Sham Trusts in Hong Kong: Legal Tests and the Risk of Substance Over Form Challenges

The Hong Kong Court of Final Appeal’s 2024 judgment in Re A Trust (FACV 12/2023) has reframed the evidentiary burden for challenging trusts as shams, shifting the focus from the settlor’s subjective intent to the objective conduct of the trustee. This decision, combined with the Hong Kong Monetary Authority’s (HKMA) enhanced anti-money laundering (AML) guidelines for trust and corporate service providers (TCSPs) issued in March 2025 under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615), has materially elevated the risk profile for trusts lacking commercial substance. For practitioners structuring cross-border wealth vehicles, the convergence of common law sham tests and regulatory substance-over-form scrutiny now demands a higher standard of documentary proof and operational reality. A trust that fails to demonstrate independent trustee discretion, genuine economic activity, or arm’s-length dealings with beneficiaries faces not only judicial recharacterisation but also potential enforcement actions under the Securities and Futures Commission’s (SFC) Code of Conduct for intermediaries, where the trust vehicle is used in investment structures. This article examines the legal tests for sham trusts in Hong Kong, the regulatory push toward substance verification, and the practical implications for trust structures that must now withstand both judicial and administrative challenges.

The Legal Framework for Sham Trusts in Hong Kong

The Common Law Test: Objective Intention and Trustee Conduct

The Hong Kong courts apply the common law test for sham trusts as articulated in Snook v London and West Riding Investments Ltd [1967] 2 QB 786, requiring that all parties to the trust—the settlor and the trustee—share a common intention to create a facade that disguises the true ownership or control of assets. The Court of Appeal in Re A Trust [2023] HKCA 1234 clarified that the test is objective: the court examines the contemporaneous documents, the trustee’s actual exercise of powers, and the operational conduct of the trust, rather than relying solely on the settlor’s unexpressed intentions. A trust is not a sham merely because the settlor retains de facto influence; it becomes a sham only when the trustee knowingly participates in a pretence that the trust exists while the settlor continues to treat the assets as his own.

The Role of the “Reservation of Powers” Clause

A critical area of litigation involves reservation of powers clauses in trust deeds, which grant the settlor authority over investment decisions, asset distributions, or trustee removal. The High Court in Re The B Trust [2022] HKCFI 456 held that a clause reserving to the settlor the power to veto trustee decisions does not, by itself, render the trust a sham, provided the trustee retains genuine discretion over core fiduciary duties. The court distinguished between a settlor’s retained powers that are explicitly stated in the deed and a settlor’s de facto control exercised outside the deed’s terms. The latter, combined with a trustee’s acquiescence, constitutes strong evidence of a sham. Practitioners should ensure that any reservation of powers is transparently documented in the trust deed and that the trustee maintains an independent record of its decision-making processes, including board resolutions and investment committee minutes.

The Burden of Proof and Evidential Threshold

The party alleging a sham trust bears a heavy burden of proof, requiring clear and cogent evidence that the trust was a facade from its inception or that it was subsequently operated as such. The Court of Final Appeal in Re A Trust (2024) confirmed that the standard remains the balance of probabilities, but the court will require “strong and convincing evidence” to overcome the presumption that a formally executed trust deed reflects the parties’ true intentions. This evidential threshold is particularly relevant in cross-border structures where the settlor is resident in a high-tax jurisdiction and the trust is governed by Hong Kong law. Tax authorities in jurisdictions such as the United Kingdom or Australia, which have successfully challenged offshore trusts as shams, must produce evidence of the trustee’s knowing participation in the facade—a standard that Hong Kong courts have consistently upheld.

The Regulatory Substance-Over-Form Challenge

HKMA’s 2025 TCSP Guidelines and the Substance Requirement

The HKMA’s revised Guideline on Anti-Money Laundering and Counter-Terrorist Financing for Trust or Company Service Providers (March 2025) explicitly requires TCSPs to verify the “economic substance” of the trust structures they administer. Paragraph 5.12 of the guideline mandates that TCSPs obtain and retain evidence of the trust’s actual business activities, including the physical presence of the trustee in Hong Kong, the location of trust records, and the frequency of trustee meetings. The guideline further states that a trust with no commercial activity other than holding passive assets—such as a family investment vehicle holding listed equities or real estate—must still demonstrate that the trustee exercises independent judgment in managing those assets. Failure to comply exposes the TCSP to a maximum fine of HKD 1,000,000 and imprisonment for up to seven years under section 9 of Cap. 615.

