Sham trusts

One of the primary objectives of using trust structures in Australia is asset protection.  A trust structure allows assets to be quarantined from the personal assets of an individual, who may be at risk of claims, but still allowing the individual to enjoy some or all of the income from the asset and perhaps to use the asset directly.  In essence, the assets of the trust are not property of the individual, even if that individual is a trustee and beneficiary.[1]

Therefore the security and long term integrity of the trust against outside claims is crucial to its purpose.  There are different principles to consider depending upon who the trust is hoped to protect against.

Creditors and claimants against an individual will sometimes level the accusation that the trust is a mere sham, and therefore the assets are indeed available.

What is a sham trust?

A sham trust isn’t a trust at all. The Courts have consistently held that for a trust to be a sham, the parties who established it must not have intended it to have legal effect as a trust.  In the typical asset protection scenario, the settlor and the trustee and beneficiaries, all earnestly wish the arrangement to have proper legal effect as a trust, to gain its protective features.  Lawyers will have been engaged and drawn documents which have been signed by the parties.

True sham trusts are quite rare.  A sham trust is intended by the parties not to be a trust at all, (i.e. the settlors wish to retain beneficial ownership of the trust funds).  The sham arises when a trust structure is presented to the world, but the settlor of the trust wishes to retain full control of the assets of the trust, and to continue to enjoy beneficial ownership of the trust assets.  Note that in this discussion, the meaning of settlor is expanded to include those who gift substantial moneys or assets to the trust.

For there to be a sham trust, there needs to be a finding that the parties to the transaction acted with dishonesty.   This is because the parties intended a transaction to appear to have a particular effect but for it actually to have a different effect.

If a trust is indeed a sham, the Courts and other parties are free to ignore the separation of the trust property from that of the settlor of the trust property.  The trust structure dissolves around the trust property, and the trust is busted!

What about typical family trusts where the trustees exercise almost complete discretion – is that a sham?

Australian family trusts are unlike most forms of trusts around the world.  In Australia, typically, the prime movers of the trust, often the matriarch and patriarch, are the trustees (or directors of the corporate trustee) primary beneficiaries, and the people who capitalise the trust.  The designated settlor, being the accountant or lawyer, contributes $20 as settlement sum, but the real funds come from the prime movers.   This can be contrasted with overseas trust structures where often the settlor is the individual who wishes to set up the trust, and settles a large sum into it.  The trustee is often independent, such as a trustee company or a lawyer or accountant.  The trustee then is charged with the role of administering the trust for the beneficiaries, and not for the settlor who established it.  The trustees generally would not take direction from the settlor after the trust is settled.

The features of an Australian family trust all indicate the trust is closely held, and controlled by the same people who benefit from it the most.  Whilst there is a large class of beneficiaries named in the deed, it is unusual for anyone other than the prime movers, their children, and perhaps a bucket company, to receive a distribution from an ordinary family trust.  If this were the case for a UK trust, alarm bells would be ringing around the word ‘sham’.

However there is almost negligible risk that an ordinary family trust will be declared a sham.  The trust obtains a tax file number and has separate finances.  As much as the prime movers use the trust for their own benefit, they understand (mostly!) that what is owned by the trust is not part of their personal estate.  And most important of all, when they set it up, they fully intended to create a structure separate from themselves, with real rights and obligations.  The structure is not a façade, but a substantive mechanism they use on the advice of their accountant or lawyer.  This structure is universally accepted in Australia without there being an allegation of it being a sham.

How to prevent sham trusts arising?

The inclusion of a company as trustee will help, but is not a bar to a finding of a sham arrangement.  The critical issue is how the parties treat the trust.  Do their actions, viewed objectively, raise the impression of a trustee holding property for others, being the beneficiaries?  Or is it instead a vehicle exclusively for the prime mover of the trust?

Steps that can be taken to avoid a trust being considered a sham trust are:

  1. have more than 1 trustee or if the trustee is a company, having multiple directors;
  2. not including any terms of trust which allow the assets of the trust to return to the settlor;
  3. ensure the trustee makes decisions for the trust without seeking guidance or permission from the at risk individual. It would be difficult to convince the Court that a trust is not a sham or alter ego of an individual, if the named independent trustee emails the at-risk individual each time a decision needs to be made;
  4. it helps to have distributions not flowing to the trustee each year in their personal capacity (e.g. if an individual is the sole trustee); and
  5. ensure all assets are separately accounted for in the books of the trust compared to personal accounts.

The makeup of a trust is a competition between control and protection. As a general proposition, the higher the control one has of the trust, the greater the chance that the trust will be deemed an ‘alter ego’ or sham.

