- The Victorian Law Reform Commission recommends creation of an ‘oppression’ remedy for beneficiaries of trading trusts.
- Where a business is conducted through a trading trust, and the beneficiaries are subject to oppressive, unfairly prejudicial or unfairly discriminatory conduct, the reform would allow a court to make orders such as requiring the trustee to cease the behaviour, or even termination of the trust or a compulsory buy-out of the beneficiary.
- The arrangements would be similar to the oppression remedies currently available to shareholders in a company.
- But the proposed reform raises questions about the merits of the trading trust structure. Should it be the government’s role to make trading trusts more attractive to business owners?
The Victorian Law Reform Commission, in a report tabled in Parliament in May this year, recommended the creation of an oppression remedy for trading trusts, like the existing remedy for companies.
Currently, where directors of a company conduct its affairs in a way that is oppressive to shareholders, the shareholders can seek court intervention under s232 of the Corporations Act. The court can apply a flexible range of remedies, including requiring the company to cease the conduct, winding it up, or ordering compulsory buy-out of the shareholders.
The VLRC notes the importance of trading trusts in today’s commercial environment in Australia, and considers that existing trust law does not adequately protect beneficiaries against oppression. The VLRC recommends that beneficiaries of trading trusts* be given oppression remedies, equivalent to the remedies they would have if they were shareholders in a company.
That all seems fair. But I wonder whether government should be promoting the use of trading trusts as an alternative to companies. I explain why below.
* The report is concerned with all trusts where trust property is used in a business, but excluding managed investment schemes, charitable trusts, and superannuation funds.
The ubiquitous Australian trading trust
Trading trusts are common in Australian commercial life. For example, I might have my company Pemberton Publicans Pty Ltd* buy a pub,** owning the pub and running the business as trustee of the Pemberton Family Trust rather than in its own capacity.
The Pemberton Family Trust would probably be a discretionary trust. Beneficiaries would be myself, my wife, our children, and perhaps other more remote relatives. The trust’s income would be earned for the benefit of the beneficiaries. Each year, the directors of Pemberton Publicans (probably my wife and I) would decide how Pemberton Publicans as trustee should distribute the income among the beneficiaries. We would probably give it to family members with the lowest marginal income tax rates, minimising tax payable by the family overall.
If we needed to keep the money in the business, the beneficiaries could immediately lend it back to the trustee. (If they weren’t willing to lend it back, they probably wouldn’t get a distribution in the first place.)
* Not a real company
** Not a real pub, either … though maybe one day …
Rationale for trading trusts
This sounds much more complicated than Pemberton Publicans owning the pub in its own right, and distributing profits to its shareholders as dividends. Why do it?
Distributions where no profits
This used to be an important benefit of trading trusts. Company law used to prohibit payment of dividends except out of profits. This was a problem for companies such as property investors, which might have cash income, but no accounting profit, because the income was eaten up by non-cash deductions such as depreciation. Trust law allows distribution of income without requiring accounting profits.
But this reason ceased to be relevant in 2010, when the profit rule was removed: Corporations Act, s254T.
The class of beneficiaries can be broad, even undefined. Individuals within a broad family description can receive distributions without the need to issue shares to them individually. In particular, it is inconvenient to issue shares to minors under 18. (Though there is little benefit in making substantial trust distributions to a minor under 18, either, as unearmned income over $416 is taxed at a penal rate of up to 66%.)
As discussed below, I think the benefit of flexibility in distributing trust income is overrated.
This is the main reason. If we have enough family members with marginal rates below the 30% corporate rate, we can pay less tax overall than if Pemberton Publicans Pty Ltd had to pay the tax on its own behalf.
But what about flexibility?
There is no reason why a proprietary company, without a trust, can’t distribute variable amounts to individual shareholders. Section 254W(1) of the Corporations Act requires public companies to pay equal dividends per share. But no such constraint applies to proprietary companies.
Pemberton Publicans Pty Ltd can issue shares to me, my wife, and our children, and pay us different dividend amounts each year, as determined by the directors. If we like, we can make this explicit, by issuing different share classes (my wife would have the A class, I would have the B class, etc). But there is no real need for different classes.
Trusts are not well suited to commerce
Lack of an oppression remedy is not the only way trusts fall short of companies as vehicles for trading.* Here are some others. Often it is banks and other lenders who think most deeply about these things when lending to trusts, but they can affect other third parties dealing with trusts just as much. (In comparing ‘trusts’ to ‘companies’, I am talking about the difference between a trading trust (which may well have a company as trustee) on the one hand, and a company acting solely in its own capacity (and not as trustee) on the other hand.)
