Family trust funds under siege

By Nick Smith  Jun 17, 2011 – Source NZ Herald 

Are family trusts still a safe haven for assets and income? asks Nick Smith.

The family trust is under siege as never before. Creditors, lawyers, government agencies and, yes, other family members are storming the trust castle walls in the courts, and pressing the government to make changes.

A raft of amendments relating to legal aid, welfare payments, GST, rest home entitlements, personal and company tax law have already come into force or are pending – all to make it easier to bust open trusts and potentially threaten their integrity as a bastion of New Zealand personal wealth.

As embattled businessmen Mark Hotchin and Rod Petricevic recently discovered, even having enough wealth to buy the best legal advice sometimes cannot protect a family trust from concerted assault by creditors and government agencies – what’s known in legal circles as trust-busting.

The affray has been so intense it has even spawned a new term: “trust-bashing” – an alleged phobia that asserts trusts are primarily formed to avoid tax, maximise government entitlements and improperly frustrate creditors, including family members.

One person’s phobia, a cynic might note, is another’s reality.

This year the Law Commission will release its fourth and final paper on trust law. Following submissions and consultation, it will issue recommendations. On the agenda is a complete overhaul of the Trustee Act, condemned by many lawyers and judges as the most poorly written and unintelligible statute on the books.

A rewrite of the Act, if recommended and adopted, would include provisions to allow courts to bust open trusts, in certain circumstances, to achieve fairness in dividing up relationship property. Under even more tightly controlled conditions, it would also provide access for creditors, including government agencies such as Inland Revenue.

The man in charge of the Commission’s inquiry into trust law, George Tanner, QC, says “we’re just asking the question: should there be an over-riding trust-busting kind of statutory provision that allows the courts to go stomping in wherever they like?

“If there are legitimate reasons for setting up a trust, they can stay,” Tanner reassures. “We’re not trying to do away with trusts.” The commission’s role, he says, is to provide a slow-moving but substantive examination of trust law.

But the commission is considering radical changes that would dramatically affect family trusts, including the establishment of an ombudsman to arbitrate disputes and, potentially, the power to impose resolution of a conflict.

Even more controversial would be the establishment of a register for trading trusts – those family entities that file returns with Inland Revenue. That would trigger a classic conflict over the right to privacy and the rights of the commercial sector.

The purpose of a register, Tanner explains, is so investors fully understand the nature of the company with which they are doing business.

Too often, adds family law specialist Stuart Cummings, businesses or investors enter into arrangements unaware that all of the assets backing the venture are actually held in a family trust, which is not on a public register. When things turn pear-shaped, there’s nothing there for creditors, including business partners.

“You get your legal advice and your lawyers tell you you’re screwed and you should have got a personal guarantee,” says Cummings. A personal guarantee can result in bankruptcy, which at least sheets home personal responsibility. A register of trading family trusts would be the business equivalent of caveat emptor.

Kiwis have always treated the family trust as a fortress, a place to protect intergenerational assets against the vagaries of future events – not least, regrettable decisions such as choosing Mr Wrong.

People want to provide for their children but are often on their second and third marriages, so it is vital, asserts Cummings, that pre-relationship assets be ring-fenced from spousal claims. Yet he readily concedes that family trusts are often misused to frustrate valid claims by spouses and other creditors.

“Why do you think Hotchin and all those guys are still sitting living in luxury? It’s because they’ve got trusts,” says Cummings.

But he argues that the authorities risk ruining the economic omelette in their efforts to crush a few bad eggs.

“For heaven’s sake, don’t lose sight of the fact that trusts operate in many spheres other than relationship property,” he argues. “Don’t screw around with trusts just because you’re trying to achieve the unachievable – justice and fairness between the parties under the concept of relationship property.

“Trusts can be used and are often used to achieve ends that would not sit comfortably with the IRD or people’s concept of being an active and equal member of the community,” Cummings comments. “But the flip side is, if you can’t provide protection for people then they won’t take risks.

“That is where trusts have such an important role to play – you ring-fence assets and put them out of your control and then take a risk, which is such a dynamic part of capitalism.”

The business community is genuinely concerned that changes to trust law will stifle entrepreneurial risk-taking, he says. But then, it is also the efforts of business cheerleaders such as Cummings that have brought these matters to a head.

