How Do Divorce Proceedings Affect Family Trusts in Hong Kong?

Family trusts are often set up as discretionary trusts to offer asset protection. Such trusts are sometimes referred to as asset protection trusts. Once assets are settled (i.e. transferred) into an asset protection trust, the assets belong to the trustee on trust for the beneficiaries. They no longer belong to the settlor of the trust. As a result, as a general principle, creditors of the settlor have no recourse to those assets unless they can show that the initial transfer of those assets into the trust was invalid or the trust itself is invalid (i.e. the trust is a sham trust).

Effect of Family Laws

In the case of a divorce or separation, however, family laws may provide additional avenues for spouses to include trust assets into the matrimonial pool of assets without having to demonstrate the trust is a sham or the transfer of those assets into the trust is invalid. This is because in Hong Kong, like many other common law jurisdictions, the Matrimonial Proceedings and Property Ordinance provides not only that a court may vary the terms of any ante-nuptial or post-nuptial settlement (e.g. the court may vary the terms of the trust to include a spouse as a beneficiary) but also because in dividing the asset pool in a divorce or separation, a court must have regard not just to the “property” of each spouse but also to their “other financial resources”.

Variation of Nuptial Settlements

The Matrimonial Proceedings and Property Ordinance provides that a court may, on granting a divorce or separation, make an order “varying for the benefit of the parties to the marriage and of the children of the family or either or any of them any ante-nuptial or post-nuptial settlement… made on the parties to the marriage”.

These powers in theory provide unlimited discretion for a Hong Kong court to vary the terms of a trust that is a “nuptial settlement”. This is so even if the trust is a foreign trust because the Recognition of Trusts Ordinance expressly gives effect to the 1984 Hague Convention on the Law Applicable to Trusts and on their Recognition. Under this international convention, laws relating to “the personal and proprietary effects of marriage” can override trust laws. Thus, where a husband and wife are domiciled or habitually resident in Hong Kong or have a substantial connection to Hong Kong, the use of a foreign trust may not shield the spouses from the application of Hong Kong family laws.

The statutory power to vary a “nuptial settlement” including a trust is particularly significant where trust assets are located in Hong Kong as in this case, a Hong Kong court will have jurisdiction over those assets, regardless of the law of the trust.

Not all family trusts however, will be regarded as a “nuptial settlement”. It has been held that a “nuptial settlement” broadly includes any arrangement where a husband makes provision for his wife or a wife for her husband. It follows that family trusts in which neither spouse is a beneficiary may fall outside the scope of a “nuptial settlement” as they do not make, as one court described it, “continuing provision for both or either of the parties to a marriage”.

Whether the removal of spouses as beneficiaries to an existing family trust will take the trust outside the scope of a “nuptial settlement” will depend on the facts of the specific case. As one court stated:

… I cannot agree that a settlement which was nuptial when made retains that essential character come what may. It is easy to instance the head of a family who has created a number of settlements to preserve the family’s fortune through two or more generations. His scheme may at one stage include nuptial settlements for his sons, their wives and issue. However at a later stage, to reflect events in the family or changes in the Taxing Acts, he might well radically revise the scheme and in so doing remove from one particular settlement a son, his wife and issue, compensating them with some advance or other security. So whether the removal of the spouses from the beneficial class does or does not erase the nuptial element must in my judgment depend on the facts and circumstances of the individual case.

In that case, it was held that the removal of the spouses as beneficiaries from a family trust shortly before the breakdown of their marriage failed to take the trust outside the scope of a “nuptial settlement”. Amongst other things, this was because the spouses continued to be joint protectors, they could be reinstated as beneficiaries, and the husband continued to receive loans from the trust to his businesses.

Financial Provision Based on Financial Resources

The Matrimonial Proceedings and Property Ordinance provides that in making financial provision for a spouse in a divorce or separation, the court should have regard to the financial resources likely to be available to each spouse. It states:

It shall be the duty of the court… to have regard to the conduct of the parties and all the circumstances of the case including the following matters, that is to say… the income, earning capacity, property and other financial resources which each of the parties to the marriage has or is likely to have in the foreseeable future...[emphasis added]

Trust Assets as Financial Resources

As a result of the Matrimonial Proceedings and Property Ordinance, though trust assets may not belong to a spouse, if they constitute a “financial resource” that is “likely” to be available to one spouse, they can be included as part of the arrangements to make financial provision for the other spouse. As one court stated:

... a discretionary beneficiary has no proprietary interest in the fund. But… whether a beneficiary under a discretionary trust has a proprietary interest is not relevant. The resource must be one that is ‘likely’ to be available… What is relevant is the likelihood of the trust fund or part of it being made available to [the spouse], either by income or capital distribution. If the [spouse] were to ask the trustees to advance him capital, would the trustees be likely to do so…

Whether trust assets do or do not constitute such a financial resource is a question of fact based on all the circumstances. There is no rule of general application to determine whether trust assets will or will not form part of the matrimonial pool of assets in a divorce.

The Kan Lai Kwan Decision

In Kan Lai Kwan v. Poon Lok To, the husband had placed the shares of the holding company for his business into a discretionary family trust. By the time of the proceedings 15 years later, the shares were valued at over US$200mn. Consistent with arrangements which are not uncommon, the husband was the chairman of the company and the protector of the trust with the right to replace the trustee. The husband, the wife and their child were the beneficiaries of the trust.

Under the terms of the trust deed, the trustee had absolute discretion to appoint capital and income to any one of the beneficiaries to the exclusion of the others.

As the husband had historically caused the holding company to declare dividends and then requested the trustee to pay those dividends to him and the trustee would then comply, the Court of Final Appeal held that the trust was a financial resource available to the husband. In this regard, it noted that the fact that the husband was able to draw upon the trust to satisfy awards made against the husband in the lower courts was clear evidence of the “overwhelming likelihood that the trustee, acting in accordance with its duties, would if requested by the [husband], advance the whole or part of the capital or income of the trust to him”.

Lessons for Family Trusts

Intergenerational family trusts are less likely to be susceptible to variation by the courts or to be treated as a financial resource of a beneficiary as they can be structured so that no one beneficiary or their spouse has specific entitlements over which the beneficiary has control.

However, family trusts set up with a view to making provision for the settlor and his or her immediate family (including spouse) may be insufficient to put the trust assets outside the reach of the family courts. Steps which reduce the control either spouse exercises over the trust or which can demonstrate that it is unlikely that either spouse can call for trust assets can blunt the risk that the trust may be regarded as a financial resource of that spouse. Equally, trust structures which firewall assets from access by the spouses may be less susceptible to variations by the courts which may affect the assets which have been firewalled.

It may be desirable for a spouse who is considering the establishment of a family trust to make provision for the immediate family including this spouse and who wishes to exercise control over trust assets to put in place a nuptial agreement in parallel with the family trust. Though Hong Kong courts have yet to hold these so-called “pre-nup” or “post-nup” agreements to be entirely binding, they have given their terms significant weight so long as both spouses entered into such agreements with (i) full disclosure of material facts and a full appreciation of the fact that the agreements will govern the financial consequences on the end of marriage, and (ii) the arrangements contemplated by the agreements are fair.