Discretionary trust
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A discretionary trust[1] 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. Where the discretionary trust is a testamentary trust, it is common for the settlor to leave a letter of wishes for the trustees to guide them as to the settlor's wishes in the exercise of their discretion.
Discretionary trusts can only arise as express trusts. It is not possible for a constructive trust or a resulting trust to arise as a discretionary trust.
Discretionary trusts can be said to be discretionary in two respects. Firstly, the trustees usually have a power to select which beneficiaries payments will be made to from within the class, and secondly, they can select the amount of trust property that the beneficiary receives. Although most discretionary trusts have both types of discretion, it is not necessarily so. It would be perfectly permissible in most legal systems for a trust to have fixed number of beneficiaries and for the trustees to have a discretion as to how much each beneficiary receives,[2] or to have a class of beneficiaries from whom they could select members, but provide that the amount to be provided is fixed.[3] Most well drafted trust instruments also provide for a power to add or exclude beneficiaries from the class;[4] 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 relate to a discretionary distribution of income, but in some cases the trustees will also have a power of appointment with respect to capital assets.
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.
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[edit] Analysis
In the case of a fixed trust, the beneficiary has a specific proprietary right in relation to the trust fund. The position is different with a discretionary trust, as each beneficiary is dependent upon the trustees to exercise their power of selection favourably.[5] In Gartside v IRC [1968] AC 553 the Inland Revenue argued that as each beneficiary might be entitled to income from the trust fund, they should each be charged as if they were entitled to the whole of the fund. Perhaps unsurprisingly, the House of Lords 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.[6]
IRC v Gartside 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,[7] 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 the 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.[8]
[edit] 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 less clear whether they are any correlating rights.[9] However, it seems clear that the trustees duty is limited to (a) determining whether or not 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 fulfil their duties, it is not necessarily clear that they would gain by any 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 the discretion in non-exhaustive discretionary trusts is more complicated, as to the duty to exercise the discretion can be satisfied by deciding to accumulate.
[edit] Purposes
Discretionary trusts still serve a useful function, despite their original source of popularity (tax savings) having diminished in most countries. The main purposes they still continue to be used include:
- 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 will be capable of 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 divorce settlement.[10]
[edit] Popularity and decline
The popularity of discretionary trusts rose exponentially after the decision of the House of Lords 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,[11] which has meant that in many countries there are now considerable tax disadvantages to discretionary trusts, which has predictably hampered their use outside the scope of charitable trusts.
- See also: Taxation of trusts
[edit] Footnotes
- ^ Sometimes referred as a family trust in Australia
- ^ Although in many jurisdictions such a trust would be characterised as a fixed trust with a discretionary power of appointment.
- ^ A common example is scholarships set up by way of a trust fund.
- ^ See Re Manisty's Settlement [1974] Ch 17 and Blausten v IRC [1972] Ch 1 256
- ^ Although a discretionary beneficiary clearly does have some species of right under a discretionary trust; they are able to renounce their position as a class member; see Re Gulbenkian's Settlement (No 2) [1970] Ch 408
- ^ Re Trafford's Settlement [1985] Ch 32
- ^ Re Smith [1928] Ch 915
- ^ See Hanbury & Martin (16th ed.) ISBN 0-421-71680-0
- ^ It has been suggested that "the discretionary trust in fact depends on a rule-concept of duty, with no such necessity for correlative rights." (1971) 87 LQR 231
- ^ Although most jurisdictions simply look through trusts for this purpose, for example, in the United Kingdom see section 25 of the Matrimonial Causes Act 1973
- ^ For example, in the United Kingdom, the Finance Act 1975 imposed "capital transfer tax" on any property settled on a discretionary trust; this was replaced in the Finance Act 1988 by inheritance tax.