Family Court lawyers have led the charge in finding inventive and often contradictory ways to achieve or deny a fair and equitable settlement for their clients.

Business disputes involving trust assets are generally dispassionate affairs; Family Court matters generate flames and smoke – and it is the real, and sometimes imagined, iniquity of those proceedings that is providing the heat to drive efforts to reform trust law.

Graham Tubb, Inland Revenue group tax counsel, acknowledges the impact of family law on the general law of trusts. “The relationship property one has been taking the headlines for the last couple of years,” he says. “The courts are being relatively proactive in the family area.”

But Tubb has bigger fish to fry: “The problem we’re having is not just trusts but companies [owned by trusts] claiming large input credit refunds,” he says.

“Trusts are clearly operating to frustrate creditors, such as IRD and the issues there have got worse,” he continues. “Without wanting to pick on any particular sector, there have been a number of well-publicised cases around property developers and non-payment of GST.”

The Crown pays out millions of dollars upfront and then, Tubb explains, when the building is sold “there’s not enough money to pay the GST. Sometimes the market’s moved or, in some cases, some near-fraudulent structures have been put in place – and that’s where the trusts come in.”

The interesting element of Tubb’s story is the powerlessness of an agency feared throughout the land to remedy what, at first blush, seems outright tax avoidance.

“We’re seeing things like a trust formed to build a building, getting a big GST refund at the beginning, eventually selling the building but the trust liability falls on the company appointed as trustee and it hasn’t got any assets – and before you know it, a new trustee is appointed and there’s another $100 shelf company.”

As a result, the government has reached for the blunt instrument and, this year, upfront GST refunds will no longer be paid, no matter how valid. This is solely due to the abuse of trust law. Beggar the entrepreneurs.

“Why is it that New Zealanders have this predilection for trusts?” asks the Law Commission’s Tanner. “Why is it that everyone must have a trust – is it that they don’t trust government? Is it that they think the government will get at their assets and, by putting them in a trust, they’re putting them out of reach?

“I don’t know,” Tanner answers his own question forlornly.

Whatever the reason, New Zealanders have embraced trust culture in record numbers. About 140,000 trading trusts filed returns in 2001; 237,500 did so in 2008, an increase of nearly 60 per cent.

Tax lawyers will point to the Labour Government’s raising of the top tax rate in 2000 as reason for the increase; Family Court lawyers finger flawed relationship property law. Others cite welfare incentives, such as Working for Families and aged-care entitlements.

Inland Revenue’s Tubb: “That’s a massive driver – relationship property stuff and other social welfare issues. There was a tendency to put homes in trusts in order to not pay their retirement levies.”

Everyone mentions the latter. As soon as gran or granddad gets a bit doddery, a trust is formed to put family assets out of reach of a government keen to reclaim both retirement home and palliative care costs. The government has now granted itself powers to “see through” trust arrangements to recover some of this money.

“They look back about five years,” notes Tubb, “but all that means is if you do your planning far enough in advance you are more likely to not have to confront the issue.”

KPMG partner Paul Dunne says the government has moved quickly to close most of the trust loopholes, including “people distancing themselves from asset and income to qualify for Working for Families and the like”.

The government achieves this by assuming that trust income not allocated to a beneficiary is the income of the settlor of the trust in terms of benefit entitlement, Dunne says. The settlor is the person who created the trust.

“There are detailed rules to determine who the settlor is,” he says, adding that if there is more than one settlor, the money is divvied up between them and even income of a trust-owned company is assumed to be the settlor’s.

“The idea,” adds IRD’s Tubb, “is to try and limit the ability to accumulate income in a trust so that’s it’s not earned for tax purposes by the settlor. It’s possibly a blunt instrument but the rules are pretty new.”

So new, in fact, that Tubb says it is too early to determine what impact the change will have on welfare entitlements.

The tax advantages to a trust have largely evaporated, Dunne says, since the government aligned the tax rates.

Yet Kiwi enthusiasm for trusts remains undimmed. “InNew Zealand, there’s one trust for every 18 people,” says law commissioner Tanner, an estimate based on IRD data and a best guesstimate for non-trading trusts. “InAustralia, it’s one for every 34 people. InCanadait’s one for every 148 and in theUnited Kingdomit’s one for every 294.”

