2.2 Trusts controlled by local authorities ― effect of the Public Audit Act 2001
2.201
The Public Audit Act 2001 resulted in a clearer definition of the Auditor-General’s
mandate. The Auditor-General is the auditor of every public entity, and of any
entity controlled by one or more public entities under the test for “control”
contained in the Public Audit Act (the control test).1
2.202
The term “public entity” includes a council-controlled organisation as defined in
the Local Government Act 2002 (the Act). The definition of “council-controlled
organisation” (CCO) in the Act is slightly different to the definition of a controlled
public entity in the Public Audit Act.2
2.203
This means that about 150 entities not formerly audited by the Auditor-General
have become public entities because of the definition of CCO in the Act or the
control test in Public Audit Act.
2.204
The application of the definition of CCO has generally been straightforward and
has not been controversial. However, the application of the control test under
the Public Audit Act has caused concerns for some trusts associated with local
authorities that have not previously been subject to public audit.
2.205
In this article, we highlight some issues that have arisen in applying the Public
Audit Act’s control test in the local government sector. A small number of trusts
have not yet accepted that they are public entities subject to the Auditor-General’s
mandate. We consider it important to advise Parliament that we are not auditing
a small number of trusts that we consider should be subject to public audit.
The control test
2.206
Under section 5 of the Public Audit Act, the Auditor-General is the auditor of every
public entity and of every entity that is controlled by one or more public entities. Both local authorities and CCOs are public entities under the Public Audit Act, so
the Auditor-General is the auditor of any entity controlled by one or more local
authorities or CCOs.
2.207
The Public Audit Act uses both legal and accounting definitions of control. Section
5(2) says that an entity is controlled by one or more other entities if:
(a) the entity is a subsidiary of any of those other entities; or
(b) the other entity or entities together control the entity within the meaning of any relevant approved financial reporting standard; or
(c) the other entity or entities can together control directly or indirectly the composition of the board of the entity within the meaning of sections 7 and 8 of the Companies Act 1993 (which, for the purposes of this paragraph, are to be read with all necessary modifications).
2.208
The two legal limbs of the control test in paragraphs (a) and (c) above are
reasonably straightforward. The definition in paragraph (a) applies where a public
entity owns a majority of shares of an incorporated subsidiary and/or has the
right to appoint a majority of directors. The definition in paragraph (c) applies
where one or more public entities have the right, directly or indirectly, to appoint a
majority of the governing body of an entity (whether incorporated or not).
2.209
Analysis of control under the accounting test in paragraph (b) is often more
difficult. This article focuses on some of the issues that have arisen in applying the
accounting test for control.
Control under the accounting test
2.210
The relevant approved financial reporting standard, for the purpose of the control
test, is Financial Reporting Standard 37: Consolidating Investments in Subsidiaries (FRS-37).3 We have used this standard to determine whether an entity is a
subsidiary of another public entity (that is, a controlled entity).
2.211
The effect of being assessed as a controlled entity under FRS-37 is that the
controlled entity must be consolidated into the parent entity’s group financial
statements and the Auditor-General is the auditor of the controlled entity.
2.212
For financial reporting periods beginning on or after 1 January 2007, an NZ IFRS
(NZ IAS 27: Consolidated and Separate Financial Statements) will apply for the
purpose of the control test. That standard also uses the concepts of control,
power, and benefit that apply under FRS-37, and refers to FRS-37 as a source of
additional guidance when applying NZ IAS 27. FRS-37 is, therefore, still relevant to
determining control for New Zealand public entities. We do not anticipate major
changes to the Auditor-General’s portfolio arising from the adoption of NZ IFRS.
2.213
We discuss in paragraphs 2.214-2.230 how we have applied FRS-37 in determining
whether a public entity controls another entity since the Public Audit Act was
enacted.
