Trust & Corporate Service

Asset Protection and Discretionary Trusts

The trust industry is fond of touting discretionary trusts as a means to protect wealth and to shield assets from creditors.  Undoubtedly, trusts can help to achieve these objectives.  However, establishing a trust by itself may yield sub-optimal results.  The level of protection and the extent to which a trust can protect wealth and shield assets depends upon how sophisticated of an approach is taken to the creation and deployment of the trust.  An over-simplistic approach may offer no protection and no shield at all.  This is why the formation and administration of a trust for the purpose of asset protection requires a trustee with a sound background in the law.

What is a Discretionary Trust?

A trust is a legal arrangement between an individual, known as the settlor, who transfers ownership and control of an asset to a person, known as the trustee, to hold for the benefit of one or more individuals, each known as a beneficiary.  Under the arrangement, legal title to the asset passes from the settlor to the trustee but the beneficial title to the asset passes to the beneficiaries.

A discretionary trust is a type of trust in which the identity of the beneficiaries and the extent to which the beneficiaries receive the benefits of the trust is at the discretion of the trustee, meaning that the trustee can decide, subject to the terms of the trust, who will be a beneficiary and how much of the assets of the trust a beneficiary receives.  

In a typical discretionary trust, the settlor will try to check the trustee’s discretion through various means.  The settlor may prescribe in the trust deed how the trustee should act.  Alternatively, the settlor may give broad discretion to the trustee in the trust deed and prepare a “letter of wishes” setting out how he or she wishes the trustee to exercise its discretion. Though the letter has no binding effect on the trustee, a trustee will normally have regard to the wishes so expressed within the framework of the trust deed and the trustee’s duties under the law.  

Equally, the settlor may appoint a person known as a “protector” or “appointor” to whom certain powers are reserved under the trust deed.  These powers may include, for example, the right to remove the trustee and appoint a new one or the right to manage the investment of the assets in the trust.

Finally, the settlor may wish to make the trust revocable or structure the trust so that upon the occurrence of certain events, all of the trust assets are distributed, thus bringing the trust to an end.

A person may use a discretionary trust to protect wealth and to shield assets from creditors because by its nature, once the person transfers his wealth and assets to the trust, creditors can no longer seize those assets to satisfy debts owed by that person.  This is because those assets no longer belong to that person and, as a general principle, a creditor can only seize the assets of the debtor and has no right to look at the assets of any other person.

Why is a Discretionary Trust Alone an Incomplete Shield?

Given the foregoing, how is it that a discretionary trust does not by itself offer complete protection of those assets from creditors?  As a starting point, the laws of many jurisdictions will define circumstances in which the transfer of assets into a trust can be attacked, the existence of the trust may be challenged, the terms of the trust itself may be modified or the beneficiaries of the trust may be required to surrender the benefits of the trust.  For this reason, an off-the-shelf “standard” trust is less likely to produce the wealth protection and asset shielding benefits that an under informed client may expect.

What is required instead to yield these benefits in any given case is a considered trust structure that not only leverages the nature of a discretionary trust but also gives due regard to the applicable laws which may, given the specific circumstances of a specific family, affect when and how assets are injected into the trust, the manner in which the trust is operated and the requisite terms of the trust.  Inherently, this process of taking these laws into account can be challenging not only in the context of the formation of the trust but also in the context of administering the trust.  For example, the applicable laws may vary depending on where the trust is established, where significant assets are located or where the settlor and his family members are resident or domiciled.  Equally, for example, the applicable laws may be in conflict with each other and different jurisdictions may resolve these conflicts differently. 

In light of the foregoing, what are some of the key considerations for someone considering the use of a discretionary trust to protect their assets?

Fraudulent Dispositions and Preferences

Perhaps most obviously, many jurisdictions have laws which allow creditors to attack the validity of transactions undertaken with intent to defraud creditors or which unfairly prefer certain creditors over other creditors.  So, for example, in the most obvious case, where a settlor who owns a business transfers some of those business’ key assets into a trust before bankruptcy, the creditors of the business may seek to clawback those assets to meet their claims against the settlor.

Illusory Dispositions

As noted above, one of the problems a settlor often faces is the desire to retain control over the assets which have been placed into a discretionary trust.  The extent of control is a matter which requires great care in many jurisdictions because if too much power is reserved to the settlor, the transfer of assets into the trust may be regarded as illusory, with the effect that at law the assets are regarded as never having been transferred at all.  

The circumstances in which the transfer of assets to a trustee may be regarded as illusory will depend on the terms of the trust itself.  Particularly where the settlor is both the protector and a beneficiary of the trust, as powers are increasingly reserved to the protector, there is a greater risk that the transfer of assets to the trustee will be regarded as illusory.  

Sham Trusts

While the enquiry as to whether a disposition to a trust is illusory depends upon the terms of the trust, in some jurisdictions, the context of the formation of the trust goes to determining whether the trust exists and thus, whether transfers of assets to the trust are effective.  Where the context suggests that there was no common intention to transfer ownership and control of the assets to the trustee despite the formation of the trust through an executed trust deed, the trust deed may be regarded as a sham and the trust may fail.  So, for example, where the settlor at all times regards the assets within a trust as his own and intends despite the trust to retain ultimate control over them, there is a risk that a court may regard the trust as a pretence to mislead other people and thus, invalidate the trust on the basis that the trust deed is a sham.

Matrimonial Laws

In some jurisdictions, matrimonial laws can have a significant impact on the structure and timing of the formation of a trust and the manner in which the trust is operated.  For example, legislation may enable a court to vary the trust as if it were a nuptial settlement (i.e. as if it were a pre- or post-nuptial agreement.  Equally, for example, as in the case of a fraudulent disposition, legislation may empower a court to set aside dispositions of property into a trust if the disposition was for the intention of defeating a claim for financial provision of a spouse.  Finally, for example, if there is an expectation that a spouse will receive benefits under a trust, the court may treat those benefits as assets of the spouse even if the trust is discretionary and the trustee has yet to exercise any discretion in favour of that spouse.

What it all means for the effectiveness of the trust as a shield?

It will be readily apparent from the foregoing that setting up a discretionary trust is not, by itself, likely to achieve asset protection objectives.

Timing will have an impact on the extent to which these objectives can be met, both in terms of when the trust is established and when assets are injected into the trust.  Where timing is unfavourable, consideration must be given to whether there are ways to compensate.  For example, in a family trust, if the desire is to protect the assets from distribution to a spouse of a child, consideration may be given to the type of interest the child may have in the trust, the circumstances in which distributions are made to the child and the type of distribution made to the child.  Even where timing is favourable, consideration should be given to how to avoid future timing issues if it is desired that further assets be placed into the trust.

Equally, to meet these asset projection objectives, it will be prudent to consider the extent of control truly required and, if a higher degree of control may be regarded as being necessary, it will be prudent to consider whether there are means external to the trust itself to achieve influence over the trustee, bearing in mind the trustee’s duties under the law and the desire to avoid the integrity of the trust and its due establishment being questioned.  

Finally, the structuring of the transfer assets to the trust and the manner of holding these assets within the trust may affect the extent to which objectives can be met.  Where transfers of assets  may be susceptible to attack in a particular jurisdiction, it may be desirable to inject these assets first into special purpose vehicles (SPVs) incorporated in a different jurisdiction and then to transfer the interest in these special purpose vehicles into the trust.  

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Hong Kong Trusts

Hong Kong trusts may be indefinite (no rule against perpetuities) and the settlor may reserve investment powers. Forced heirship laws do not apply.

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We discuss different types of Hong Kong trusts including discretionary trusts, fixed trusts, living trusts and testamentary trusts