Lack of power
No-one dealing with an Australian company incorporated under the Corporations Act needs to worry whether the company has power to enter into the relevant transaction, as all such companies have full legal capacity: Corporations Act, s124. This does not apply to trusts. Trustees’ powers may be limited by the trust deed, and you need to inspect the trust deed to see whether or not the transaction is within power.
For example, it is common to find trust deeds that permit guarantees but not indemnities; or that permit the grant of security for the trusts’ own borrowings but not to secure the borrowings of a third party.
In practice, some banks make a business decision not to review their trust customers’ trust deeds, and to accept the risk that some transactions will be beyond power. But the risk remains.
Beneficiaries’ rights may prevail over third parties.
Where a trustee breaches its duties to beneficiaries, the beneficiaries can make good their loss out of the trust assets. That right may prevail over the right of a third party against the trust assets.
So if the Pemberton Family Trust Deed only authorises the running of a pub, but Pemberton Publicans Pty Ltd engages in loss-making speculative derivative transactions in breach of the deed, the breweries and others owed money from making supplies to the pub business may find their claims rank behind the claims of my family members who have lost out because of the unauthorised speculative dealings.
The laws around dealing with an insolvent trust* are surprisingly unclear. There is no straightforward procedure for terminating a trust equivalent to the regulated procedure for winding up a company under the Corporations Act. The way in which voluntary administration procedures operate for trustee companies – particularly where they hold assets both as trustee and in their own capacity, or as trustee of several trusts – is often not clear.
* and, strictly speaking, even what the phrase ‘insolvent trust’ means
While a trading trust is profitable, things tend to run well. But when it does not, third parties such as suppliers of goods and services can be in a more precarious position than if they were dealing with a company. Their rights can be affected by problems such as the following, some of which could only be discovered with detailed legal due diligence, and some not at all.
- The trust is not properly constituted, or there are defects in the trust deed.
- Special rules for approval of transactions, set out in the trust deed, are not complied with.
- The transaction is not within powers conferred by the trust deed.
- Money is owed to beneficiaries because of breaches of duty by trustee.
- Assets that seem to be part of the trading trust in fact relate to a different trust.
Should we make trusts more like companies?
I suggest not.
Company structure is better
As outlined above, trusts suffer from several defects as vehicles for commercial activity when compared to companies. The old rationale of being able to distribute cash in the absence of accounting profits is no longer relevant. Leaving aside tax, it’s difficult now to see much reason to prefer a trust over a company as a trading vehicle. And does tax minimisation really justify the legislative effort – especially when trust vehicles create traps for unwary third parties dealing with them?
No commonwealth uniformity
Trust law is a state matter. Company law has been unified by the Commonwealth using the constitutional ‘trading corporations’ power, but trust law cannot be. The VLRC’s proposed reform would apply in Victoria only, unless all other states and territories adopt equivalent laws. Jurisdictional differences in business dealings are unhelpful, and I do not see the benefit in increasing them via promotion of trusts as a business structure.
Anyway, are beneficiaries really like shareholders?
Shareholders usually pay for their shares. Trust beneficiaries may not, particularly in a discretionary trust where beneficiaries are often a broadly-defined class of family members. Some may not even know they are beneficiaries. Do they really deserve ‘fair’ treatment in the same way as shareholders? In one sense, of course, yes; but disputes about oppression may arise in much broader contexts for trusts than for companies. If I use my family trading trust to make a one-off distribution to my sister’s children, might my brother’s children be able to complain that I should have done the same for them?
The VLRC report acknowledges this issue, pointing out that courts will be able to take account of the differences in selecting the appropriate remedies. A remote family member may be able to get the court to order the trustee to give appropriate consideration to the member when deciding on distribution, but may have little chance of being able to get the trust terminated. So the expanded remedies may not lead to unfair outcomes; but the broad definitions of many classes of beneficiaries may lead to more disputes.
It could have been so different
Back in 2000, the Government proposed to tax discretionary trusts like companies, and released exposure draft legislation, but the proposal was later withdrawn.*
I suspect if that reform had gone ahead, the use of trading trusts in Australia would now be significantly reduced, and the VLRC’s proposal would not be under consideration.
* The history is conveniently summarised here.
The Government will no doubt consider a response to the report. As I see it, there is a choice between two competing viewpoints:
- the functional approach – trading trusts achieve similar business objectives to companies, and so outcomes and remedies should be similar where possible.
- what’s best for business – trading trusts no longer offer significant advantages to business owners other than reduced taxation, and involve potentially serious pitfalls for third parties dealing with the trusts; so it is not desirable for Government to adopt reforms that encourage use of trusts in place of companies.
My own preference is the latter, which leads me to suggest the reform is not a desirable one.