2.214
The approach under FRS-37 is to consider the substance of the relationship
between two entities to determine whether one controls another. Control is
defined in FRS-37 as:
“Control” by one entity over another entity exists in circumstances where the following parts (a) and (b) are both satisfied:
(a) the first entity has the capacity to determine the financing and operatingpolicies that guide the activities of the second entity, except in the following circumstances where such capacity is not required:
(i) where such policies have been irreversibly predetermined by the first entity or its agent; or
(ii) where the determination of such policies is unable to materially impact the level of potential ownership benefits that arise from the activities of the second entity.
(b) the first entity has an entitlement to a significant level of current or future ownership benefits, including the reduction of ownership losses, which arise from the activities of the second entity.
2.215
Part (a) of the definition is referred to in FRS-37 as the “power” element, and part
(b) as the “benefit” element. These elements are linked, as ownership benefits are
derived from the policies that guide the activities of a subsidiary. Both elements
must be present for control to exist, unless one of the exceptions to the power
element in subparagraphs (i) or (ii) applies.
Power element
2.216
Under FRS-37, an entity is presumed to control another entity if it appoints a
majority of members of the second entity’s governing body or controls a majority
of voting rights at a meeting.4 FRS-37 overlaps with the legal limbs of the control
test in this respect. However, FRS-37 goes further than the legal tests by setting
out other indicators of power that are not solely related to appointment of the
governing body or voting rights. Examples of other indicators of power include
where an entity has a direct or indirect ability to:
- determine the revenue raising, expenditure, and resource allocation policies of another entity, including an ability to modify or approve the entity’s budget; or
- veto, overrule, or modify decisions of the governing body other than for the purpose of protecting existing legal or contractual rights or restrictions.
2.217
The exceptions to the power element (subparagraphs (i) and (ii) in the FRS-37
definition of control) are also a significant extension to the legal tests of control
(see paragraph 2.222).
Benefit element
2.218
The benefit element requires the parent entity to have an entitlement to a
significant level of ownership benefits from the subsidiary’s activities or a greater
entitlement to benefits than any other possible parent entity. Ownership benefits
give a return on an investment.
2.219
Types of ownership benefits include:
- benefits from the distribution of earnings or net assets (for example, a right to a significant level of the net assets of an entity in liquidation); or
- other benefits from control over net assets (for example, synergistic benefits from a parent and subsidiary combining their activities); or
- benefits from an entity undertaking activities that are complementary to those of the parent.
2.220
In our experience, the activities of trusts formed by public entities often
complement those of the public entity. FRS-37 states:
A parent’s entitlement to other ownership benefits may also arise in circumstances where there is a supply of goods or services to a third party by the possible subsidiary, which meets an operating objective of the parent. For example, it is common for special entities such as trusts to be established to provide certain services to support the operating objectives of another entity. In such circumstances, a parent may benefit from complementary activities. Because it can be difficult to identify clearly whether a given circumstance establishes an entitlement to receive the benefits resulting from complementary activities, this Standard takes the position that such entitlement arises when all three of the following conditions apply:
- the supply of goods or services by the possible subsidiary is directly consistent with, and is likely to enhance, the operating objectives of the parent, and
- determination of the nature of the goods or services to be supplied is a direct consequence of the exercise of the parent’s decision-making ability over the activities of the possible subsidiary, and
- the parent is relieved, as a result of the activity of the possible subsidiary, of an actual or constructive obligation to provide such supply; or the parent has a right to receive a future service delivery from the possible subsidiary that is not subject to additional funding to be provided by the parent.
2.221
Because of the wide-ranging powers and functions of local authorities, it is
common to find that the activities of a trust are complementary to, or consistent
with, the objectives of the local authority. Where the local authority set up the
trust and the trustees are unable to make substantive changes to the terms of the
trust, it is likely that the local authority controls the trust under FRS-37.
Exceptions to the power element
2.222
FRS-37 identifies two circumstances where it is not necessary to have the power
element to satisfy the definition of control (see paragraph 2.214).
