TRUST QUARTERLY REVIEW CONTENTS 02 FOREWORD VOLUME 11 ISSUE The Editors

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1 TRUST VOLUME 11 ISSUE QUARTERLY REVIEW CONTENTS 02 FOREWORD The Editors PREST v PETRODEL RESOURCES LTD Patrick Harney, Laura Brown and Holly Jones PITT v HMRC AND FUTTER v HMRC Jennifer Seaman and Richard Wilson SHAPELESS TRUSTS Adam S Hofri-Winogradow DOMICILE AS A BARRIER TO FAMILY PROVISION CLAIMS Sidney Ross THE PRINCIPLE IN GOVERNMENT OF INDIA v TAYLOR Carlyle K Rogers SERVICE OF TRUST CLAIMS OUT OF THE JURISDICTION Simon Taube QC BOOK REVIEW International Trust And Divorce Litigation, second edition, by Mark Harper et al PRODUCED BY IN ASSOCIATION WITH 1

2 FOREWORD THE EDITORS A TRULY INTERNATIONAL AFFAIR A COLLECTION OF ARTICLES THAT HIGHLIGHT THE MULTIJURISDICTIONAL NATURE OF MODERN TRUST WORK BY THE EDITORS This issue of Trust Quarterly Review provides a reminder, if it were needed, of the breadth of international developments that affect the day-to-day practice of trust and estate practitioners, and the need for us all to keep abreast of such matters. The recent decision of the UK Supreme Court in Prest v Petrodel is a prime example: this case has been the talk of trust and estate practitioners not only in London but also on the other side of the globe, in Australia. Patrick Harney TEP and colleagues consider the implications of the case from a family law perspective, and the use of family investment companies for high-net-worth wealth planning. The UK Supreme Court decision in Pitt v HMRC and Futter v HMRC, and where it leaves the socalled rule in Re Hastings-Bass and the equitable doctrine of mistake, is another key development that merits close study. Jennifer Seaman and Richard Wilson expand on coverage that appeared recently in the STEP Journal. We then head to Israel. Shapeless trusts are not well-known; such a heading is not encountered in the mainstream trust textbooks. Adam S Hofri-Wingogradow explains their characteristics, drawing a comparison with Chinese trust law and touching on settlor title retention trusts, under which title to the trust assets remains vested in the settlor despite the appointment of another person or body as trustee. The international theme is continued in a review by Sidney Ross of the extent to which domicile or similar concepts have a role in family provision. He also looks ahead at possible reform, which could involve an alternative ground of jurisdiction being added alongside the wellestablished element of domicile. In recent years, international cooperation in tax enforcement has, as we know, proceeded apace. It is timely to pause to consider whether we can still say that the hallowed principle from Government of India v Taylor holds true. Carlyle K Rogers studies various developments that may suggest that the principle has had its day. Simon Taube QC s paper, Widening the Gateways, written on behalf of the Trust Law Committee, examines the Civil Procedure Rules that deal with the service of proceedings on a defendant outside the jurisdiction of England and Wales, and advocates changes to those rules in cases concerning trusts. We conclude this issue with divorce: Edward Buckland reviews the second edition of International Trust and Divorce Litigation, a text that has already secured a well-deserved place in explaining the complexities of dealing with trusts in the context of divorce. THE EDITORS 2

3 FAMILY INVESTMENT COMPANIES PATRICK HARNEY, LAURA BROWN AND HOLLY JONES PREST v PETRODEL RESOURCES LTD ARE FAMILY INVESTMENT COMPANIES STILL A VIABLE ALTERNATIVE TO TRUSTS? BY PATRICK HARNEY TEP, LAURA BROWN AND HOLLY JONES Ever since the Finance Act 2006 clampdown on the use of trusts by UK domiciliaries and, as a separate development, the 2009 amendments to the corporation tax legislation, family investment companies (FICs) have become an extremely useful and sometimes essential tool in the family wealth-planner s armoury. The England and Wales Court of Appeal judgment in Petrodel [2012] EWCA Civ 1395 affirmed this and indeed served as a reminder to those who practise in family law that if there is no evidence of impropriety, it will not be open to a judge to make orders transferring assets owned by a company. 1 In Petrodel [2013] UKSC 34, the companies lost on appeal to the Supreme Court and their seven properties were ordered to be transferred to the wife, but, paradoxically, the judgment confirms the efficacy of FICs as wealth-protection vehicles where sensibly and appropriately used. This article first examines the implications of Petrodel from a family law perspective and goes on to consider the use of FICs as vehicles for separating control and ownership in a tax-efficient manner. Petrodel The judgment of the Supreme Court in Petrodel was handed down on 12 June It was following 1. Patrick Harney, Holly Jones and Spencer Clarke, The new holy grail?, STEP Journal, Volume 21, Issue 2, p60 (March 2013) an appeal by the wife of the decision made in the Court of Appeal, following an appeal by the companies (the husband taking no further part in the proceedings following the decision of Moylan J in the High Court, as he failed to meet the separate conditions for leave to appeal). At first instance Moylan J made an order that the husband pay the wife a lump sum of GBP17.5 million. When the husband failed to make the payment, Moylan J ordered the companies (in which the husband had a controlling interest) to transfer seven London properties to the wife in part satisfaction of the order, having found the husband to be the effective owner of those properties. This was in reliance on the obiter dicta in Nicholas v Nicholas [1984] FLR 285. The companies appealed this order on the basis that the Family Court had no jurisdiction to make it because although it was correct that the husband controlled the companies, they were separate legal entities and it was the companies that owned the properties not the husband. The Court of Appeal allowed the companies appeal by a majority. The wife appealed this decision to the Supreme Court. In an interesting twist, although the wife lost on all but one of the points argued on her behalf, she won her appeal and the order of Moylan J was reinstated. The basis upon which the Supreme Court reached this decision (Lord Sumption giving the lead judgment) was by a different route from Moylan J, and it considered 3

