2.2 Trusts controlled by local authorities ― effect of the Public Audit Act 2001

Local government: Results of the 2005/06 audits.

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

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

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.

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.

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

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.

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).

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).

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

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).

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.

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.

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.

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.

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

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.

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

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.

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.

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.

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

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).

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

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)


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.

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.

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.

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.

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.

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

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.

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).

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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

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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