2.223
We have found that the first circumstance often applies to trusts formed by
public entities. This is where the policies that guide the activities of an entity
have been predetermined and are unable to be modified. In such cases, a power
element is not necessary, although the benefit element is still required. Any
party that has set up such an entity, and has ownership benefits, has control. These arrangements are sometimes described as “irreversible predetermined
mechanisms” or “autopilots”. This is discussed further in paragraphs 2.225-2.230.
Trusts controlled by local authorities
2.224
Since the Public Audit Act was passed, we have identified a number of charitable
trusts in the local government sector as being controlled by one or more local
authorities in terms of FRS-37. The most common circumstances of control
include:
- a local authority that has the right to appoint all or a majority of the trustees, in which case control under FRS-37 is presumed to exist in the absence of evidence to rebut that presumption – the presumption is generally not rebuttable if the local authority receives significant ownership benefits from the charitable trust; and
- a charitable trust set up by a local authority where the local authority does not
appoint a majority of trustees but the trust’s:
- objects or purposes have been determined by the local authority and cannot be changed; and
- complementary activities provide benefits to the local authority (FRS-37 refers to such arrangements as autopilots, discussed in paragraphs 2.225- 2.230)
Autopilots
2.225
In the case of a trust set up for charitable purposes, it is reasonably common to
find either that the objects or purposes specified in the trust deed cannot be
changed or that substantive changes to the terms of the trust cannot be made. In some cases, substantive changes could be made only if it is no longer possible
or practicable to achieve the objects and if approved by the High Court.5 Trustees
of charitable trusts often have a power to make amendments to procedural
or technical aspects of trust deeds to give better effect to the purposes of the
trust, provided that any such changes do not affect the status of the trust for
income tax purposes. In our view, this is not the same as having a power to make
substantive changes to the terms of the trust.
2.226
Such trust deeds can be an “irreversible predetermined mechanism” or “autopilot”
in terms of the first exception to the power element in FRS-37. Where that is the case, the power element under the standard does not have to be present and
the parent entity does not need to have an ongoing power to appoint trustees or
some other form of power.
2.227
We have found that many trusts controlled by local authorities are in this category
– that is, the policies that guide the activities of the trust had been irreversibly
predetermined by the local authority when the trust was set up. Where the
local authority is entitled to receive benefits from the trust’s activities and the
trustees cannot make substantive changes to the objects of the trust that would
affect the local authority’s entitlement to receive those benefits, the significant
policy direction of the trust is unlikely to change and the local authority therefore
controls the trust under FRS-37.
2.228
In many cases, local authorities have set up trusts at arm’s length so that the trust
would be able to perform its functions independently. Examples that we have
considered include fundraising trusts set up for large capital projects, such as
events centres, or trusts set up to operate facilities such as museums or libraries.
2.229
Many local authorities and trusts have found it surprising to be told that many
such trusts are controlled for accounting purposes under FRS-37 and are therefore
public entities. This is partly because the standard did not apply when the trusts
were set up. The concept of control is not seen as appropriate for a trust, as the
trustees are under a legal duty to act independently in accordance with the
objects of the trust and do not consider themselves to be controlled in any sense
by the organisation that set up the trust.
2.230
In general trust law, once a settlor has given property to trustees on trust, the
settlor has divested themselves of the asset. The trustees do not get ongoing
funding from the settlor and must act independently of the settlor. The
accounting standard does not sit easily with trust law in this respect, but it does
acknowledge that entities often form trusts to provide services that support their
objectives. The standard-setters were clearly aware of its possible application to
trusts.
Disputes with controlled entities
2.231
We have had protracted debates with trustees of a small number of trusts about
whether the trusts are in fact controlled by local authorities under FRS-37.
2.232
One issue is whether the objects and purposes of a trust are “the financing and
operating policies that guide the activities of the entity” within the meaning of
FRS-37. The definition of control in FRS-37 refers to “the financing and operating
policies that guide the activities of the second entity”. In the case of a charitable trust, we consider that the policies that guide the activities of the trust are
the objects or purposes of the trust rather than day-to-day administrative
matters such as the particular powers applying to the operational, borrowing, or
investment activities of the trust (which, in any case, must be exercised to further
the trust’s objects or purposes).
