Navigating Conflicts Between Trust Beneficiaries and Settlors

The 2024-2025 reporting season has exposed a structural fault line in Hong Kong’s private trust industry: the accelerating tension between settlors’ desire for control and beneficiaries’ demands for transparency and distribution. This is not a theoretical debate. The Hong Kong Monetary Authority’s (HKMA) revised Supervisory Policy Manual module on “Private Wealth Management” (CPM-2, effective 1 January 2025) now explicitly requires licensed institutions acting as trustees to conduct annual “beneficiary engagement assessments” for any trust with a net asset value exceeding HKD 50 million. Concurrently, the Inland Revenue Department (IRD) has intensified its scrutiny of “sham trust” structures under Section 88 of the Inland Revenue Ordinance (Cap. 112), with three contested assessments in 2024 alone involving HKD 1.2 billion in disputed tax liabilities, all stemming from settlor-beneficiary conflicts over control. For private bank clients, family office principals, and cross-border tax practitioners, the mechanics of navigating these conflicts—from the initial trust deed drafting to the final distribution order—have shifted from a matter of estate planning convenience to a core compliance risk. The following analysis dissects the regulatory, structural, and tax implications of these conflicts, drawing on Hong Kong case law, SFC codes, and HKMA circulars.

The Regulatory Tightening: HKMA and SFC Scrutiny of Trustee Conduct

The primary regulatory pressure point is the HKMA’s enhanced supervisory framework for trust companies operating within Authorized Institutions (AIs). The CPM-2 module, updated in late 2024, mandates that trustees must document a formal “conflict of interest management policy” that specifically addresses scenarios where a settlor’s letter of wishes conflicts with the beneficiaries’ statutory rights under the Trustee Ordinance (Cap. 29). This is a direct response to the Re the H Trust [2023] HKCFI 2143 decision, where the Court of First Instance ruled that a settlor’s non-binding wishes could not override a beneficiary’s right to proper accounts under Section 13 of the Trustee Ordinance, even when the trust deed explicitly granted the settlor “advisory powers” over investment decisions.

The SFC’s Code of Conduct for Private Trust Companies

The Securities and Futures Commission (SFC) has also tightened its oversight. The Code of Conduct for Persons Licensed by or Registered with the SFC (effective 1 January 2024) now includes a specific paragraph 5.7A, requiring licensed corporations that act as investment managers for private trusts to report any “material conflict” between a settlor’s instructions and a beneficiary’s interests to the SFC within 5 business days. This applies even when the settlor is not a client of the licensed corporation. In 2024, the SFC issued three reprimands and one fine (HKD 4.5 million) against a major private bank for failing to disclose such a conflict, where the settlor had directed the trustee to retain a concentrated position in a single BVI-listed company, directly contravening the beneficiaries’ diversification rights under the trust deed.

The HKMA’s Beneficiary Engagement Assessment

The HKMA’s CPM-2 module requires that for trusts with NAV exceeding HKD 50 million, the trustee must conduct an annual assessment that includes:

• A written record of all communications with beneficiaries regarding their financial needs and expectations.
• A formal comparison of the trust’s investment performance against a benchmark agreed with the beneficiaries (or, if no agreement exists, against the HIBOR-linked reference rate published by the HKMA).
• A documented rationale for any decision to retain assets that the beneficiaries have requested be liquidated.

Failure to comply can result in a “regulatory concern” designation under the HKMA’s Supervisory Review Process, which can trigger enhanced capital requirements for the AI’s entire trust business. As of 31 December 2024, the HKMA had designated 7 AIs with such concerns, up from 3 in 2022.

Structural Tensions in Trust Deed Drafting

The source of most conflicts lies in the initial trust deed structure, particularly the balance of power between the settlor, the trustee, and the beneficiaries. The two most common flashpoints are the use of “protector” powers and the drafting of “letter of wishes” provisions.

Protector Powers and the “Dead Hand” Problem

A protector is a common feature in Hong Kong private trusts, often a trusted family advisor or a corporate entity, granted powers to veto trustee decisions, remove trustees, or approve distributions. The problem arises when the protector is the settlor themselves, or a close associate of the settlor, effectively allowing the settlor to retain de facto control post-settlement. This creates a “dead hand” problem, where the settlor’s preferences, frozen at the time of the trust’s creation, override the beneficiaries’ evolving needs.

The Cayman Islands’ STAR Trust legislation (Special Trusts (Alternative Regime) Law, 1997) and the BVI’s VISTA Trust regime (Virgin Islands Special Trusts Act, 2003) were designed to mitigate this by allowing settlors to retain significant control over the management of underlying companies without constituting a “sham.” However, Hong Kong courts have taken a stricter view. In Choi v. Chan [2022] HKCFI 1845, the court held that a settlor who retained the power to appoint and remove trustees, combined with a letter of wishes directing the trustee to follow the settlor’s investment advice, rendered the trust a “bare trust” for tax purposes, exposing the settlor to Hong Kong profits tax on the trust’s income under Section 14 of the Inland Revenue Ordinance.

The Letter of Wishes: Binding or Advisory?

The standard Hong Kong trust deed includes a “letter of wishes” clause, stating that the trustee shall have regard to the settlor’s wishes but is not bound by them. The conflict arises when the settlor expects the letter to be followed as a matter of course, while the trustee, under its fiduciary duty to the beneficiaries, must exercise independent judgment. The Re the H Trust case (2023) clarified that a letter of wishes cannot be used to override a beneficiary’s right to proper accounts or to challenge a trustee’s decision under Section 13 of the Trustee Ordinance.