4 FAMILY INVESTMENT COMPANIES PATRICK HARNEY, LAURA BROWN AND HOLLY JONES It is not possible to pierce the corporate veil just because it is in the interests of justice a number of different angles used by family lawyers to access assets held in corporate and trust structures on divorce. The Supreme Court considered three options: i) whether the wording at s24(1)(a) of the Matrimonial Causes Act 1973 allowed them to redistribute the property on the basis that the husband was entitled and thereby to pierce the corporate veil in order to do so; (ii) whether the Petrodel companies were nuptial settlements; and (iii) whether the properties were held on trust by the companies for the husband. In respect of (i), the Supreme Court took the view that piercing the corporate veil is possible in a small residual category of cases where the abuse of the corporate veil to evade or frustrate the law can be addressed only by disregarding the legal personality of the company (para 35). Lord Sumption endorsed Munby J s judgment in Ben Hashem v Al Shayif [2009] 1 FLR 115, which sets out a useful summary of when the corporate veil can be pierced. It is not possible to do so just because it is in the interests of justice : there needs to be impropriety linked to the use of the company structure to avoid or conceal liability. In addition, even if the Court was able to pierce the corporate veil, it could only be done as far as it was necessary in order to provide a remedy for the particular wrong which those controlling the company had done (thus reaffirming the principle of the corporate veil). This did not therefore assist the wife, given the finding by Moylan J at first instance that there had been no impropriety that would allow the piercing of the corporate veil. The Supreme Court also gave little time to (ii), with Lord Sumption saying at para 53: The Court ruled in the course of argument that leave would be refused. The point was not argued below and does not appear seriously arguable here. This does lead to questions in respect of the recent Mostyn J decision in DR v GR and others [2013] EWHC 1196 (Fam). It was (iii) that led the Supreme Court to decide in the wife s favour. This was due to the fact that Moylan J had left this option open, having not made any finding on the point (save that the matrimonial home was held on trust for the husband as it has a special significance for the Family Court). The properties had been bought with the husband s money, not the companies. It was also based on the husband s conduct during the proceedings and the fact that this allowed the Supreme Court to make adverse inferences and come to this conclusion given that the defective character of the material is almost entirely due to his persistent obstruction and mendacity (para 43). It is important to note the different treatment of the matrimonial home by the Family Courts, which was recognised by Lord Sumption (para 52), who suggested that in many cases the facts are quite likely to justify the inference that the property was held on trust for a spouse who 4

5 FAMILY INVESTMENT COMPANIES PATRICK HARNEY, LAURA BROWN AND HOLLY JONES owned and controlled the company. In this case the wife was fortunate that there were a number of UK properties (not just the matrimonial home, which would have gone only a small way to satisfying her claim) about which the Court could make orders that could be enforced and could at least go towards satisfying her financial claims against the husband (subject to the mortgages on the properties). This will not always be the case. As a result, while it is clear that the Supreme Court strongly endorsed the legal delineation between companies and individuals, and the limited circumstances in which the corporate veil could be pierced, it did seek to find a fair outcome for the wife. It is, however, important for family lawyers to note that this decision and a number of other recent decisions, including Imerman [2010] EWCA Civ 908 and Radmacher [2010] UKSC 42, seem (after many years of the law moving in the opposite direction) to be moving back to being more in favour of the stronger financial party. This is to say nothing of the growing problem of enforcement given the higher number of cross-jurisdictional cases but that is beyond the scope of this article. It would seem that in the future, the stronger financial party can avail themselves of an increasing number of options in terms of their assets and how they are held, not only as tax-efficient structures but also as protective structures on any divorce, while the weaker financial party will need to ensure that they take advice as early as possible and possibly during the marriage to protect their position on any divorce. With the increasing use of prenuptial agreements, following this decision it seems that the business of marriage becomes ever less romantic and ever more commercial. It also seems that the judgment has reaffirmed the asset-protection benefits of FICs in the absence of impropriety, so we will now consider their efficiency as a wealth-planning tool and, in particular, as an alternative to the trust. Use of FICs as an alternative to a trust The family trust has been an important and useful wealth-planning vehicle since the time of the Crusades. The trust offered the wealthy individual an effective means of separating control and ownership of assets and a tax-efficient vehicle for holding family wealth, both during lifetime and after death. Sadly, the trust s force now seems to be waning. In recent years the English family courts have seen fit to look through trustee ownership of assets on a divorce. 2 In addition, the Finance Act 2006 completely changed the wealth-planning landscape for UK-domiciled families by making accumulation and maintenance trusts creatures of history and by extending the relevant property regime including the 20 per cent lifetime entry charge on gifts over the nil-rate band (which was also frozen at GBP325,000 until 2017/18 in the most recent Budget) to almost all lifetime trusts. As a result of these changes, although the trust can still achieve separation of control and ownership, the separation now comes at a significant cost and a family can no longer be certain that the separation will be respected by the courts on a divorce. This had led families to consider other wealth-planning vehicles. Before considering FICs in detail, it is also helpful to consider other vehicles that have been put forward as an alternative to trusts since Family limited partnerships (FLPs), structured under the Limited Partnership Act 1907, were very topical immediately after the Finance Act 2006, and at first glance they are an ideal vehicle for separating control and ownership. The parents would retain control through their ownership of the general partner and they would make potentially exempt transfers of limited partnership shares (holding cash or unappreciated assets) to their children. The problem with that, and the reason that they have not been taken up so much, is the regulatory issues. They are 2. For example, Charman v Charman (No. 2) [2007] 1 FLR 1246 and Whaley v Whaley [2011] EWCA Civ 619 5

