Percentage Trusts/Unitrusts – Guidance from the Ontario Court of Appeal

The Ontario Court of Appeal released a decision last week that provides insightful guidance with respect to the use of “percentage trusts”, also known as “unitrusts”. 

In The Canada Trust Company v. Browne (Primo Poloniato Grandchildren’s Trust), the settler, the founder of a successful food products company, set up a substantial trust in favour of his grandchildren (income beneficiaries) and his great-grandchildren (capital beneficiaries).  On consent of the beneficiaries, including the Children’s Lawyer on behalf of minor, unborn and unascertained beneficiaries, the trust was varied in 1997 to change it to a percentage trust.  As a percentage trust, the trustee was permitted a freer hand to make investments (for example in equities) in order to maximize the value of the trust for the benefit of all beneficiaries, without concern as to whether those investments were income-producing or growth-oriented.  The entitlement of income beneficiaries was altered such that they were no longer entitled to income produced by the trust, but to yearly distributions based on a percentage of a yearly rate of return of the trust as defined in the trust variation. That percentage is subject to a formula that restricts increases year over year but also provides that distributions shall not be less than those in the preceding year.  If the income-producing investments chosen by the trustee do not produce sufficient income to make the distributions, the trustee is permitted to sell equities or other capital investments in order to generate sufficient funds to make the percentage distributions to income beneficiaries.

Of course the reason for the amendment of the trust was the bullish performance of stock markets in the 1990s and the comparatively poor performance of a trust restricted to interest-based investments.  Based on expert evidence as to the likely continued upward performance of equity markets, the Court in 1997 approved the variation on the grounds that was for the benefit of all beneficiaries.

Of course what goes up sometimes comes down.  The downturn in equity markets had the effect of reducing the trust’s rate of return.  In order to maintain distributions to income beneficiaries under the percentage interest formula of the trust as varied (remember distributions could not be less than the previous year), the trustee was required to sell trust assets.  The trustee brought an application to the Court for advice and directions to clarify the trustee’s obligations, in particular “whether it retained a duty to maintain an even hand between the income and capital beneficiaries in managing Trust distributions, and therefore a discretion to stop making the prescribed percentage payments to the income beneficiaries that were eroding the value of the Trust”.

The application judge found that by the wording of the trust as varied, the trustee did not have such discretion.  The Children’s Lawyer appealed on behalf of capital beneficiaries.  The Court of Appeal upheld the lower court decision.  In essence, the Court of Appeal agreed with the application judge that the mandatory language of the trust as varied required the trustee to make the payments to income beneficiaries and permitted the sale of trust assets to do so.  After a review of the law, the Court found that the trust as varied ousted the trustee’s “even hand” obligation with respect to management of trust disbursements.  The Court rejected the capital beneficiaries’ attack of the 1997 variation as having the intent and effect of benefitting income beneficiaries at the expense of capital beneficiaries.  While it found as a fact that such was not the intent, the issue before the Court was not the intent and effect of the 1997 variation (as that had been determined in 1997), but interpretting the obligations of the trustee as a result of that variation.  The Court noted that “in a percentage trust, the trustee’s duty is not to obtain a large income yield while preserving the capital but, instead, to increase the size of the entire trust for the benefit of both classes of beneficiaries. This includes increasing the capital rather than preserving it, and therefore involves an investment strategy that may include more risk.” [my emphasis]

In obiter, the Court of Appeal did address how percentage interest trusts can be prepared in order to avoid the situation in this case.  The Court stated:

“The experience of this Trust has reinforced the need for percentage trusts to be drafted with specific safeguard mechanisms in place that will allow the trustee to review and revise the annual percentage payable to the income beneficiaries based on the changing value of the trust to ensure that one set of beneficiaries is not favoured over the other. Commentators on the percentage trust concept have recommended including a “force majeure” clause to protect against unforeseen anomalies. …

Two options would be to include a clause providing for a periodic reset by the trustee of the percentage payable to income beneficiaries, or an option for the trustee to apply to the court for advice and directions on such a reset.

It is also clear that the material provided to the court in support of a variation application seeking to convert a trust into a percentage trust must include not only upside projections but also potential downside projections that take into account a possible future market downturn. This will give the approving court the basis to include the appropriate safeguards that will ensure, to the extent possible, that the variation will in fact continue to be for the benefit of the future capital beneficiaries.”

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