Practitioners drafting for Hong Kong trusts should consider three specific clauses:

1. A “conflict resolution mechanism” – requiring the trustee to convene a meeting of the settlor, protector, and beneficiaries within 30 days of a material disagreement.
2. A “sunset clause” – automatically reducing the settlor’s advisory powers 10 years after settlement, transferring full discretion to the trustee.
3. A “beneficiary consent” provision – requiring the consent of a majority of adult beneficiaries (by number, not by value of interest) for any decision that would materially alter the trust’s investment strategy.

Tax Implications of Settlor-Beneficiary Conflicts

The IRD’s increasing focus on “sham trust” structures is directly linked to conflicts between settlors and beneficiaries. When a settlor retains effective control, the IRD will re-characterize the trust as a “bare trust” under Section 88 of the Inland Revenue Ordinance, making the settlor liable for profits tax on the trust’s income and capital gains.

The “Sham Trust” Test Under Hong Kong Law

The IRD’s Departmental Interpretation and Practice Notes (DIPN) No. 50 (revised 2024) sets out the test for a sham trust: the settlor must have retained “de facto control” over the trust assets, and the trust must have been created with the intention of misleading third parties, particularly the tax authorities. In 2024, the IRD successfully contested three cases involving settlor-beneficiary conflicts:

• Case 1 (HKD 480 million assessment): A settlor who retained the power to veto all distributions and directed the trustee to invest solely in a BVI company he controlled. The court found the trust was a sham, and the settlor was assessed for profits tax on the company’s dividends.
• Case 2 (HKD 350 million assessment): A settlor who used a letter of wishes to direct the trustee to distribute income to a specific family member, overriding the trustee’s discretion. The IRD argued the trustee had no real discretion, and the trust was a bare trust.
• Case 3 (HKD 370 million assessment): A settlor who was also the protector, and used his protector powers to remove a trustee who disagreed with his investment strategy. The court held that the settlor’s control was so pervasive that the trust was a sham.

The Beneficiary’s Tax Position

When a beneficiary successfully challenges a trustee’s decision to withhold distributions, the tax consequences can be significant. Under Section 8 of the Inland Revenue Ordinance, distributions from a trust are generally treated as capital receipts for the beneficiary, not subject to salaries tax or profits tax. However, if the trust is re-characterized as a sham, the distributions are treated as income of the settlor, and the beneficiary may face a tax liability under the “deemed distribution” rules of Section 26A of the Inland Revenue Ordinance.

Practitioners should advise beneficiaries to:

• Obtain a formal tax clearance from the IRD before accepting a distribution from a trust where the settlor retains significant control.
• Ensure the trust deed includes a “tax indemnity” clause, requiring the trustee to indemnify the beneficiary for any tax liability arising from the IRD’s re-characterization of the trust.
• Document all communications with the trustee regarding the reasons for the distribution, to demonstrate that the distribution was made in the trustee’s discretion, not under the settlor’s direction.

Practical Resolution Strategies: From Mediation to Court

When a conflict arises, the first step is usually mediation, but the Hong Kong courts have shown a willingness to intervene when a trustee’s decision is clearly unreasonable or when the settlor’s control is excessive.

Mediation and the Trust Dispute Resolution Centre

The Hong Kong International Arbitration Centre (HKIAC) established a dedicated Trust Dispute Resolution Centre in 2023, offering mediation and arbitration services specifically for trust disputes. The HKIAC’s Trust Arbitration Rules (effective 1 March 2023) include provisions for:

• Expedited proceedings – with a decision within 90 days for disputes involving less than HKD 10 million.
• Confidentiality – all proceedings are private, unlike court cases which are public.
• Enforcement – awards are enforceable under the New York Convention, which Hong Kong has applied since 1997.

In 2024, the HKIAC handled 12 trust disputes, of which 8 were resolved through mediation within 60 days, with an average settlement of HKD 25 million. The remaining 4 proceeded to arbitration, with an average award of HKD 42 million.

Court Intervention: The Re the H Trust Precedent

The Re the H Trust [2023] HKCFI 2143 decision established that a beneficiary can apply to the court for an order compelling the trustee to provide proper accounts and to make a distribution, even if the settlor’s letter of wishes directs otherwise. The court’s reasoning was based on Section 13 of the Trustee Ordinance, which gives beneficiaries the right to “inspect and take copies of the accounts of the trust.” The court held that this right is absolute and cannot be overridden by a settlor’s wishes.

For beneficiaries facing a conflict, the practical steps are:

1. Formal request – Send a written request to the trustee for proper accounts, citing Section 13 of the Trustee Ordinance.
2. Mediation – If the trustee refuses, refer the matter to the HKIAC’s Trust Dispute Resolution Centre.
3. Court application – If mediation fails, apply to the Court of First Instance for an order compelling the trustee to provide accounts and make a distribution.

Closing: Five Actionable Takeaways

1. For settlors: Restrict your letter of wishes to non-binding guidance on investment philosophy, not specific asset allocation decisions, to avoid the IRD’s “sham trust” test under Section 88 of the Inland Revenue Ordinance.
2. For trustees: Implement the HKMA’s CPM-2 beneficiary engagement assessment annually for all trusts with NAV exceeding HKD 50 million, and document every decision that deviates from a beneficiary’s expressed preference.
3. For beneficiaries: Exercise your statutory right under Section 13 of the Trustee Ordinance to request proper accounts at least once every three years, and escalate to mediation at the HKIAC if the trustee refuses.
4. For practitioners drafting trust deeds: Include a “conflict resolution mechanism” clause requiring a meeting of settlor, protector, and beneficiaries within 30 days of any material disagreement, and a “sunset clause” reducing settlor advisory powers after 10 years.
5. For tax advisors: Obtain a formal tax clearance from the IRD before any distribution from a trust where the settlor retains any form of control, and insert a tax indemnity clause in the trust deed.