Discretionary trusts are overwhelmingly used to minimise tax, defeat and frustrate future creditors and deprive separating spouses of a fair share of joint property. The latter two are euphemistically described as "asset protection".
When a legal institution does substantial harm to a significant portion of society's members, it is just and proper to review it. That time is very close for discretionary trusts.
On current settings, tax revenue lost due to discretionary trusts is at least $2 billion a year. But the non-tax damage – in asset protection – is much harder to measure.
Beneficiaries of discretionary trusts do not have a fixed entitlement to income or capital earned by the trustee. Generally, the only way they get an income distribution or capital distribution is through the trustee (often a $2 company) exercising its discretion in their favour. Assets in the trust are in a state of "suspended beneficial ownership".
Because beneficiaries of a discretionary trust have no legal entitlement to income or assets in the trust, beneficiaries' creditors cannot access those assets.
This is the case even though there is a clear expectation, down the track, that the beneficiary will get some assets and income and that the beneficiary has received income in the past.
Further, creditors (for example, suppliers of goods) of a trust are on very shaky ground when the enterprise in the trust fails. Creditors will not get access to the beneficiaries' assets, and if "misconduct" has not occurred, creditors will not get access to the assets of the directors of the corporate trustee.
In regard to relationship breakdown, the family court has generally done a good job in achieving fair outcomes where a divorcing partner (usually male) claims that because assets are in a discretionary trust, they are not owned by anyone and therefore cannot come into the property pool.
Recently, however, asset protection has evolved into "contractually removing" the husband from any connection with the trust as soon there is a hint of relationship problems. Why should the "cheated" spouse have to suffer the legal expenses and stress to assert their property rights in these situations?
In regard to tax minimisation, the widespread practice is that the trustee allocates the trust's taxable income across as many family members as required so the tax bill is reduced, many times to zero or a negligible amount.
Allocations of $20,500 of trust income can be made to children under 18 (for example, a five-day-old baby) with that child paying zero tax
This usually focuses on using adult tax-free thresholds ($20,500), low tax bands and/or a bucket company as a beneficiary where tax is capped at 30%. The sole purpose of the allocations is to minimise income tax. The allocations can also be varied from year to year.
Moreover, the use of the testamentary trust – a discretionary trust created under a will – is an affront to fairness. Allocations of $20,500 of trust income can be made to children under 18 (for example, a five-day-old baby) with that child paying zero tax.
This tax break can last for 80 years if there are sufficient children and grandchildren in the family.
The discretionary trust can be used to give maximum flexibility in making gifts to beneficiaries to take account of changed circumstances over a long period of time (for example, if son Johnny has lost his job he can be given a bit extra this year).
This is a legitimate feature of the discretionary trust, and is one of the reasons for their conception. The problem is, however, that this usage is dwarfed by the asset protection and tax minimisation usages. In any event, achieving flexibility in making gifts to children, and so on, can be achieved and has been done without the use of a discretionary trust.
The "suspended beneficial ownership" feature of the discretionary trust (no one beneficially owns the assets) makes it an attractive institution to "tie up property" for an extended period so it cannot be sold.
This feature can be important to a farming couple, who do not want their farm sold outside the family, even for a period after death. This feature can be retained without the need to deliver the extraordinary tax breaks.
When the overwhelming use of the discretionary trust is tax minimisation, defeating creditors and frustrating divorcing spouses' access to their fair property rights, the case for a comprehensive review is pretty strong.
Justice Peter Young, a leading equity and trust law judge said this in 1997: "When one sees that discretionary trusts are used for the anti-social purpose of minimising taxation or defeating the rights of wives, there does not seem to be any reason in conscience why a court of equity should take any notice of them at all."
This sentiment has even more resonance in 2017.
Dale Boccabella is an associate professor of taxation law at UNSW Business School. A version of this post appeared in The Age.