What happens if the trust is a sham?

If a trust is determined by a Court to be a sham, then the trust fails, and the property which was supposed to be trust property reverts back to the settlor.

Once a trust is declared a sham trust, with no legal effect, the accounts and tax returns of the trust would need to be reviewed and amended as necessary.  This would risk adverse tax assessments in unpredictable ways depending upon the circumstances.  Moneys owing by the trust would instead be owed by the settlor/s.  It would be an untidy and potentially expensive process to unwind a sham trust.

However many times it is only 1 transaction or series of transactions which are the sham, not the whole trust relationship.  Once a trust is validly formed, it is more likely that a maligned transaction will be a sham by itself (rather than the trust) or that the trustee committed a breach of trust rather than a sham, because of the obligations on the trustee.

Modern trust deeds have multiple provisions driving the trust away from being a sham trust structure.

Sham trusts in the family Law arena

Upon dissolution of a marriage or de facto relationship the property of the former partners must be divided between them.  If there is a trust controlled or enjoyed by one of the parties to the relationship, it must be determined if the assets of the trust are:

  1. property of the parties; or
  2. a financial resource of the parties.

If the trust is a financial resource of the parties, the Court will not make an order over its assets, but may alter the division of other property to account for the fact that a party has access to this financial resource.

If the trust is a sham, the assets of the trust will unavoidably be property of the relationship, and available for distribution by the Family Court.   However, the trust does not need to be a sham to be susceptible to orders over its assets in family law.

There are also a range of other family law considerations which are too substantial to be included in this article.  Suffice to say, the vast majority of trusts which as ‘busted’ by the Family Court are not done so on the basis that the trust was a sham, but instead that the assets of the trust are property to a party of the marriage.  This is determined essentially by the effective control that party exercises over the trust.  The classic case on point is Kennon v Spry.

Kennon v Spry

In the case of Kennon v Spry[2], Dr Spry was the trustee of the trust.  He was not appointor of the trust, nor a beneficiary.  His daughters were the beneficiaries.  Whilst this trust may seem somewhat distinct from Dr Spry, we must remember that he was the legal owner (as trustee) of the trust assets, and he exercised untrammelled control over the trust assets to the exclusion of all others.

The High Court found that the assets of the trust were able to be considered property of Dr Spry’s for the purposes of the family law proceeding.  It did not label the arrangement as a ‘sham’ and noted that there was no allegation that the trust was a sham.

One of the lessons from this case is that where property has been acquired by one of the parties to the marriage, and that party still retains control of the property, the fact that beneficial entitlement passes to other people (i.e. a trust declared in favour of family members) will not prevent the property being accessible by the Family Court.

However, having separate legal title i.e. a trustee who is not the at risk individual, will not be enough to protect the trust assets for family law purposes.

The trustee must not be a mere puppet or alter ego of the individual.   They need to truly have and independent mind when exercising discretion as the trustee.

Unpaid present entitlements

The accounts of many family trusts show large and growing unpaid present entitlements (UPEs) to the prime movers of the trust.  The same can happen for testamentary discretionary trusts.  This occurs when a distribution of income is declared, but not paid, because the income is reinvested into the trust’s investments or business.  This is usual and necessary to build wealth in the trust.

However from an asset protection perspective the UPEs need to be carefully considered.  The UPEs are a legally enforceable debt from the trust to the beneficiary.   If the beneficiary has a claim against them, they will need to declare that UPE as one of the assets which is part of their personal estate.  If the claim succeeds, the UPE will need to be paid to the creditors of the beneficiary.  The perfectly structure asset protection trust is then busted wide open to the extent of the UPE.

There are a range of strategies to address this risk, but there is no general prescription, because tax considerations drive this aspect of structuring.  Forgiving UPEs can sometimes be available, but Part IVA of the Tax Act must be considered to ensure that the arrangement does not have the appearance of a scheme to avoid tax.

Conclusion

It is highly unlikely that your family trust is a sham.  However, this will not be enough to ensure that it provides the asset protection features that you seek.  We can advise you on trust structuring to ensure your trust assets remain secure and available for you and the next generation/s of your family.

This is most critical where a family trust operates a business which spans two or three generations.  The structuring of such a trust will determine whether any assets of the trust are available in the event of separation of a couple involved directly or indirectly in the family business.

[1] This article was inspired by the engaging presentation and paper on the topic by Professor Patrick Parkinson on 13 September 2019 at the QLD STEP conference

[2] Kennon v Spry (2008) 83 ALJR 145

2019-09-26T11:20:32+00:00September 26th, 2019|