Guide to the benefits of owning company shares through a discretionary trust

Introduction to Discretionary Trusts

I have been dealing with trusts, from many different jurisdictions, for more than 25 years. Not all those trusts have been discretionary but the majority have been and that is still the case today. It is also a truism that the directly held trust fund assets, of those discretionary trusts, usually consist of the shares of one or more companies with various kinds of business activities including owning investment portfolios.

However, I acknowledge that, in modern times, it is becoming increasingly popular, (from a management of assets perspective), for trustees to be the limited partner of a limited partnership. Nevertheless, even in such case, it is common for the limited partnership to own the shares of one or more companies. Thus, there is indirect ownership of company shares, in such case, by the trustee.

A typical irrevocable discretionary trust ("DT") will have an assets contributor, usually called a Settlor, because he is the person who "settles" the initial assets into the trust. The Settlor will usually enter into an written agreement with a person called a Trustee who will hold and manage the assets for the future benefit of persons that the Settlor has nominated to benefit from the DT. These persons are called Beneficiaries and the Settlor can also be a beneficiary if he wishes to be. The DT agreement is commonly called a Trust Deed or a Trust Instrument.

It should be noted that the word "person" applies to corporate entities as well as individuals. Thus, it is possible for a Settlor to be a corporate entity and beneficiaries can also be corporate entities. However, it is usually the case that Settlors and beneficiaries are individuals. Trustees can also be individuals but it is now preferred that independent Trustees are corporate entities and especially trustee companies, which have been licensed by a regulatory authority, to deliver trustee services. A licensed trustee is far less likely to commit a fraud than an individual trustee, as most individual trustees are not subject to regulatory oversight. (Some law firms will also provide "low-risk" trustee services too).

Discretion to appoint income and capital

Another feature of the DT is that the Trustee will usually have absolute discretion as to when it makes an appointment of income and/or capital to a beneficiary. This is a discretion that applies to vesting of trust fund income and/or assets and the present entitlement to enjoy such income or capital by a beneficiary.

Thus, a person can be a beneficiary of an DT and never receive an appointment of income and/or capital and it can be the case that some beneficiaries may receive a greater share of the trust fund assets than others. Indeed, I recall that I was one among four beneficiaries of a DT and I was the only one to receive the remaining trust fund assets, when the DT was terminated, at the discretion of the Trustee, although the Settlor was instrumental in helping them to reach that decision. (Thanks Dad!!).

Thus, because of these appointment discretions, it can be argued that no discretionary beneficiary has an absolute entitlement to the trust fund assets, (or any part of them), at any time, until they have received a partial or full distribution of the trust fund assets. (The entitlement "vests" when the distribution is effectively made).

No beneficial ownership by beneficiaries

If the shares of an underlying company ("UC") are the sole trust fund asset, directly held by the DT trustee, then there is no beneficial ownership of the UC, by the beneficiaries, until the DT terminates or the shares of the UC are distributed in specie to one or more beneficiaries. Beneficiaries may benefit from the UC's business activities, in future, but there is no absolute certainty that they will. The Trustee is legal owner of the UC but the Trustee cannot benefit, (unless it is also a beneficiary), from the UC's income, except for payment of its fees, as detailed in the Trust Deed, and reimbursement of costs incurred through trust administration.

Why is this important? From a tax point of view, it can be the case that income earned by the UC should not incur a tax liability, for the Settlor, as he no longer legally owns or beneficially owns the UC. Similarly, the beneficiaries should also be exempt from a tax liability as they do not beneficially own the UC either. Assuming a beneficiary lives in a high tax country then it is likely that he/she will only have any kind of tax liability once they receive a distribution, from the DT, which is required to be reported to their local tax authority.

Creditor Protection

This makes an DT an incredibly powerful tax deferral tool, (assuming there is no taxation of trust income), and the DT may offer creditor protection too. Thus, creditors of a Settlor cannot seize ownership of the UC and/or benefit from its profits, as the UC is no longer owned by the Settlor. (Assuming the debt arose, after the UC was transferred to the Trustee's ownership, as otherwise the transfer is voidable by "claw back" rules that exist in most jurisdictions). Similarly, beneficiary creditors are equally powerless until the beneficiary receives some (or all) of the shares of the UC or a distribution from the DT.