2.233
Another issue is whether the policies that guide the activities of the subsidiary
can be modified – that is, whether the trustees can make substantive changes
to the objects or purposes of the trust. In our view, it is not possible for trustees
to make substantive changes to the terms of the trust in a way that affects the
parent entity’s entitlement to ownership benefits. For example, the trustees of a
charitable trust set up to raise funds for the benefit of a particular entity would be
likely to be in breach of their duty if they were to change the objects and purposes
of the trust to benefit another entity.
2.234
In some cases, trustees have questioned whether the local authority set up the
trust. This is partly a question of fact, and often the trusts and local authorities
have not been willing or able to make records or evidence of the facts of
establishment available to us. In some cases, we have been told that the person,
such as a mayor or chief executive of a local authority, settled a trust associated
with the local authority in their private capacity rather than on behalf of the local
authority.
2.235
Trustees have also questioned whether the public entity derives ownership
benefits from the activities of the trust. In most cases, we consider that the
activities of the subsidiary trust are complementary to those of the parent where
the three requirements in FRS-37 for complementary benefits apply and the
benefit test is met.
2.236
In many cases, the real concern of trustees is with the idea that they are controlled
by another entity when in legal terms and in practice they are independent. They
are also concerned about the possible effect of being consolidated into the group
financial statements of a public entity. Some trustees have told us that they
believe that consolidation would affect their ability to raise funds from members
of the public and other funding organisations, as they would be perceived to be
part of a publicly funded entity.
2.237
We do not know whether this concern has eventuated for those trusts that
have been consolidated. If the trustees’ concerns were realised, this would be an
unintended consequence of the application of the control test. In our view, being
subject to public audit and the greater accountability associated with that may
enhance a trust’s appeal to the public and funding organisations.
2.238
Trustees tend to be less concerned about the Auditor-General appointing their
auditor than about the potential effect of consolidation. The concern about
consolidation has proved to be an obstacle to our appointing an auditor in a small
number of cases, and some trusts have not been willing to accept that they are
subject to the Auditor-General’s mandate.
2.239
Where the activities of a subsidiary entity are material to the activities of a parent
entity, generally accepted accounting practice (GAAP) requires the parent to
consolidate the subsidiary entity into its group financial statements. Where the
parent entity is not willing to do so or is unable to do so because the subsidiary
will not provide the necessary information, then the audit opinion on the group
financial statements of the parent entity may need to be qualified.
2.240
In some cases, the trustees have considered winding up the trust to avoid
consolidation and public audit, or resettling the trust fund on a new trust that
would not be subject to public audit. In some instances, if the trust deed does not
contain an express power to resettle, trustees have found that they do not have
the ability to resettle the trust in the way they seek.
2.241
We are aware of one trust in the local government sector that took this step. The
Manukau Community Charitable Trust (known as Trust Manukau) was formed in
2000 to perform charitable activities to benefit communities in the Manukau City
Council region. The Mayor of Manukau City Council had settled the trust.
2.242
We had concluded that the charitable objects in the trust deed were entrenched
and that the activities of the trust were complementary to those of the council. Accordingly, the council had established an “autopilot” in terms of FRS-37, with
the result that the Auditor-General was responsible for appointing the trust’s
auditor and the council needed to consolidate the trust’s activities into its group
financial statements.
2.243
The trustees did not accept our assessment that the trust was controlled by the
council under FRS-37. The trustees considered that, even though setting up the
trust had initially been a Manukau City Council initiative, the mayor was acting
in his private capacity as the “first citizen” when he settled the trust. The trustees
noted that there was no formal council minute that authorised the mayor to act
on behalf of the council to set up the trust.
2.244
The trustees also disagreed with our assessment that the activities of the trust
were directly consistent with or complemented the council’s operating activities
and that the council therefore received ownership benefits from the trust’s
activities.