6 FAMILY INVESTMENT COMPANIES PATRICK HARNEY, LAURA BROWN AND HOLLY JONES Often clients are drawn to FICs because of their familiarity with the legal and taxation regime considered to be collective investment schemes in the UK, and for that reason there are significant regulatory requirements: the need to appoint an FSA-authorised operator. So it is hard to justify the costs of an FLP with investable assets of less than GBP10 million, and they have not been used widely. Family general partnerships (FGPs) are something our firm has used as an alternative way to separate control and ownership. They can achieve a lot of the same objectives as FLPs: passing assets down a generation, but keeping control in the senior generation. Under the Financial Services and Markets Act 2000 in the UK, a collective investment scheme arises where you have an arrangement for the pooling of property or the holding of property, and the participants do not have day-to-day control. Clearly, that is what you have with a limited partnership under the 1907 Act. With an FGP the same issues can arise. If control is in the hands of the senior generation, you would end up with a collective investment scheme, but it is possible with careful drafting to arrange for the senior generation, effectively, to have weighted votes without the arrangement constituting a collective investment scheme. All the participants can participate in the management of the partnership, but the real control remains with the senior generation. Interestingly, limited companies are exempted from being treated as collective investment schemes. 3 Companies were traditionally avoided as family investment holding vehicles by UK-domiciled families because of the double layer of corporate and personal taxation necessary to extract investment profits. Until 2009, the tax treatment of dividends received by UK-resident companies from companies resident outside the UK compared to those from other UK-resident companies was unattractive. However, changes were introduced in 2009 which significantly enhanced the tax treatment of dividend income received by UK companies and the rate of corporation tax is now on a downhill trajectory to 20 per cent from 1 April In addition, in contrast to other vehicles, the legal regime surrounding FICs has remained stable while the regimes surrounding trusts and partnerships have had some turbulent years. Often clients are drawn to FICs because of their familiarity with the legal and taxation regime. The separation of control and ownership: the structure of an FIC The first question to ask is how an FIC should be structured. The answer is that this will always depend on the facts. There is no specific way an FIC needs to be structured, and this is why an FIC is potentially such a useful investment vehicle. At the very least, an FIC will be one 3. Section 236, Financial Services and Markets Act

7 FAMILY INVESTMENT COMPANIES PATRICK HARNEY, LAURA BROWN AND HOLLY JONES private company, the shareholders of which are family members and/or family trusts. It will have a memorandum and articles of association, and it will have a shareholders agreement. The memorandum and articles will be public documents, but the shareholders agreement will be private, so this often contains any family governance procedures. The shareholders agreement may or may not be supported by a family constitution. A sample structure might look like the diagram below. Sample FIC structure Jennifer: 50,000 B ordinary shares James: 50,000 B ordinary shares Discretionary trust: 662,000 A ordinary shares James: loan of GBP700,000 Stephen: 419,000 C ordinary shares Jennifer: loan of GBP700,000 Penelope: 419,000 D ordinary shares FIC 7

8 FAMILY INVESTMENT COMPANIES PATRICK HARNEY, LAURA BROWN AND HOLLY JONES James and Jennifer have two children: Stephen and Penelope. James and Jennifer have just sold their business for GBP3 million. They have plenty of other assets so have decided to engage in some estate planning with the GBP3 million. They want to invest half of the amount for their children, and they want to continue to be able to benefit from the remaining half. Stephen is at university but James and Jennifer are concerned that the new friends he has made are a bad influence on him. Penelope is only 16 years old and so is not legally capable of owning assets herself. Her parents could make a gift to her that would be held on a bare trust until she is 18 years old, but they are worried about her receiving a significant amount of money at that age. So what should James and Jennifer do? One suggestion is that they use the funds to set up an FIC. A primary objective of the parents is to retain control of the assets in the FIC but also to For the parents to retain control of the FIC, they need to retain control of the shareholder voting rights. This can be done by limiting the voting rights of the FIC to those classes of shares which the parents hold get GBP1.5 million out of their estates and held for the benefit of their children. To achieve this using an FIC, the key consideration at the outset is what share classes the FIC will have and what rights will be attached to each of those share classes. The diagram on the previous page assumes there will be a combination of A, B, C and D ordinary shares. Each share class can have its own bespoke rights, and it is through these rights that the estateplanning objectives of the parents can be met. In this example, for the parents to retain control of the FIC, they need to retain control of the shareholder voting rights. This can be done by limiting the voting rights of the FIC to those classes of shares which the parents hold. The parents can hold the voting rights personally or through a trust. One way of achieving this is for the parents to fund a discretionary trust for the benefit of their children and remoter issue with up to GBP662,000 (the combination of their nil-rate bands and annual allowances for this year and last). They could be appointed trustees of the trust and, as trustees, they subscribe for up to GBP662,000 of A ordinary shares. To achieve their aim of getting the monies out of their estates, the settlors/parents will need to be irrevocably excluded from benefit from the trusts. As trustees, James and Jennifer will control the voting rights of the FIC as the trustees hold the majority of the voting shares in the FIC. In the future, either Stephen or Penelope (or both) could also be added as trustees; this can be a useful way of initiating their involvement in the management of the FIC and the family wealth. As James and Jennifer can only contribute up to GBP662,000 without triggering an inheritance tax liability, they will need to consider other ways of funding the FIC. How they achieve this will depend on how much of the GBP3 million they wish to give away. In the example above, they want to retain the benefit of GBP1.5 million. This amount can still be used to fund the FIC, but to keep the benefit of it James and Jennifer could either subscribe for additional B ordinary shares which have voting rights and dividend rights or make loans to the 8