Tax minimization

Many UCs are incorporated by DT Trustees from funds contributed to them, by the Settlor, but it is becoming increasingly common for Settlors to contribute the shares of a company, directly owned by the Settlor, to the DT Trustee and for that company to become the UC. This is often because continued ownership of the company will cause the Settlor to incur a tax liability. Thus, it is better to contribute the shares of the company to a DT Trustee than have the legal obligation to report the income of the company and pay tax on said income even if not yet received. (Most high tax countries now have "attribution" rules where income earned by a company, and especially passive investment income, is "attributed" to the beneficial owners of said company, (even if they have received no dividends from the income earned), which creates a reportable tax liability.

Death benefits

A DT can also solve problems that may be caused by beneficial owner decease. For example, I own a couple of offshore companies where I am the sole director and shareholder. Furthermore, I am also the sole signatory on each company's bank account, which is not an uncommon situation for offshore companies that are still owned directly by beneficial owners. Unless I restructure, then there's going to be a lot of problems, upon my decease, as nobody can sign on the bank accounts and there will be no shareholder to appoint a replacement director and signatory. Sure, I have a will, (which some beneficial owners don't), but there will have to be application to the relevant courts, (after the probate process), to appoint a new director and shareholder, which is likely to be a long-winded and expensive process. In the meantime, my long-suffering wife may have to pawn what remains of her chattels and personal assets, as almost all my assets are held by companies (for tax planning reasons). Even if the devil looks after his own, and I outlive the "trouble and strife", I would normally still have "attribution" issues too. Fortunately, I am tax resident in the Isle of Man which abolished its attribution rules a few years ago.

If the shares of my companies were held by a DT Trustee then none of these issues would apply. Even if I am sole director and signatory, for an UC, the DT Trustee can easily replace me as director/signatory, when I pass on, and usually without application to a court. The shares of the UC can also be transferred to a DT beneficiary if that is deemed to be in the long-term interests of the beneficiary. In addition, I don't have to worry about attribution rules as I wouldn't be the beneficial owner of the UC.

You are forgiven for asking why I am not also the Settlor of a DT? In response, I advise that I am seemingly afflicted by the almost incurable disease of UK domicile and UK domiciles have inheritance tax penalties if they wish to establish DTs. Which is very annoying, in my case, as I wasn't even born in the UK, and I haven't lived there for 30 years either. (Feel free to contact me for alternative solutions to such issues).

Sale of asset benefits

It is very often the case that a DT Trustee can sell an UC to an unrelated party without any tax issues for the Settlor or any DT beneficiary. The sales income can be received by the DT Trustee and reinvested without tax penalty to the beneficiaries. Even if the sales income is ultimately distributed to a beneficiary that beneficiary will be tax assessed on the income received rather than the capital gain. (There are means to reduce this taxable income).

Nominee arrangements

One of the issues with DTs is that they usually cost at least US$5,000 (and often way more) to establish and maintain per annum. Thus, some beneficial owners prefer to use other arrangements such as "nominee" directors and shareholders, which may prove cheaper initially. This is a widespread practice in offshore jurisdictions and nominees are in use in onshore jurisdictions too.

The preference when using a "nominee", as a director, will be to have a corporate director. However, many jurisdictions are now insisting that at least one individual acts as a director of a company registered in that jurisdiction. Some jurisdictions are going further and prohibiting the use of corporate directors altogether.

For a beneficial owner, who is a considering using a "nominee" director, please be aware that a well- trained individual director will not slavishly follow your requests, as a director has a duty to act in the interests of the company, which they are providing director services to, and not in the interests of a 3rd party, even if that 3rd party is the beneficial owner of the company. Nevertheless, it is a financial services truism that most nominee directors have little or no understanding of director duties. That kind of director relies on his indemnity agreement, to protect him from harm, blissfully unaware that most such agreements aren't worth the paper they are written on, as they are often unenforceable. (The indemnity agreement won't keep him/her from going to jail, either, if the instructions of a beneficial owner shall cause him/her, or the company represented, to commit a criminal offence).

There can also be issues if you use an individual as nominee shareholder of the company. There is always the danger of fraud, as in the case where a nominee claims to be the beneficial owner of the company as well as the legal owner. Nevertheless, I am more concerned with the case where a nominee shareholder dies while still holding 100% of the shares of the company. It seems that there would be no way to transfer the shares of the company back to the beneficial owner, or to another nominee, without a court process, which will be expensive and long-winded. The court process will also determine that the nominee was a trustee of a constructive trust, and that means that the nominee was acting as a trustee, but without any written agreement to same, which was perilous for the beneficiaries of this constructive trust. (There is also the danger that the shares of the UC will be treated as part of the deceased nominee's estate if there is no court process!).

