Discretionary trust
Encyclopedia
In British and Canadian law, a discretionary trust is a trust
where the beneficiaries
and/or their entitlements to the trust fund are not fixed, but are determined by the criteria set out in the trust instrument
by the settlor
. It is sometimes referred to as a family trust in Australia
. Where the discretionary trust is a testamentary trust
, it is common for the settlor to leave a letter of wishes
for the trustee
s to guide them as to the settlor's wishes in the exercise of their discretion. Letters of wishes are not legally binding documents.
Discretionary trusts can only arise as express trust
s. It is not possible for a constructive trust
or a resulting trust
to arise as a discretionary trust.
Discretionary trusts can be discretionary in two respects. First, the trustees usually have the power to determine which beneficiaries (from within the class) will receive payments from the trust. Second, trustees can select the amount of trust property that the beneficiary receives. Although most discretionary trusts allow both types of discretion, either can be allowed on its own. It is permissible in most legal systems for a trust to have a fixed number of beneficiaries and for the trustees to have discretion as to how much each beneficiary receives, or to have a class of beneficiaries from whom they could select members, but provide that the amount to be provided is fixed. Most well-drafted trust instruments also provide for a power to add or exclude beneficiaries from the class; this allows the trustees greater flexibility to deal with changes in circumstances (and, in particular, changes in the revenue laws of the applicable jurisdiction).
Characteristically, discretionary trusts provide for a discretionary distribution of income only, but in some cases the trustees also have a power of appointment with respect to the capital in the trust, i.e. the corpus.
Discretionary trusts are usually sub-divided into two types:
rejected this argument. Even where there is a sole member of the class remaining, so long as there is a possibility that another member of the class could come into existence, that member is not considered a sole beneficiary for purposes of taxation liability.
Gartside v IRC concerned a non-exhaustive discretionary trust; however, in Re Weir's Settlement [1969] 1 Ch 657 and Sainsbury v IRC [1970] Ch 712, the courts held that the same analysis was equally applicable to exhaustive discretionary trusts.
The rights of individual beneficiaries under a discretionary trust being uncertain, it was open to question to what extent the beneficiaries of a discretionary trust (if all of adult age and sound mind) could utilise the rule in Saunders v Vautier. It had been held that beneficiaries under a discretionary trust could do so, although that authority was decided pre-McPhail v Doulton, where to be valid the trustees had to be able to draw up a "complete list" of beneficiaries. That notwithstanding, leading commentators have suggested that provided all of the beneficiaries could be ascertained, they should still retain the right to terminate the trust under the rule, so long as it is an exhaustive discretionary trust.
In Re Locker's Settlement [1977] 1 WLR 1323 the trustees of a discretionary trust did not make any distributions for a number of years based upon the expressed wishes of the settlor. The trust then fell dormant, and after several more years, the trustees sought directions. The court held that their discretionary powers continued, and that they should exercise it in respect of the dormant years now as they should have done at the time. The court reaffirmed that if trustees refuse to distribute income, or refuse to exercise their discretion, although the court could not compel it be exercised in a particular manner, it could order that the trustees be replaced.
The position with a duty to consider exercising discretion in non-exhaustive discretionary trusts is more complicated, as the duty to exercise discretion can be satisfied by deciding to accumulate.
in McPhail v Doulton
[1971] AC 424 where Lord Wilberforce
restated the test for certainty of objects in connection with discretionary trusts. Previously, it had been understood that for the trust to be valid, the trustees had to be able to draw up a "complete list" of all the possible beneficiaries, and if they could not do so, the trust was void
. But Lord Wilberforce held that provided it could be said of any person whether they were "in or out" of the class, as described by the settlor, the trust would be valid.
Because under a discretionary trust, no one beneficiary could be said to have title to any trust assets prior to a distribution, this made discretionary trusts a powerful weapon for tax planners. Inevitably, the surge in popularity has led to a legislative response in most jurisdictions, thus in many countries there are now considerable tax disadvantages to discretionary trusts, which has predictably hampered their use outside the scope of charitable trust
s.