9 FAMILY INVESTMENT COMPANIES PATRICK HARNEY, LAURA BROWN AND HOLLY JONES FIC. Alternatively, James and Jennifer could subscribe for preference shares in the FIC instead of loans. However, unless there is a reason for them to participate by way of preference shares it is preferable for them to provide additional funding by way of loan as there are fewer company law considerations on making loan repayments. One point to note on this structure is that if James and Jennifer subscribe for additional B shares in the FIC then it is important to irrevocably limit the amount of dividend income which can be paid to this share class to the percentage of the overall share capital retained by James and Jennifer at any one time, to ensure that a gift with reservation of benefit (GROB) cannot occur. Care would also need to be taken, if James and Jennifer had subscribed for preference shares, that the GROB rules are not in point on a redemption. In fact, where possible, there is a strong preference that parents do not retain any equity interest in the FIC as this will trigger the need to manage the GROB issue both immediately and in the long term. It also makes the drafting of the documents more complex. To achieve their objective of gifting up to GBP1.5 million to their children, James and Jennifer could create an additional share class for each of them. Subscribing for different share classes can enable a dividend to be declared on one share class but not on the other (i.e. money can be passed to Stephen and Penelope independently of the other). This alternative structure is shown below. In this approach, the parents do not retain any funds for themselves. Instead, they each contribute their nil-rate band to a discretionary trust, which holds the ordinary shares in the FIC and thereby controls the voting rights. Because the parents do not retain any shares in their own names the GROB concerns are significantly reduced. The remaining funding is provided by way of preference shares, which are held in the names of the children (via bare trustees if needed). The terms of those shares could be drafted with or without income rights (although see below) and, Alternative FIC structure: Discretionary trust: 100% of ordinary shares (GBP662,000) Children: GBP5 million of preference shares held through bare trustees (if needed) FIC 9

10 FAMILY INVESTMENT COMPANIES PATRICK HARNEY, LAURA BROWN AND HOLLY JONES more importantly, can be drafted to delay any redemption rights until the children are older. There are some technical points to consider here. The first is that if the preference shares do not carry income rights and are not repayable for a specified period, in economic terms they would be similar to an interest-free loan for a fixed term and HMRC might argue that the holder of the preference shares is making a lifetime chargeable transfer to the company (and to the ordinary shareholders of the company, i.e. the trust). To avoid this, the preference shares could carry appropriate income rights. The issue this creates is that the holder of the shares would have an ongoing income tax liability or, if the coupon is rolled up for a fixed period subject to the directors discretion to pay earlier, the holder may receive more money on the eventual redemption of the preference shares than was originally intended and so this issue will need to be balanced against the risk of a lifetime transfer. The second point to consider is whether any tax issues arise from how the preference shares are subscribed for. The subscription options are that either the parents subscribe cash for the shares and then gift the shares to the children, or the parents gift cash to the children and the children (in Penelope s case through her bare trustee) could subscribe for the shares in their own names. The first option presents an inherent capital gains tax (CGT) risk. The transfer of the shares from the parent to the child is a disposal for market value for CGT purposes because the parties are connected. When determining that market value, the risk is that because the share rights are restricted, HMRC could argue that the market value is less than the initial subscription monies. If such an argument were successful, the children s base cost in the shares will be lower than what was actually subscribed for them by their parents, so the children would make a much larger capital gain when the shares are eventually disposed of. The alternative is for the parents to gift monies to the children and the children to subscribe for the shares themselves. This, however, may not be suitable if the children are over 18 years old as they could then choose to invest the monies in something else! However, if the child is under 18 the funds can be held on bare trust for them and invested on their behalf. Although unlikely, it is worth noting the possibility that when the child reaches 18, they could, in theory, choose to repudiate the contract entered into by the bare trustees on their behalf or they could bring a claim for breach of fiduciary duties by the bare trustees if the child feels the money has been poorly invested. In practice, the risk of these claims being brought, and then being successful, is low for a number of reasons. But the risk is worth considering. Once the subscription process is finished, and the FIC fully funded, the first objective of retaining control while changing ownership will have been achieved. The next question is how monies can be extracted from the FIC in a tax-efficient way, and this is where the recent changes to the taxation of companies in the UK come to the fore. Taxation of FICs: mitigating the effect of the traditional double-tax charge The double-tax charge on (i) profits in the company and (ii) subsequent profit extraction by the shareholder was traditionally why a company was unattractive as a wealth-holding vehicle. Profits in the company Due to recent decreases in the corporation tax rate, there is now a significant difference between corporation tax rates (currently 23 per cent and due to decrease to 20 per cent by 1 April 2015) and the top income tax rate of 45 per cent. As a result, because the FIC can, after 1 April 2015, reinvest GBP80 out of every GBP100 of profit, it is in a significantly better position to accumulate post-tax wealth than an individual holder of the same investments, who could reinvest only GBP55 out of every GBP100 of profit. An FIC will also be in a better position to accumulate posttax wealth derived from capital gains, not only because it enjoys the lower corporation tax rate 10

