Background

Trusts play a big role in asset protection and income tax planning for many individuals. It would probably be true to say trusts are one of the great innovations of the English judiciary. Proposals by the legislature to change how the income of trusts are taxed usually meets stiff resistance from noisy, small but powerful interest groups. Many sections of the business community consider the right to conduct their affairs through trusts as a fundamental right similar to operating via a limited liability company.

The trust is a creature of equity. It does not have a separate legal personality, hence it requires a trustee, typically an individual or a company.  The company is typically used due to its limited liability.

Extent of the use of trusts

Taxation statistics for 2012/3 from the ATO reveal 780,105 trust tax returns were lodged compared with 854,745 company returns. Of these 323,605 trusts were classified as micro or small entities based on business income. Micro or small entities report between $1 and $10 million of business income. The statistics do not enable the identification of the number of the trusts having a corporate trustee, but we would assume, based on the RSM experience of advising clients, that a large proportion of these trusts have a corporate trustee.

The corporate insolvency dilemma

A corporate trustee of a trust presents a unique range of difficulties for corporate insolvency practitioners. The trustee is personally liable for liabilities incurred in its capacity as trustee of the trust. Many creditors will either not know or understand the implications of extending credit to a trading trust. Equity gives the trustee company a right to have trust assets applied to meet liabilities incurred as trustee.  This right of indemnity from the assets of the trust affords the trustee with some relief in meeting the trust liabilities.

The affairs of the insolvent company may be further complicated by it trading and incurring debts in its own capacity or as trustee of other trading trusts.

However deeds establishing trusts are not uniform and may contain many provisions with serious implications for an external administrator to a corporate trustee.

Proposal for reform

In 1988 the Australian Law Reform Commission (ALRC) identified a number of issues that required resolution and made recommendations to resolve them:

  • Power of external administrator to administer trust property
  • Power of external administrator to administer both the affairs of the company and the trust
  • Limitations on the right of indemnity and the exercise of the right of indemnity
  • Circumstances in which a corporate trustee can be removed
  • Extent to which trust property can be applied to meet obligations incurred that the trustee was not empowered to incur under the trust deed
  • The order of distribution of trust property to creditors

Due to the legislature’s lack of appetite for insolvency law reform, the legislature ignored these recommendations.

Impact of failing to act

This has left external administrators to deal with these issues as and when they arise when appointed to insolvent corporate trustees. Dealing with these issues on this basis is costly, time consuming and the outcome uncertain. One or more applications to Court will be required to obtain the orders and powers necessary to deal with the issues related to trading trusts. Legal practitioners benefit from the legislature’s failure to implement the ALRC’s recommendations.

In contrast, the costs of external administrators are the subject of continuing scrutiny from stakeholders, regulators and the legislature. The failure of the legislature to deal with this issue has loaded the dice against external administrators.

What is happening in practice?

In many cases the assets of the trust are so minimal that issues associated with a corporate trading trust are ignored by the external administrator as the costs of dealing with the issues outweigh the risks of ignoring them.

In some cases the external administrator will apply to be appointed receiver of the trust assets and after realisation of the assets apply to the court for directions to deal with the proceeds in the manner proposed. Normally to pay them to the insolvent estate of the corporate trustee for distribution to creditors in accordance with the Corporations Law (“the Law”).

In other cases external administrators realise assets of the trust and then apply to the court for directions to deal with the proceeds. A recent example is the case In the matter of Independent Contractor Services (Aust) Pty Ltd ACN 119 186 971 (in liquidation) (No 2) [2016] NSWSC 106.

In court appointments the external administrator’s knowledge of the company’s activities is extremely limited. The external administrator may often realise the assets before becoming aware of the company’s role as a trustee.  In practice this often occurs on receipt of a BAS for the trust sometime after the appointment.

It is likely that many external administrators are making a practical, commercial decision to ignore the existence of the trust and treating assets of the trust as company property and dealing with their proceeds in accordance with the Law.

What is the risk anyway?

The continuing and ever expanding use of corporate trading trusts to conduct commercial activities by small and medium sized enterprises means insolvency practitioners will continue to be exposed to insolvent corporate trustees.

Any application to Court for directions has risks that the Court will act in a manner contrary to the applicant’s expectations. Costs of legal advice and court applications have significant impacts on the likelihood of creditors benefiting from the external administration of insolvent corporate trustees .

The legal costs associated with making applications to court for directions in administrations of corporate trustees are borne by unsecured creditors. This is a cost that is not borne by unsecured creditors of a company not acting as a trustee. Is it appropriate that creditors should bear these costs when the trust structure to all intents operates in the same manner as a company? Further creditors and employees often have no visibility of the underlying business structure of the company they are dealing with or are employed by.

It is time for the legislature to act to provide external administrators with statutory powers to deal with trust property and distribute the proceeds of the trust property. This will facilitate the cost effective administration of insolvent companies that are trustees of trusts.  It is time for the recommendations of the ALRC in regard to trading trusts to be implemented.

If you have any questions in relation to this article, please contact your local RSM adviser or David Kerr.

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