Trust law
In common law legal systems, a trust is a relationship whereby property is held by one party for the benefit of another...
where the beneficiaries
Beneficiary (trust)
In trust law, a beneficiary or cestui que use, a.k.a. cestui que trust, is the person or persons who are entitled to the benefit of any trust arrangement. A beneficiary will normally be a natural person, but it is perfectly possible to have a company as the beneficiary of a trust, and this often...
and/or their entitlements to the trust fund are not fixed, but are determined by the criteria set out in the trust instrument
Trust instrument
A trust instrument is an instrument in writing executed by a settlor used to constitute a trust...
by the settlor
Settlor
In law a settlor is a person who settles property on trust law for the benefit of beneficiaries. In some legal systems, a settlor is also referred to as a trustor, or occasionally, a grantor or donor. Where the trust is a testamentary trust, the settlor is usually referred to as the testator...
. It is sometimes referred to as a family trust in Australia
Australia
Australia , officially the Commonwealth of Australia, is a country in the Southern Hemisphere comprising the mainland of the Australian continent, the island of Tasmania, and numerous smaller islands in the Indian and Pacific Oceans. It is the world's sixth-largest country by total area...
. Where the discretionary trust is a testamentary trust
Testamentary trust
A testamentary trust is a trust which arises upon the death of the testator, and which is specified in his or her will...
, it is common for the settlor to leave a letter of wishes
Letter of wishes
A letter of wishes is a non-binding indication by the settlor of the manner in which he wishes the trustees to exercise their discretion in relation to a discretionary trust....
for the trustee
Trustee
Trustee is a legal term which, in its broadest sense, can refer to any person who holds property, authority, or a position of trust or responsibility for the benefit of another...
s to guide them as to the settlor's wishes in the exercise of their discretion. Letters of wishes are not legally binding documents.
Discretionary trusts can only arise as express trust
Express trust
Where property is passed from an owner to a person an implied express trust, but no gift is made by the owner to that person, it is therefore held for the owner by the person, and this is the Resulting trust; where property should for some reason of public policy or rule of Equity be held by a...
s. It is not possible for a constructive trust
Constructive trust
A constructive trust is an equitable remedy resembling a trust imposed by a court to benefit a party that has been wrongfully deprived of its rights due to either a person obtaining or holding legal right to property which they should not possess due to unjust enrichment or interference...
or a resulting trust
Resulting trust
A resulting trust is the creation of an implied trust by operation of law, as where property gets transferred to one who pays nothing for it; and then is implied to have held the property for benefit of another person. The trust property is said to "result" back to the transferor...
to arise as a discretionary trust.
Discretionary trusts can be discretionary in two respects. First, the trustees usually have the power to determine which beneficiaries (from within the class) will receive payments from the trust. Second, trustees can select the amount of trust property that the beneficiary receives. Although most discretionary trusts allow both types of discretion, either can be allowed on its own. It is permissible in most legal systems for a trust to have a fixed number of beneficiaries and for the trustees to have discretion as to how much each beneficiary receives, or to have a class of beneficiaries from whom they could select members, but provide that the amount to be provided is fixed. Most well-drafted trust instruments also provide for a power to add or exclude beneficiaries from the class; this allows the trustees greater flexibility to deal with changes in circumstances (and, in particular, changes in the revenue laws of the applicable jurisdiction).
Characteristically, discretionary trusts provide for a discretionary distribution of income only, but in some cases the trustees also have a power of appointment with respect to the capital in the trust, i.e. the corpus.
Discretionary trusts are usually sub-divided into two types:
- exhaustive, where the trustees must distribute all income accruing to the trust fund; and
- non-exhaustive, where the trustees have a power to accumulate income.
Analysis
In a fixed trust the beneficiary has a specific proprietary right in relation to the trust fund. Each beneficiary of a discretionary trust, in contrast, is dependent upon the trustees to exercise their power of selection favourably. In Gartside v IRC [1968] AC 553 the Inland Revenue argued that as each beneficiary might be entitled to income from the trust fund, each should be charged as if he were entitled to the whole of the fund. Perhaps unsurprisingly, the House of LordsJudicial functions of the House of Lords
The House of Lords, in addition to having a legislative function, historically also had a judicial function. It functioned as a court of first instance for the trials of peers, for impeachment cases, and as a court of last resort within the United Kingdom. In the latter case the House's...
rejected this argument. Even where there is a sole member of the class remaining, so long as there is a possibility that another member of the class could come into existence, that member is not considered a sole beneficiary for purposes of taxation liability.