11 FAMILY INVESTMENT COMPANIES PATRICK HARNEY, LAURA BROWN AND HOLLY JONES The income tax position on receipt of income from the discretionary trust can be improved by granting life interests to beneficiaries when compared to the 28 per cent CGT rate for an individual, but also because as a company it can still benefit from indexation allowance. Profit extraction Profit extraction can, at first, appear inefficient because of the double-tax charge. However, is this charge as bad as first thought? First, the lower corporation tax rate makes the cost of double taxation lower than it once was. Also, changes to the taxation of dividend income mean dividend income will not be subject to double tax. Second, the 2009 changes to the taxation of dividends received by non-uk companies have extended an exemption from corporation tax from dividends paid by UK-resident companies to dividends paid by a company resident in most countries with which the UK has a tax treaty. 4 This has increased the tax efficiency of FICs that directly invest in equities by allowing them to receive dividend income free from corporation tax. Also note that double taxation is an issue only if the trust beneficiary is a higher or additional rate taxpayer. If the recipient is a basic rate taxpayer, because of the 10 per cent tax credit, up to about GBP32,010 can be distributed to them free of tax in this current tax year. This can prove to be a very efficient way of funding university education. Finally, the income tax position on receipt of income from the discretionary trust can be 4. Part 9A of the Corporation Tax Act 2009 improved by granting life interests over some or all of the trust fund (which can be revocable for flexibility reasons) to beneficiaries. 5 The company directors (the parents) can still control the dividend flow from the FIC, and so limit the income received by the trust, and thus the beneficiaries. Conclusion Salomon v A Salomon and Co Ltd [1897] AC 22 is alive and well after Petrodel. This means sensibly used corporate structures, particularly where there is third-party ownership, can be effective to protect assets in the event of divorce. This, combined with the potential tax benefits, means FICs, particularly when combined with trusts and other ownership structures, have a significant role to play in wealth planning for UK-domiciled families. FICs are creatures of contract not of equity and they should not be seen so much as replacements for trusts (which after all remain one of English law s greatest innovations) but as powerful tools to be combined with trusts and other vehicles to hold family wealth. PATRICK HARNEY TEP IS A PARTNER IN THE PRIVATE CLIENT GROUP, LAURA BROWN IS A SOLICITOR AND COLLABORATIVE LAWYER IN THE FAMILY GROUP AND HOLLY JONES IS A SOLICITOR IN THE PRIVATE CLIENT GROUP AT FORSTERS LLP 5. Subject to not falling foul of the child of settlor anti-avoidance provisions found in s629 of the Income Tax (Trading and Other Income) Act 2006, which in practice means that the interest in possession beneficiary needs to be 18 or over if they are a child of the settlor 11

12 PITT v HMRC AND FUTTER v HMRC JENNIFER SEAMAN AND RICHARD WILSON AN EXERCISE IN GOOD CITIZENSHIP? WHERE THE PITT v HMRC AND FUTTER v HMRC DECISION LEAVES TRUSTEES IN APPLICATIONS FOR RECTIFICATION OF MISTAKES BY JENNIFER SEAMAN AND RICHARD WILSON The cases of Pitt v HMRC and Futter v HMRC [2013] UKSC 26 provided the UK Supreme Court with the opportunity to resolve the uncertainties that had existed in two important areas of trust law: the so-called rule in Re Hastings-Bass (the rule) and the equitable doctrine of mistake. Judgment in the two combined appeals was handed down on 9 May The sole judgment was given by Lord Walker, with whom the other six members of the panel agreed. The judgment clarifies the underlying principles in both of these areas, making it clear that where a transaction is impugned on the basis of the rule or mistake, the result is that the transaction is voidable (i.e. the Court may set it aside) rather than void (i.e. a nullity). Thus, where the case for relief is made out, the Court is asked to grant the equitable remedy of rescission and consequently has discretion as to whether the transaction should be rescinded. It may decline to do so on a number of grounds, including clean hands or public policy. In his judgment, Lord Walker made striking comments on how the courts might approach the question of granting equitable relief in cases involving tax avoidance, suggesting that it may be a basis for the refusal of relief. This article examines these comments in the context of apparent changing attitudes towards tax avoidance and what impact this may have for future cases in which equitable relief is sought. The facts of Pitt v Holt and Futter v Futter and the High Court decisions Mr Pitt had suffered serious head injuries in a road traffic accident, resulting in mental incapacity. Mr Pitt received an award of GBP1.2 million for damages for the injuries he suffered. His wife, Mrs Pitt, was appointed as his receiver by the Court of Protection. She sought advice from a firm of financial advisors on how best to structure the settlement for Mr Pitt s benefit. The firm advised that the damages should be settled in a discretionary settlement. This was done in 1994, with the approval of the Court of Protection. However, the financial advisors overlooked inheritance tax (IHT) liability and there was an immediate charge of GBP100,000 IHT, with the prospect of further tax becoming due on the tenth anniversary of the settlement in The total tax liability amounted to between GBP200,000 and GBP300,000: a significant proportion of the trust fund. IHT could have been avoided entirely if the settlement had taken the form of an interest in possession trust or a discretionary trust complying with s89 of the Inheritance Tax Act Either of these alternatives would have been feasible. Mrs Pitt and her advisors became aware of the IHT problem in In 2006, Mrs Pitt 12