You can possibly solve these issues by having the shares jointly owned by two nominees, in the expectation that they won't die simultaneously, but then the anticipated cost savings may also evaporate. Laughably, there are also fiduciaries who promote the solution of "pre-signed and undated share transfer agreements", as a solution to this issue. (Very common in Asia). In the event of a nominee's decease, the fiduciary will date the share transfer agreement ("STA"), with the day before the nominee dies, and then will use the STA to transfer the shares either to another nominee or to the beneficial owner. This is not only technically illegal but it is also a fraud (plus the transfer is reversible if the fraud is proved). It is puzzling that regulatory authorities will still permit the promotion of such frauds when they are now "cracking down" on all other illegal transfers.

It may now be evident that my preferred nominee solution is the nominee shareholder, which is a corporate entity, preferably established in a "no corporate taxes" jurisdiction and directly owned by a licensed professional fiduciary. We have no decease of nominee shareholder issues, to concern us in such case, as companies have perpetual life so long as they are properly maintained.

Nevertheless, there are issues that corporate nominee shareholders do not solve, which are as follows:

• Income earned by the "nominee owned" company may still be "attributed" to the beneficial owner, as the corporate shareholder is only the legal owner. So, without a change in beneficial ownership, the attributed income is reportable to the beneficial owner's tax authorities;
• The only person(s) who are legally permitted to benefit from a company's profits and/or assets are the company's shareholder(s). So how does our 3rd party beneficial owner benefit? Legally speaking the company should declare a dividend in favour of the actual shareholder(s) and the shareholder(s) should direct that the dividend is paid to the beneficial owner instead of them. (But most nominee arrangements do not observe such legal niceties);
• Sadly, it is often the case that the beneficial owner is the signatory on the company's bank account and takes cash, for his benefit, whenever he feels the need. This is not only a breach of the company's charter but it is a breach of fiduciary duty, on the part of the directors, to permit such a signatory arrangement to exist;
• Whatever income or other benefit, which the beneficial owner "earns" from the company, is almost undoubtedly reportable to the beneficial owner's tax authorities.

Many of these issues will not exist with a DT, with the exception that a cash distribution to a Settlor, (or another beneficiary), will usually be reportable. However, DTs also offer the flexibility to buy assets, which beneficiaries might wish to own, on behalf of a beneficiary. In such case, the DT has effective beneficial ownership of those assets and not the beneficiary directly. Nevertheless, enjoyment of such assets may lead to a "benefit in kind" tax charge, for beneficiaries, which they need to be aware of. (Although any such charge will certainly be far less than receiving a distribution in order to purchase the desired asset directly).

If there was one thing I ultimately learned, during my financial services career, it was to never own substantial assets directly, as you need income, to maintain those assets, and any income received is tax reportable. Ideally, you own all substantial assets through one or more corporate entities. It is also most preferable that those corporate entities are ultimately owned by a DT Trustee (except in my peculiar case).

So the DT may seem initially more expensive than a nominee arrangement but it can prove to be far cheaper, in the long run, when you tot up the tax savings and/or potential legal costs!

Summary of DT benefits

• Any asset contributed to an DT is no longer legally or beneficially owned by the contributor;
• Thus, income earned by those assets, including income earned by UCs, is usually not required to be reported by the Settlor or beneficiaries of the DT;
• DTs can be a very effective tool for beneficiary tax deferral if the trustee is in a low or no tax jurisdiction;
• DTs deliver creditor protection benefits;
• DTs can be effective for tax minimization if properly structured;
• DT's protect against the consequences of beneficial and/or legal owner decease as estate asset transfer does not occur through the owner's will;
• DTs are more tax efficient for legal ownership than nominee owners, who are bare trustees, in any case, but without the beneficiary protections of a trust agreement.

For and on behalf of

Global Legal Group

Ed Rogers, Partner

GLG is a UAE based legal and tax advisory service firm, which delivers specialist legal services, to its individual and corporate clients, and the firm also provides tax and wealth planning advice too.