His estimate, widely accepted, suggests there are more than 200,000 non-trading family trusts. How many of those involved, Tanner asks, know what their duties are? Not many, is his educated guess.

The Trustee Act needs to be brought into line with the Companies Act, Tanner suggests, including explicit provisions spelling out trustee duties.

One duty is to inform beneficiaries, but “I don’t think many trustees tell beneficiaries anything – a lot of them don’t know they’re beneficiaries at all.

“It was done with directors’ duties in 1993 when the new Companies Act was passed – that sets it out in about a page and a half,” he says. “We’re looking at that.”

One issue, Cummings argues, is the unwillingness of beneficiaries to sue trustees for dereliction of duty. A statutory requirement of fiduciary duty would assist in bringing errant trustees to heel.

Another upcoming change to trust law is the abolition of gift duty. Trustees can now gift beneficiaries up to $27,000 a year; anything more than that amount attracts the duty.

“There was about $1 million gift duty paid and it cost about $60 million to administer,” notes KPMG’s Dunne, who welcomes the abolition.

But lawyer Cummings warns that the move will create a gross inequity by removing one of the primary vehicles for achieving a fair and equitable division of relationship property.

When people place a house in a family trust a debt is created, says Cummings. This debt can only be gifted off at $27,000 a year.

When a spouse or partner sues for their share of the property, he continues, often the only valuable asset is the debt, half of which belongs to the plaintiff.

“The debt’s a good thing; it means it’s outside the trust,” Cummings says. Family Court judges will often order a trust’s debts to be called up, allowing a division of assets.

But with the abolition of gift duty, the debt can be immediately gifted away, leaving nothing for the litigant to claim, he says.

At present only trust income can be accessed to address compensation claims. Cummings argues that if the government abolishes gift duty, then it must amend the law to allow the courts to order a division of trust capital to achieve a fair and equitable settlement.

“The inequalities created by trusts – accessing capital is the only available solution,” he contends. “Parliament, in passing the Property Relationship Act, stopped short of enabling the courts to go that far,” comments law commissioner Tanner. “Parliament says that the object of the legislation is not to enable trusts that have been properly set up to be undone.”

It’s not just disgruntled spouses crying foul; many creditors, particularly IRD, believe trust law is weighted too heavily in favour of avoiding responsibility.

Tubb says the law is clear that the transfer of property into trusts to defeat creditors can be reversed “but it can be a difficult set of rules to apply. From a creditor’s point of view, trusts are pretty complex and relatively unregulated.”

Cummings is adamant that the integrity of genuine trusts must be maintained: “Relationship property law should and does reflect the reality and the right to own separate property. A trust containing separate property should always be inviolable.”

Plenty of Options to Tighten Control

Suggested changes to trust law include:

* Rewriting the Trustee Act to explicitly allow courts to bust open trusts under certain circumstances.

* Compelling trading trusts that file returns with IRD to publicly register, possibly including revealing their assets. A register would allow companies and investors full knowledge before entering a business relationship with a trust-owned entity.

* Amending the Relationship Property Act to allow the Family Court to pay out family trust capital, not just income, in the event of a divorce or dissolution.

* Raising the bar for trust governance by amending the Act to explicitly set out trustees’ fiduciary duties. This would make it easier for beneficiaries to sue trustees, and for regulators to prosecute for breaches.

* Creation of a family trust ombudsman to arbitrate disputes, possibly including the ability to impose resolution on parties.

Trusts – the basics

A family trust is perhaps the most versatile vehicle for protecting commercial and private assets from creditors, the government, family members and other interests.

A trust can be many things to many people – everyone from corporates, to property developers, to small businesses and families have established trusts.

A trust is created by a settlor, traditionally the person with the assets. Today the settlor is often an accountant or lawyer. A settlor can also be a trustee, and can appoint trustees. Settlors and trustees can also be beneficiaries.

The trustees are empowered to deal with the assets of the trust in any manner they feel is in the best interests of the beneficiaries. The trust deed will almost always grant them an indemnity from any consequence of their actions, except those arising from deliberate dishonesty.