Discretionary Trust

A Discretionary Trust is a form of trust where the trustee has the authority to decide how to allocate the income and capital of the trust among a group of beneficiaries. The trustee exercises this discretion according to the terms laid out in the trust deed, which typically defines the range of beneficiaries but does not mandate fixed entitlements. This structure is often used for asset protection, tax planning, and managing family wealth across generations.

Key Characteristics

  1. Trustee’s Discretion: The defining feature of a discretionary trust is that trustees have the power to determine which beneficiaries will receive trust distributions and how much they will receive. This discretion allows trustees to adapt to changing circumstances and the needs of the beneficiaries.
  2. Beneficiaries: While a discretionary trust specifies a class or group of potential beneficiaries, none of the beneficiaries have a fixed entitlement to the trust’s income or capital. Instead, their interest is contingent upon the trustee’s decisions.
  3. Trust Deed: The trust deed outlines the trustee’s powers, duties, and the class of beneficiaries. It serves as the governing document and can include specific guidance for the trustee, though the trustee’s ultimate decision-making power remains broad.
  4. Asset Protection and Tax Efficiency: Discretionary trusts are commonly used for protecting assets from creditors and managing tax liabilities. Since the trustee can distribute income in a way that minimizes the tax burden, they are a useful tool for tax planning.

Examples of Discretionary Trusts in Practice

Example 1: Family Wealth Management

The Brown Family establishes a discretionary trust to manage and protect family wealth. The trust deed names the Brown children and grandchildren as potential beneficiaries. The trustee, a professional appointed by the family, assesses the needs of each beneficiary annually. For example, one year, the trustee allocates more income to a grandchild needing university tuition, while another year, more funds go to support a child starting a business. This approach ensures that family resources are distributed equitably and in line with the family’s changing needs.

The trustee also has the flexibility to withhold distributions if beneficiaries exhibit financial irresponsibility. This arrangement protects family assets while providing financial assistance where needed. Furthermore, since distributions can be adjusted for tax efficiency, the overall tax burden on the trust’s income is minimized.


Example 2: Asset Protection from Creditors

Mr. Smith, a successful entrepreneur, sets up a discretionary trust to safeguard his personal assets from potential business creditors. He appoints his spouse and children as beneficiaries but does not assign fixed entitlements to any of them. By doing so, his assets are legally held by the trust rather than being his personal property. If Mr. Smith’s business faces financial difficulties and creditors seek repayment, the assets within the discretionary trust are generally protected because they do not belong to him personally.

The trustee, in this case, decides when and to whom to distribute the trust assets. As the trustee retains discretion, creditors cannot force distributions to satisfy Mr. Smith’s debts. This example highlights the effectiveness of discretionary trusts as a mechanism for asset protection.


Example 3: Charitable Discretionary Trusts

A wealthy philanthropist creates a discretionary trust for charitable purposes, naming several charitable organizations as potential beneficiaries. The trustee is given discretion to allocate funds to different charities based on societal needs and the effectiveness of the charities’ work. In one year, the trustee may distribute funds to disaster relief efforts, while in another, they might prioritize educational initiatives.

This discretionary framework allows the philanthropist to support charitable causes flexibly, ensuring that funds are used where they are most needed over time. It also allows for adjustments in response to emerging social issues or changes in the effectiveness of different charitable organizations.


Prominent Cases Involving Discretionary Trusts

Gartside v. Inland Revenue Commissioners (1968)

One landmark case concerning discretionary trusts is Gartside v. Inland Revenue Commissioners. The House of Lords addressed the question of whether the interest of a beneficiary in a discretionary trust could be assessed for estate duty. The court held that, because beneficiaries have no fixed right to income or capital, only a right to be considered for distributions, their interest could not be valued as a present entitlement. This case underscores the principle that beneficiaries of a discretionary trust have no guaranteed rights to the trust assets, highlighting the protective nature of such trusts.


Breakspear v. Ackland (2008)

In Breakspear v. Ackland, the court examined the rights of beneficiaries to information about the trustees’ decision-making process. The High Court ruled that the “letter of wishes” written by the settlor to guide the trustees was confidential and did not need to be disclosed to the beneficiaries. This case emphasized the discretionary power of trustees and the limited rights of beneficiaries to challenge trustee decisions, affirming the trust’s confidentiality aspects.


Commissioner of Taxation v. Clarke (2020)

In Commissioner of Taxation v. Clarke, the Australian High Court evaluated whether the trust income distributed to a beneficiary should be subject to tax. The court examined how discretionary powers impacted the tax treatment of distributions. The decision highlighted the complexities of tax liabilities in discretionary trusts and reinforced the importance of proper tax planning to avoid adverse tax consequences.