13 PITT v HMRC AND FUTTER v HMRC JENNIFER SEAMAN AND RICHARD WILSON commenced proceedings against the financial advisors for professional negligence. Mr Pitt died in After taking further advice, Mr Pitt s personal representatives commenced proceedings to have the settlement set aside under the rule or on the ground of mistake. For the first time in a long history of such cases, HMRC actively opposed the application. The first-instance judge, Robert Englehart QC, held that a receiver was in the same position as a trustee, as a fiduciary, and set aside the settlement under the rule, on the basis that Mrs Pitt had failed to take into account a relevant consideration (namely the IHT charge) and that had she done so, she would not have acted as she did. 1 He was not satisfied that there was any real mistake, but if there was a mistake it was only about the consequences of the transaction, and therefore, on the authority of Gibbon v Mitchell [1990] 1 WLR 1304, relief could not be granted. In Futter, there were two settlements made by Mr Futter in Both settlements had nonresident trustees, but in 2004, resident trustees (Mr Futter and a solicitor) were appointed. Both settlements had stockpiled gains not yet distributed to the beneficiaries or brought in to charge for capital gains tax (CGT) purposes. On 31 March 2008, acting on the advice of the firm of which one of the trustees was a partner, the trustees distributed the whole capital of one settlement to Mr Futter and on 3 April 2008 distributed GBP36,000 from the other settlement to Mr Futter s three children in equal shares in exercise of the power of advancement. The trustees incorrectly believed that the gains attributed to Mr Futter and his children would be set off by personal losses, with the result that no tax liability would arise. Unfortunately, this analysis overlooked s2(4) of the Taxation of Chargeable Gains Act 1992, which prevented any set-off of personal losses against the gains deemed accruing to the beneficiaries as a result 1. Applying the test as set out by Lloyd LJ in Sieff v Fox [2005] 1 WLR 3811 of the distributions. As a result, Mr Futter and his children were liable for CGT. The trustees applied to have the deed of enlargement and deeds of advancement declared void under the rule. As in Pitt, HMRC opposed the application. At first instance, Norris J held that the deeds were void on the basis of the rule. 2 The Court of Appeal HMRC appealed in both Futter and Pitt. The appeals were heard together by a Court of Appeal consisting of Mummery, Longmore and Lloyd LJJ. Lloyd LJ gave the leading judgment of the Court of Appeal and held that the rule did not apply in either case. Adopting the principle first identified by Lightman J in Abacus Trust Co (Isle of Man) Ltd v Barr, 3 the Court held that, in such circumstances, the Court can intervene only where a breach of fiduciary duty has been committed. Because the trustees/receiver had acted within the scope of their respective powers and on the basis of professional advice (albeit incorrect advice) they had not committed any breach of duty. On the issue of mistake, the Court of Appeal held that Mrs Pitt s mistake was not as to the legal effect of the settlement but merely as to its fiscal consequences. Therefore, applying the Gibbon v Mitchell test, it was held that she was not entitled to avoid the settlement on the grounds of mistake. The Futter trustees and Mrs Pitt appealed to the Supreme Court. The decision of the Supreme Court Lord Walker dismissed the appeal of the Futter trustees and Mrs Pitt under the rule. As the Court of Appeal had done, the Supreme Court held that where trustees act on erroneous tax advice, they do not personally commit any breach of duty, so the exercise of their powers cannot be impugned. Thus, it is now clear that the court will only intervene to set aside a trustee s exercise of 2. [2010] EWHC 449 (Ch). As in Pitt, the Court applied the formulation of the rule set out in Sieff 3. [2003] Ch

