Family Trusts: Handle With Care

PORTFOLIO POINT: The court case around Gina Rinehart’s family trust highlights the need for all investors to approach these valuable tax vehicles carefully.

There are more than 600,000 family trusts operating in Australia and they are a popular asset protection vehicle for many Eureka Report readers. In recent weeks, the explosive story of how iron ore billionaire Gina Rinehart and her daughter Ginia have split from the rest of the family in a family trust dispute has hit the headlines. The majority of media coverage centres around Gina Rinehart’s decision to extend the tenure of the trust by half a century'¦ even WA Premier Colin Barnett has been asked to intervene! But we wanted to know how family trusts actually work, the best way to treat these vehicles and how regular investors might avoid the horrors of a family trust dispute. Bernie O'Sullivan has written a book on the subject and today he offers an expert guide. – Eureka Report managing editor James Kirby

I can imagine Gina Rinehart looking out her window and wondering, “how did it all come to this?”

The now very-public dispute over the Hope Margaret Hancock Trust (Hancock Trust) has traits of wealth, power, family brawling and glimpses into the private affairs of a wealthy family – epic ingredients for a media feast.

But a difficulty that always existed with the Hancock Trust was that it was due to end ('vest’) on September 6 2011, when the youngest beneficiary attained 25 years of age – only 23 years after the trust was established. This was problematic, because the vesting of a trust is a capital gains tax (CGT) event and so if any trust assets are 'pregnant’ with capital gains at the vesting date, then CGT issues arise. It is understood that the capital gain that would arise if the Hancock Trust vested in September 2011 would be in the hundreds of millions of dollars.

In the days leading up to September 6 2011, Mrs Gina Rinehart (in her capacity as trustee of the Hancock Trust) was corresponding with her children about the possibility of them all agreeing to extend the vesting date of the Hancock Trust to 2068, with the aim of delaying a CGT event being triggered.

Reportedly, the proposal by Mrs Rinehart to extend the vesting date seems to have been complicated by a request by her that the children also sign a deed giving up certain rights. It appears that this request did not appeal to the children and, as time was quickly running out, Mrs Rinehart purportedly extended the vesting date to 2068. The children now say that they did not agree to this extension and allege that their mother is not an appropriate person to act as trustee. The matter is likely to be before the courts for some time yet.

This dispute is the latest in a number of recent cases involving family trusts. So what issues do these cases deal with and what lessons can be learnt?

By way of background, 'family trust’ is the generic term given to a trust created during a person’s lifetime. The features of a typical family trust are:

• It is 'discretionary’, meaning that the trustee has discretion as to whether to make distributions and, if so, whom to and in what proportions;

• It has been established at the request of a person who is referred to in the trust deed as the 'Primary Beneficiary’;

• The beneficiaries of the trust are a broad group including the Primary Beneficiary, their spouse, children and other lineal descendants, their siblings, nieces and nephews and trusts or companies they or other beneficiaries are associated with;

• The Primary Beneficiary controls the trust by virtue of their role as trustee (or director of the company trustee) and 'appointer’ of the trust (the appointer has the power to replace the trustee); and

• The trustee has very broad powers, such as the ability to invest in virtually any type of investment and to lend monies to beneficiaries on generous terms;

• The 'vesting date’ is usually the date 80 years from when the trust was established (but, as with the Hancock Trust, can be earlier).

Key lessons from recent cases involving family trusts are:

Trustees should not seek to control the way in which beneficiaries behave. A classic example is the Western Australian case where two uncles controlled a trust, the main beneficiaries of which were their nieces. The uncles made it clear to the nieces that they expected them to live their lives in a certain way, otherwise they would not receive future distributions. The court removed the uncles from their controlling positions.

Beware the Family Court. Although beneficiaries of family trusts have a 'discretionary’ interest in the trust and not a 'fixed’ interest, their interest may in some cases be regarded by the Family Court as 'property of the marriage’, some or all of which can be allocated to a former spouse. Primary Beneficiaries are understandably concerned about the possibility of claims against the trust by their partner or (increasingly, as the Primary Beneficiaries age) by their children’s partners. Strategies dealing with this significant risk must be implemented wherever possible.

Primary Beneficiaries do not own the trust assets. It is not uncommon for a Primary Beneficiary to mistakenly regard the assets in the family trust as their own personal property. Two problems arise from this misconception: First, the trustee (under the control of the Primary Beneficiary) treats the assets as belonging to the Primary Beneficiary and ignores the significant obligations and duties owed to the trust and other beneficiaries, leaving the trustee open to being sued. Second, many Primary Beneficiaries make a will mistakenly believing they are disposing of the family trust assets, when in fact none of the assets in the family trust form part of their estate and therefore cannot be dealt with by their will. It is essential that a person controlling a family trust puts in place a 'family trust succession plan’ to ensure tax-effective intergenerational transfer of control of the trust and its assets.

Amending the deed is not always easy (or possible). Some deed amendments can only be made with the approval of all the beneficiaries or the court. However, as the beneficiaries of a family trust usually include minors and unborn children, it is often impossible to obtain the agreement of 'all the beneficiaries’. Seeking the approval of the court is costly, results in the details of the trust becoming public and in any event may not be successful. Sometimes amending a deed simply is not practicable or possible.

Amending the deed can amount to a resettlement for tax purposes. Some deed amendments change the nature of the family trust so much that the Commissioner of Taxation will regard the old trust to have been wound up and a new trust established. In such an event, the trust is said to have been 'resettled’ and a CGT event to have occurred on the date of the change, giving rise to a potentially significant CGT liability. It is essential that advice be obtained before changes are made to family trust deeds.

Compliance pays. Some trusts have, shall we say, compliance issues. A judge will not hesitate in referring a matter to the Commissioner of Taxation if taxation compliance issues exist. Other compliance issues may relate to the legality of past resolutions or distributions. It is not uncommon for an aggrieved beneficiary to use past shortcomings in compliance as leverage in their request for a greater share of the trust fund.

Be careful with promises. Many family trusts operate family businesses that employ family members. Take care with promises such as “One day, all this will be yours!” as they can give equitable and legal rights to the promisee. A recent Victorian case went all the way to the Supreme Court of Appeal because of a dispute between a father and a daughter over alleged representations regarding control of the trust upon the father’s death. The father successfully defended the claim, but the cost to all parties (in dollar and emotional/family terms) must have been enormous. If you have a family member who is under a mistaken impression with regards to their future role in the business, bite the bullet now and set the record straight. You will both be better off in the long term.

Understand loan accounts. Many family trusts make regular 'book-entry distributions’ to beneficiaries, such as the Primary Beneficiary’s children. The 'distributions’ are not physically paid from the trust, but recorded as journal entries showing the amount leaving the trust then returning as a loan back to the family trust from the beneficiary. It is imperative that legal consequences of these distributions/loans are understood, because at some stage the beneficiary just might knock on the trustee’s door and ask that the accumulated loans be repaid! Sometimes the beneficiary’s spouse will be delighted to discover that these loan accounts exist and form part of the 'property of the marriage’ pool of assets that can be divided by the Family Court.

Family trusts were first regularly established in the 1970s and 1980s. The time for transfer of control of these trusts is now rapidly approaching. Many trustees have not given adequate attention to the need to protect trust assets. It is essential that advice is sought from a lawyer experienced in all aspects of wealth succession to avoid the types of bitter, expensive and public disputes that we now see arising.

Bernie O’Sullivan is a lawyer specialising in private client matters, including family trusts. He founded Bernie O’Sullivan Lawyers and is the lead author of Estate and Business Succession Planning (now in its fourth edition), published by The Tax Institute.