Gartside v IRC concerned a non-exhaustive discretionary trust; however, in Re Weir's Settlement [1969] 1 Ch 657 and Sainsbury v IRC [1970] Ch 712, the courts held that the same analysis was equally applicable to exhaustive discretionary trusts.
The rights of individual beneficiaries under a discretionary trust being uncertain, it was open to question to what extent the beneficiaries of a discretionary trust (if all of adult age and sound mind) could utilise the rule in Saunders v Vautier. It had been held that beneficiaries under a discretionary trust could do so, although that authority was decided pre-McPhail v Doulton, where to be valid the trustees had to be able to draw up a "complete list" of beneficiaries. That notwithstanding, leading commentators have suggested that provided all of the beneficiaries could be ascertained, they should still retain the right to terminate the trust under the rule, so long as it is an exhaustive discretionary trust.
Duties
The ordinary correlation between beneficiaries' rights and trustees' duties which arises in fixed trusts is absent in discretionary trusts. Although there are clearly duties, it is less clear whether there are any correlating rights. However, it seems clear that the trustees' duty is limited to (a) determining whether to exercise their discretion, and (b) exercising their discretion lawfully under the terms of the trust. Whilst the beneficiaries will have standing to sue the trustees for failing to fulfill their duties, it is not clear that they would gain by such action.In Re Locker's Settlement [1977] 1 WLR 1323 the trustees of a discretionary trust did not make any distributions for a number of years based upon the expressed wishes of the settlor. The trust then fell dormant, and after several more years, the trustees sought directions. The court held that their discretionary powers continued, and that they should exercise it in respect of the dormant years now as they should have done at the time. The court reaffirmed that if trustees refuse to distribute income, or refuse to exercise their discretion, although the court could not compel it be exercised in a particular manner, it could order that the trustees be replaced.
The position with a duty to consider exercising discretion in non-exhaustive discretionary trusts is more complicated, as the duty to exercise discretion can be satisfied by deciding to accumulate.
Purposes
Discretionary trusts still serve a useful function, despite their original source of popularity (tax savings) having diminished in most countries. They still continue to be used for these reasons, among others:- to protect improvident beneficiaries against creditors - as the beneficiary has no claim to any specific part of the trust fund, none of the trust fund is vulnerable to attachment by the trustee in bankruptcy of any beneficiary
- to exercise control over young or improvident beneficiaries
- to create flexibility to react to changes in circumstances
- in certain jurisdictions, a discretionary trust can be used to protect family assets from forming part of any divorceDivorceDivorce is the final termination of a marital union, canceling the legal duties and responsibilities of marriage and dissolving the bonds of matrimony between the parties...
settlement.
Popularity and decline
The popularity of discretionary trusts rose sharply after the decision of the House of LordsJudicial functions of the House of Lords
The House of Lords, in addition to having a legislative function, historically also had a judicial function. It functioned as a court of first instance for the trials of peers, for impeachment cases, and as a court of last resort within the United Kingdom. In the latter case the House's...
in McPhail v Doulton
McPhail v Doulton
Re Baden's Deed Trusts or McPhail v Doulton [1971] AC 424 was a landmark decision of the House of Lords in English trusts law.-Facts:...
[1971] AC 424 where Lord Wilberforce
Richard Wilberforce, Baron Wilberforce
Richard Orme Wilberforce, Baron Wilberforce, PC was a Lord of Appeal in Ordinary in the House of Lords from 1964 to 1982....
restated the test for certainty of objects in connection with discretionary trusts. Previously, it had been understood that for the trust to be valid, the trustees had to be able to draw up a "complete list" of all the possible beneficiaries, and if they could not do so, the trust was void
Void (law)
In law, void means of no legal effect. An action, document or transaction which is void is of no legal effect whatsoever: an absolute nullity - the law treats it as if it had never existed or happened....
. But Lord Wilberforce held that provided it could be said of any person whether they were "in or out" of the class, as described by the settlor, the trust would be valid.
Because under a discretionary trust, no one beneficiary could be said to have title to any trust assets prior to a distribution, this made discretionary trusts a powerful weapon for tax planners. Inevitably, the surge in popularity has led to a legislative response in most jurisdictions, thus in many countries there are now considerable tax disadvantages to discretionary trusts, which has predictably hampered their use outside the scope of charitable trust
Charitable trust
A charitable trust is an irrevocable trust established for charitable purposes, and is a more specific term than "charitable organization".-United States:...
s.