14 PITT v HMRC AND FUTTER v HMRC JENNIFER SEAMAN AND RICHARD WILSON discretion on the basis of a failure to take into account a relevant consideration (or taking into account an irrelevant consideration), including fiscal considerations if that failure amounts to a breach of duty by the trustee. Ordinarily, a trustee who acts on professional advice does not commit a breach of duty, even where that advice is wrong. 4 However, the Supreme Court allowed Mrs Pitt s appeal on the basis of mistake. It held that the distinction between mistakes as to effects and consequences drawn by Millett J in Gibbon v Mitchell was not an appropriate one and that, looking at the matters as a whole in Mrs Pitt s case, there was a causative mistake of sufficient gravity for it to be unjust or unconscionable to leave the mistake uncorrected. As a consequence, the test for mistake is broader than was previously the case, being satisfied when... there is a mistake either as to the legal character or nature of a transaction, or as to some matter of fact or law which is basic to the transaction. 5 Further, the injustice (or unfairness or unconscionableness) of leaving a mistaken disposition uncorrected must be evaluated objectively, but with an intense focus... on the facts of the particular case. 6 The Court refused the appellants in Futter permission to argue mistake in their appeal, but having done so made certain observations concerning the difficulties that they might have encountered in doing so because their actions had been part of an arrangement to mitigate tax. The Court suggested that in deciding whether to grant the equitable discretionary relief of rescission, it may consider it appropriate to decline relief to parties who had been engaging in tax avoidance. This raises important questions about the ability 4. What is not clear from the judgment is whether there will be circumstances in which the advice given is so obviously wrong that no reasonable trustee could have acted upon it. In such circumstances, we would argue that a trustee who simply acts upon the advice must have committed a breach of duty. However, the refusal of the Supreme Court to adopt such an approach in Futter (where one of the trustees was an experienced private client solicitor) suggests that the cases in which it will be possible to establish this are likely to be extremely few and far between 5. Per Lord Walker at [122] 6. [126] to use the court to remedy mistakes made in the context of tax planning. Mistakes about tax Both the Court of Appeal and the Supreme Court recognised that tax would ordinarily be a relevant factor for trustees to take into account when exercising their powers. 7 Lord Walker said: In the private client world trusts are mostly established by and for wealthy families for whom taxes (whether on capital, capital gains or income) are a constant preoccupation. It might be said, especially by those who still regard family trusts as potentially beneficial to society as a whole, that the greater danger is not of trustees thinking too little about tax, but of tax and tax avoidance driving out consideration of other relevant matters... That is particularly true of offshore trusts... The reality is, of course, that many actions taken by trustees will be driven by a tax-saving motive, with the result that a tax mistake will often be a causative one, as the perceived tax advantage will have been the very reason for the exercise of the power in the first place. The application of either the rule or the doctrine of mistake results in the Court having to make a decision as to whether the equitable remedy of rescission should be granted, and in making that decision the courts will have to assess whether on the facts of any particular case it is unjust or unfair to grant that relief. This has particularly interesting repercussions for mistakes about tax. At one end of the spectrum is the argument (advanced by HMRC) that a mistake which relates exclusively to tax cannot in any circumstances be relieved. The Court rejected this on the grounds that this is much too wide and unsupported by principle or authority. 8 However, Lord Walker went on to say: But it is still necessary to consider whether there are some types of mistake about tax which should not 7. CA at [115]; and SC at [65] and [95] 8. [132] 14

15 PITT v HMRC AND FUTTER v HMRC JENNIFER SEAMAN AND RICHARD WILSON In cases of aggressive tax avoidance, the Court expressed reservations as to whether it should grant equitable relief to a party who has made a mistake attract relief. Tax mitigation or tax avoidance was the motive behind almost all of the Hastings-Bass cases that were concerned with family trusts (as opposed to pensions trusts)... Looking at the mistake as to tax made in Pitt, Lord Walker recognised that Mr Pitt s settlement could have complied with s89 of the Inheritance Tax Act 1984 without artificiality or any abuse of the statutory relief, and it was precisely the sort of trust to which Parliament intended to grant relief by section As a result, the Court was prepared to grant relief in Mrs Pitt s case. At the other end of the spectrum are cases of what might be described as aggressive tax avoidance. In cases of that nature, the Court expressed reservations as to whether it should grant equitable relief to a party who has made a mistake and seeks to have it remedied by the court: In some cases of artificial tax avoidance the court might think it right to refuse relief, either on the ground that such claimants, acting on supposedly expert advice, must be taken to have accepted the risk that the scheme would prove ineffective, or on the ground that discretionary relief should be refused on grounds of public policy. Since the seminal decision of the House of Lords in WT Ramsay Ltd v IRC [1982] AC 300 there has been an increasing strong and general recognition that artificial tax avoidance is a social 9. [134] evil which puts an unfair burden on the shoulders of those who do not adopt such measures. But it is unnecessary to consider that further on these appeals. It is easy to see (and sympathise with) the public policy concern that those who engage in some of the more aggressive schemes should be taken to have assumed the risk of mistakes being made. The case of Abacus Trust Co (Isle of Man) v National Society for the Prevention of Cruelty to Children 10 is a good example of a case where the Court would be likely to refuse to grant discretionary relief. The case involved a flip-flop scheme which required the exercise of a power after a particular date (on the advice of leading counsel). The trustees mistakenly exercised the power too early (i.e. in the wrong tax year), giving rise to undesirable tax consequences. Under the rule as it was believed to apply at the time, the Court held that the exercise was void (and therefore there was no question of it exercising its discretion in respect of relief ) and the trustees were able to escape the consequences of their mistake. However, while under the reformulated tests for the rule and mistake it seems that the trustees would satisfy the substantive tests, 11 the Court can (and, we argue, would) refuse to grant relief on discretionary grounds. 10. [2001] STC The failure to follow leading counsel s advice by exercising the power too early appears to constitute a sufficient breach of duty to engage the rule 15

