The benefits of using a discretionary trading trust for tax planning, concessions, benefits and asset protection are well established in today’s business accounting scene. Interposing a corporate entity as the trustee is becoming an increasingly common way to operate the business of the trust.

But are trust assets as safe as you—and your clients—think they are?

Here’s how the corporate structure is commonly used to operate the business of a discretionary trust:

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In this scenario, the structure generally has the directors/shareholders of the trustee company (as well as family members and other entities such as trusts or companies) as the beneficiaries. This effectively gives them control of both the trustee company and the trust. The trust structure separates legal ownership and control (which vests in the trustee company) and the beneficial asset (which vests in the beneficiaries of the assets).

However, businesses using a structure such as this are just as likely to encounter financial difficulty as a company trading in its own capacity (i.e. where the company isn’t trading as a trustee of a trading trust). So if the trust becomes insolvent, what happens to those affected? And what mechanisms are in place to wind down the business?

The next diagram explains the process of a business incurring and paying a debt using the structure we mentioned earlier.

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If the trust can’t pay its debts as and when they fall due, the trustee company is liable for those debts and may need to be placed into liquidation.

Trustee’s right of indemnity and liquidation

While a trustee holds the asset in the trust for the benefit of the beneficiaries in accordance with the terms of any trust deed, they have the right to be indemnified from any such assets (e.g. to pay any creditors). This means the trustee can use the assets of the trust for that purpose before  it’s distributed to any beneficiaries.

If the trustee company is placed in liquidation, then the trustee’s right of indemnity still remains and is considered an asset in the liquidation. Recent court cases have shown this indemnity generally survives even when the trustee changes or is automatically removed upon an insolvency event.

State trust statutes generally stipulate a trust deed must include the trustee with a right of indemnity against trust assets. This is included in the New South Wales legislation under Section 59 of the Trustee Act 1925 (NSW), and is sometimes referred to as an implied indemnity.

Liquidator’s power of sale of trust assets

A trustee company liquidator has the right to use trust assets to satisfy those liabilities incurred by the trustee company in the proper administration of the trust pursuant to the trustee’s right and indemnity and the terms of the trust.

It’s common for trust deeds to provide for the automatic removal of the trustee upon an insolvency event.

The removal of the trustee, and the liquidator’s right to deal with trust assets, has been the subject of much ambiguity in recent years. The recent Federal Court case of Neeeat Holdings (in liq) [2013] FCA 61 clarified the following principles:

  1. If liquidation causes a trustee to be removed, it remains entitled to hold the assets as against the beneficiaries and any trustee to exercise its right of indemnity out of the trust assets.
  2. A liquidator may exercise a statutory power of sale over trust assets without seeking the Court’s leave to do so as long as the liquidator has legal title to dispose of the asset.

Exposures faced by directors of trustee companies

If the trustee is not entitled to be completely indemnified out of the assets contained in the trust, Section 197 of the Corporations Act 2001 (Cth) holds the director(s) of the trustee company personally liable for debts incurred by the trustee. That means they are personally liable for those debts if:

  • the trust deed specifically excludes the right of indemnity
  • the trustee is not entitled to be completely indemnified out of the assets contained in the trust for some other reason (such as a breach of trust).

If the directors of the trustee company continue to incur debts on behalf of the trust when it is insolvent, the insolvent trading provisions of the Corporations Act 2001 (Cth) may also apply. If this has occurred, a Court can order the director involved to pay compensation to the trustee company equal to the amount of loss or damage suffered by its creditors.

Trust assets aren’t always as safe as you might think, especially if the corporate trustee has been trading an insolvent business on behalf of the trustee. And replacing an insolvent trustee with a new one won’t stop a liquidator or creditors from chasing the assets of the trust. The outgoing trustee retains its right to be indemnified out of the assets of the trust or any liabilities incurred by the trustee company in the administration of the trust.

So when choosing the trustee for a discretionary trust holding valuable non-business assets, make sure they avoid any trading or other risky activity (e.g. giving guarantees) that would endanger those assets.

If you’d like to ask us any questions about these issues, feel free to get in touch. We’d be happy to have an initial chat over the telephone with you, without cost or obligation.