2.245
The trustees were concerned about being defined as a public entity and the
requirement that the trust’s financial statements be consolidated within
the annual financial statements of Manukau City Council. They believed this
requirement would defeat the trust’s original purpose – namely to raise funds
from the private sector to support community development projects in Manukau.
2.246
The trustees told us that they had given assurances to donors about their
independence from the council, and this would be compromised by consolidation
into the council’s financial statements. They considered too that the trust must be
seen by the public of Manukau to be independent of the Manukau City Council to
effectively carry out the objects and purposes for which it was formed.
2.247
The trustees told us that they considered whether to pursue other legal avenues
such as a declaratory judgment from the High Court on the nature of the
relationship between the council and the trust (and therefore whether FRS-37
was applicable), but in the event decided that this option was too costly. The
trustees then investigated the option of winding up the trust and starting a new
legal entity that had the same broad goals but that would not be subject to the
provisions of the Act and FRS-37.
2.248
The trustees consulted us and the council about their intention to wind up the
trust. The trustees told us that they wished to maintain the ongoing support and
goodwill of council for any future activities that a successor organisation might
carry out. The Manukau City Council agreed to accept early repayment of a loan
that it made to the trust in 2001 and then re-advance those funds to the new
trust on the same terms.
2.249
We are generally reluctant to provide entities with advice about how to avoid
being subject to public audit, as we consider that it is undesirable for assets
that are subject to public audit (and the accountability that goes with that) to
be transferred to another entity that is not publicly accountable. We are also
concerned about potential wasteful expenditure by trusts in seeking to avoid
public audit, especially where there is no explicit power in a trust deed to resettle
trust assets or where approval of the High Court would be required. However, in
this case, we appreciated being consulted by the trust and noted that the trust
was also consulting with the council. We gave some general comments on the
proposal to wind up the trust and resettle the trust fund.
2.250
The trustees resolved to wind up the Manukau Community Charitable Trust and
settle the trust assets on a new trust, the Manukau Community Foundation, in
October 2005. The Manukau Community Foundation was set up in such as way as
to avoid being subject to public audit or consolidation by the council.
2.251
Apart from the Trust Manukau case outlined above and a small number of other
trusts that are subject to ongoing debate, we have resolved most disagreements
with controlled entities and they have eventually accepted our view that they
are controlled under FRS-37. We have explained that the test for control under
FRS-37 is relevant for accounting purposes only and does not affect the role or
independence of the trustees. In many cases, we have been able to appoint the
trust’s existing auditor to conduct the audit on our behalf.
2.252
We can appreciate why our conclusions are sometimes contentious for trustees
who regard themselves as completely independent from the settlor entity and are
concerned about the implications of “control”. The Auditor-General is bound by
the Public Audit Act, which aims to ensure that there is public accountability for
all public entities, including controlled public entities. We have explained that, in
determining control under the Public Audit Act, we are applying the accounting
standard as we understand it. We have suggested to entities that they should
raise their concerns about the application of the standard to trusts with the
standard-setters.6
2.253
If we reach the point where a controlled public entity refuses to accept that
the Auditor-General is its auditor, we consider that it is important to advise
Parliament and provide the name of the controlled entity. We do not yet need to
take this step, but will do so as necessary in the future.
1:There is a detailed explanation of the control test on our website www.oag.govt.nz.
2: The definition of CCO is also wider than the definition of a local authority trading enterprise under the Local Government Act 1974, as it includes both profit and non-profit entities.
3: The standard was issued in October 2001 and applies to general purpose financial reports covering periods ending on or after 31 December 2002.
4: Paragraph 5.10 of FRS-37 sets out other circumstances that establish “rebuttable presumptions” that control exists.
5: The Charitable Trusts Act 1957 contains a regime for the variation of charitable trusts where the trust fails in some way.
6: The Financial Reporting Standards Board of the Institute of Chartered Accountants.
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