16 PITT v HMRC AND FUTTER v HMRC JENNIFER SEAMAN AND RICHARD WILSON The more difficult questions arise in the cases that lie somewhere between these two extremes. Futter is perhaps a good example: the trustees were not engaged in any aggressive scheme; they merely acted as they did because there was a perceived opportunity to extract funds from the trusts in a tax-efficient way, more quickly than by making small distributions over a number of years to use the beneficiaries annual exemptions for CGT. Lord Walker s view on the situation was that: Had mistake been raised... there would have been an issue of some importance as to whether the court should assist in extricating claimants from a tax-avoidance scheme which had gone wrong. The scheme adopted by Mr Futter was by no means at the extreme of artificiality but it was hardly an exercise in good citizenship. Given these comments, it is doubtful whether Lord Walker would have set aside the Futter trustees tax mistake if the point had been allowed to be raised in the Supreme Court. Judicial attitudes to tax avoidance The Court s apparent willingness to refuse relief on the grounds of tax avoidance (in, it seems, a very broad sense) appears to represent a distinct move away from the judicial view of tax avoidance which underpinned the majority decision of the House of Lords in IRC v The Duke of Westminster. 12 In IRC v The Duke of Westminster, the Duke of Westminster executed a series of deeds in which he covenanted to pay several individuals, all in his employment at fixed wages or salaries, certain weekly sums for a period of seven years or the joint lives of the parties. After the completion of the deeds the individuals continued in the Duke s employment and continued to receive such sums, as with the sum payable by the deed, made up to the amount of the wages or salary payable before the deed and no more. The IRC said that the payments made under the deed were, in substance, remuneration for services and could not be deducted from the Duke s total income for the purposes of surtax. The Duke said that the payments were annual payments which he was entitled to deduct. The majority of the House of Lords held that the deeds were genuine and bona fide and, on a proper construction of the deeds, the payments were annual payments and were not remuneration for services. In reaching this decision, Lord Tomlin made the now famous comments that: Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax. This so-called doctrine of the substance seems to me to be nothing more than an attempt to make a man pay notwithstanding that he has so ordered his affairs that the amount of tax sought from him is not legally claimable. 13 Lord Russell said at p24:... I confess that I view with disfavour the doctrine that in taxation cases the subject is to be taxed if, in accordance with a Court s view of what it considers the substance of the transaction, the Court thinks that the case falls within the contemplation or spirit of the statute. The subject is not taxable by inference or by analogy, but only by the plain words of a statute applicable to the facts and circumstances of his case Even Lord Atkin (who dissented and held that the substance of the transaction was that the payments were remuneration) recognised that: the subject, whether poor and humble or wealthy and noble, has the legal right so to dispose of his capital and income as to attract upon himself the least amount of tax. The only function of a Court of law is to determine the legal result of his dispositions so far as they affect tax. 12. [1936] AC pp

17 PITT v HMRC AND FUTTER v HMRC JENNIFER SEAMAN AND RICHARD WILSON We submit that if one compares the views of the House of Lords in 1935 in the Duke of Westminster case with the views of the Supreme Court in 2013, a clear change in approach can be seen. Whereas in IRC v Duke of Westminster the House of Lords appears to have found little wrong with a taxpayer using the tax legislation to his advantage, provided he stayed within the rules, the Supreme Court s comments in Futter suggest that when the court is asked to provide assistance when things go wrong in that context, it will be reluctant to do so. Effectively, therefore, a person engaged in tax avoidance is now considered not to have clean hands for the purposes of obtaining equitable relief. Perhaps the difference in views can be explained by the fact that the House of Lords and the Supreme Court were asked to do two different things. In Futter and Pitt the court was being asked to exercise its equitable discretion to do something positive: intervene and set aside a disposition on grounds of mistake. Whereas in the Duke of Westminster, the court was only being asked to construe the words of deeds and a statute to decide whether or not payments were remuneration for services. If the court is being asked to exercise its discretion to do something positive, arguably it is proper for the court to want to assess the justice of the disposition and understand the substance of the transaction first, before deciding whether or not to set it aside on the grounds of mistake. This is in contrast to the court merely being asked to construe a document and statue to decide whether or not a transaction should be taxed, which does not require an active exercise of discretion to intervene and set aside a transaction. Notwithstanding that, it is difficult to ignore the apparent shift in judicial attitude towards tax mitigation or avoidance. Such a change in approach is also evidenced by the long line of cases concerning tax avoidance decided since the Duke of Westminster, including WT Ramsay Ltd v IRC [1982] AC 300; IRC v Challenge Corp [1987] AC 155 and Ensign Tankers (Leasing) Ltd v Stokes It is difficult to ignore the apparent shift in judicial attitude towards tax mitigation or avoidance. The change in approach is evidenced by the long line of cases concerning tax avoidance decided since the Duke of Westminster [1992] 1 AC 655, where courts demonstrated a desire to explore the substance of a transaction to see if it involved artificial (and therefore unacceptable) tax avoidance. However, as recently as 1993, the House of Lords upheld an aggressive tax avoidance scheme. In IRC v Fitzwilliam, 14 counsel was asked by the trustees of the Earl Fitzwilliam s estate to explore ways of reducing the liability to capital transfer tax that might arise on the death of Lady Fitzwilliam and devised a scheme to reduce the tax liability. The Inland Revenue sought to attack it as a pre-ordained, pre-planned tax avoidance scheme under the Ramsay principle but the appeal was dismissed. However, the House of Lords held that the scheme was part of a pre-planned tax avoidance scheme. Lord Templeman, in a typically forthright dissenting judgment, described 14. [1993] 1 WLR