209 Property Law Act 1974 (Qld); sec. 6 Perpetuities and Accumulations Act 1992 (Tas); sec 5 Perpetuities and Accumulations Act 1968 (Vic); sec. 101 Property Law Act 1969 (WA)). 

The 80 year legislative period is compulsory in ACT and NSW and is an option to the 21 year after a life in being rule in the other jurisdictions

The perpetuity period is only breached when it becomes certain that the trust will not vest within the perpetuity period (Nemesis Australia P/L v FCT [2005] FCA 1273).

A trust where South Australian law is the proper law of the trust does not need a vesting date, but a court can wind-up the trust after 80 years from its establishment (sec. 61 Law of Property Act 1936 (SA)).

South Australian law will be the proper law of a trust where the trust instrument specifies that law applies (Re Estate of Webb; Webb v Rogers (1992) 57 SASR 193 at 204).  However, another jurisdiction may not be bound to accept that proper law if the place of administration, the habitual residence of the trustee or the location of the assets and trust activities are more closely connected with the other jurisdiction (Augustus v Permanent Trustee Co (Canberra) Ltd [1971] HCA 25; Challeram v Chellaram [1985] 1 Ch 409; Salkeld v Salkeld (No 2) [2000] SASC 296).

Specifying the proper law of the trust to be South Australian law to avoid perpetuity laws may not be effective, particularly where all other aspects of a trust are in another jurisdiction.

Discretionary trust instruments should permit the extension or reduction of the vesting date of the discretionary trust within the perpetuity laws to avoid the costs of court proceeding under the Trustee Act to wind up or extend the duration of the discretionary trust.