When marriages fail, validity of family trusts can be tested

By Ouyang Fangfei and Zheng Chunjie, Merits & Tree Law Offices
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Whether a spouse can claim property that is part of an established family trust is an unavoidable issue that concerns the protection of each of the marital parties’ rights, but can also mean the trust being deemed a sham in the course of a marital breakdown. The question is one that rivets the attention of high net-worth clients.

Ouyang Fangfei, Merits & Tree Law Offices
Ouyang Fangfei
Partner
Merits & Tree Law Offices

It is a common concern of both the settlor and their spouse whether the trust property can be divided in a divorce. Under the Trust Law, the property used to establish a trust must be owned legally by the settlor. Therefore, the legality and integrity of the property ownership often constitute the first challenge to the trust’s validity.

According to the Civil Code, the wages, bonuses, remuneration for labour services, gains from production, business operations and investment acquired by a spouse during marriage and those disposition rights shall be jointly owned by the couple, unless otherwise specified in writing. Therefore, the settlor is generally required to issue a declaration on the ownership of the trust property before establishing the family trust and delivering the assets. Spousal consent is required if the settlor is married. Such arrangements may confirm that the property delivered by the settlor to the trustee is either his or her personal legal property or communal property disposed of with spousal consent.

So, a family trust set up by the settlor with premarital property or with the communal property during the marriage with effective spousal consent shall be genuine and valid as long as there are no other circumstances that may render the trust invalid. In accordance with the independence of the trust property stipulated in the Trust Law, the trust property at this time is independent of the settlor’s other property, and the spouse is not entitled to claim a division of the trust property on the grounds of marriage dissolution.

Zheng Chunjie, Merits & Tree Law Offices
Zheng Chunjie
Partner
Merits & Tree Law Offices

If the trust’s validity is confirmed and maintained, whether the spouses can divide the property of the family trust beneficiary becomes another critical issue. If one of the spouses is the beneficiary of a family trust established by a third party and enjoys the right to benefit from the trust, this is generally considered a gift from the settlor. The trust property owned by beneficiaries is their personal property, stipulated expressly in the trust agreement, akin to the system of testamentary succession and designated gifting in the Civil Code, which should be respected.

On the other hand, one of the spouses is the beneficiary of the family trust established by himself or herself, and enjoys the beneficiary’s right, which is of a self-beneficial nature. However, it seems reasonable that the settlor’s spousal consent letter on the establishment of the trust can constitute a written approval for the delivery of the trust property and the content of the trust documents, which confirms that the trust property of the beneficiary is his or her personal property.

In reality, disputes often arise in more complex situations. A common scenario is where the settlor has not obtained valid spousal consent for the delivery of the trust property at the time of setting up the trust, or where the initial spousal consent has been obtained but in the absence of the following consent for adding trust property during the existence of the trust.

In such cases, the trust’s validity or the delivery of trust property needs to be determined in conjunction with the relevant provisions of the Civil Code and the Trust Law. If the setting up of a family trust or the delivery of trust property by a settlor constitutes a “transfer of community property in bad faith”, and no subsequent spousal consent is obtained, then the spouse is more likely to file litigation against the validity of the trust, with the settlor and the trustee as co-defendants. In this case, the trustee may be exposed to liability, unless it can prove absence of fault.

A related issue is whether one of the spouses can claim the return of the trust benefits distributed to the other spouse, who is the beneficiary, during the trust term. On this issue, the provisions of the Trust Law on the revocation rights of creditors state: “If a trust established by a settlor harms the interests of its creditors, they are entitled to request the people’s court to revoke the trust.

By the preceding paragraph, the revocation of a trust by the people’s court shall not affect the trust interests already acquired by the bona fide beneficiaries.” This would suggest that trust property distributed to bona fide beneficiaries during the trust term cannot be requested to be returned by their spouses, who, as creditors, can claim compensation from beneficiaries.

Unlike trust property that has not been distributed, trust benefits distributed to bona fide beneficiaries have undergone the complete transfer process of real rights and should already be held intact by the beneficiaries.

The trustee’s fiduciary duty will be tested before establishing the trust, in light of the changeability of marital status, the size and the length of duration of the family trust. Due diligence by the trustee on the purpose of the trust, the marital situation, the source of the trust property and the reasonableness of the beneficiaries should not be overlooked before establishing the structure.

Also, in order to avoid disruptions to the stability of the trust caused by the breakdown of the settlor’s marriage, it may be worth adding to the documents establishing the trust arrangements for the disposition of the settlor’s trust property and trust beneficiary rights in the event of divorce.

Ouyang Fangfei and Zheng Chunjie are partners at Merits & Tree Law Offices

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Merits & Tree Law Offices
5, 12/F, Raffles City Beijing Office Tower
1 Dongzhimen South Street, Beijing 100007, China
Tel: +86 10 5650 0900
Fax: +86 10 5650 0999
E-mail: fangfei.ouyang@meritsandtree.com
chunjie.zheng@meritsandtree.com

www.meritsandtree.com

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