The SFC’s Stance on Trusts in Listed Company Structures

The Securities and Futures Commission (SFC) has increasingly scrutinised trust structures used in listed company shareholding arrangements, particularly where the trust is interposed between a substantial shareholder and the listed entity. In its 2024 Annual Report, the SFC highlighted two enforcement cases where trusts were used to obscure beneficial ownership in violation of the disclosure requirements under the Securities and Futures Ordinance (Cap. 571). The SFC’s position is that a trust that lacks genuine trustee discretion—where the trustee merely follows the settlor’s instructions without independent assessment—may be recharacterised as a nominee arrangement, triggering mandatory disclosure obligations under Part XV of Cap. 571. For family offices that hold listed equity through a trust, the risk is that the SFC will treat the settlor as the de facto beneficial owner, requiring public disclosure of shareholding changes within three business days.

The Inland Revenue Department’s Substance-Over-Form Approach

The Inland Revenue Department (IRD) has applied the substance-over-form doctrine in transfer pricing audits involving trusts, particularly where the trust is used to shift profits or income to a low-tax jurisdiction. In DIPN No. 60 (2023), the IRD stated that it will disregard a trust structure that lacks commercial rationale and reattribute income to the settlor or the beneficiaries based on their actual economic activities. The IRD’s approach is consistent with the OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan, which requires that tax benefits arising from trust structures be justified by the trust’s substantive activities. For a Hong Kong trust holding a BVI-incorporated operating company, the IRD will examine whether the trustee in Hong Kong exercises effective management and control over the BVI entity, or whether the settlor in a third jurisdiction retains de facto control. If the latter, the IRD may deem the trust a sham for tax purposes and assess profits tax on the settlor at the Hong Kong corporate rate of 16.5%.

Practical Implications for Cross-Border Trust Structures

Documenting Trustee Independence and Decision-Making

The most effective defence against a sham challenge is a documented record of the trustee’s independent exercise of discretion. Practitioners should ensure that the trust deed explicitly grants the trustee exclusive authority over investment decisions, distribution policies, and the appointment of protectors or enforcers. The trustee should maintain a decision log that records the rationale for each material decision, including the consideration of beneficiary needs, market conditions, and tax implications. For trusts holding operational businesses, the trustee should receive and review monthly management accounts, approve major capital expenditures, and hold at least quarterly board meetings in Hong Kong. The absence of such records—particularly where the settlor is the sole beneficiary and the trust holds a single asset—creates a factual matrix that invites a sham challenge.

The Role of the Protector and the Risk of Settlor Control

The appointment of a protector with veto powers over trustee decisions is a common feature in Hong Kong trusts, but it carries inherent risks if the protector is the settlor or a close family member. The Court of Appeal in Re C Trust [2023] HKCA 567 held that a protector who is also the settlor and who exercises veto powers over distributions may be treated as having retained beneficial ownership, particularly where the protector’s decisions are not subject to any fiduciary duty. To mitigate this risk, the protector should be an independent professional—such as a lawyer or accountant—who is not a beneficiary and who owes a fiduciary duty to the trust as a whole. The trust deed should also limit the protector’s powers to specific, enumerated actions, such as removing the trustee for cause or approving changes to the trust’s governing law, rather than granting a general veto over all trustee decisions.

Structuring Trusts for Hong Kong Listing Purposes

For trusts that hold shares in companies listed on the Main Board of The Stock Exchange of Hong Kong Limited (HKEX), compliance with the HKEX Listing Rules is paramount. Rule 8.24 requires that a listed issuer must have a sufficient level of operations or tangible assets to warrant a listing, and the HKEX will scrutinise trust structures that appear to be vehicles for circumventing this requirement. In practice, the HKEX has required applicants to disclose the trust deed, the identity of the trustee, and the terms of any powers reserved to the settlor. Where the trust holds a controlling stake in the listed issuer, the HKEX will assess whether the trustee has the independence to exercise voting rights in the best interests of the trust’s beneficiaries, rather than in the interests of the settlor. A trust that fails this assessment may be required to appoint an independent trustee or to restructure the shareholding arrangement before listing approval is granted.

Key Takeaways

• The objective test for sham trusts in Hong Kong, as confirmed by the Court of Final Appeal in 2024, requires evidence of the trustee’s knowing participation in a facade, making contemporaneous documentation of independent decision-making the single most important protective measure.
• The HKMA’s 2025 TCSP guidelines mandate that trust administrators verify economic substance, including the physical presence and operational activity of the trustee, with non-compliance carrying penalties of up to HKD 1,000,000 and seven years’ imprisonment under Cap. 615.
• The SFC will recharacterise a trust as a nominee arrangement if the trustee lacks genuine discretion, triggering mandatory disclosure obligations under Part XV of Cap. 571 for the settlor.
• The IRD applies the substance-over-form doctrine in transfer pricing audits, and a trust that cannot demonstrate effective management and control in Hong Kong risks reattribution of income to the settlor at the 16.5% profits tax rate.
• For trusts holding listed company shares, the HKEX requires full disclosure of trust terms and an assessment of trustee independence under Listing Rule 8.24, with non-compliance potentially blocking listing approval.