Trusts Law Update - March 2011

"Can we have our tax back?"
"No" says English Court of Appeal

The English Court of Appeal (CA) issued a land-mark decision on 9 March 2011 in two conjoined cases which will now severely restrict the ability of trustees or settlors of trusts to undo actions that have triggered unintended tax consequences. The impact of the CA's decision in these two cases, which are known as Futter v Futter and Pitt v Holt (2011), is discussed below.

Prior to the CA's decision on 9 March 2011, trustees and settlors had been able to use a number of legal avenues to set aside tax charges that had been incurred inadvertently. The doctrines used were, first, "the rule in Hastings-Bass" and secondly, the doctrine of mistake or recission. Although emanating from the English Court, the doctrines have been applied frequently in recent years by the courts in Jersey, Guernsey and the Cayman Islands. Once a trustee's or settlor's action had been set aside, the unintended tax consequences that flowed from the action could then be undone. In a number of cases in England in the last few years alone, trustees, settlors and beneficiaries had used the doctrines mentioned above to recover tax of several million pounds and much greater liabilities have been avoided in the offshore jurisdictions. The CA has now severely limited the basis upon which such actions can be undone to specific and not particularly common situations.

What was the CA's decision?

In the case, the trustees of an offshore trust sought advice from London lawyers on mitigating some tax charges as a result of the Finance Act 2008 changes. The advice led to some unexpected tax charges. The trustees successfully applied for an order to set aside their actions under "the rule in Hastings-Bass". The UK tax authority (HMRC) appealed. The CA agreed with HMRC's appeal and held that "the rule in Hastings-Bass" had no legal basis and was an example of the law taking a wrong turn.

Now, according to the CA ruling, it will only be possible to set aside a trust error and recover the tax where:

• There is a technical mistake with the exercise of the trustee's power, such that they have purported to do something that they were simply not permitted to do; for example, they have used the wrong document to evidence the exercise of their power; or
• There is a breach of trust on the part of the trustee, and a beneficiary brings legal proceedings to establish that the action was a breach of trust and asks for the trustee's action to be declared void on this basis. The CA recognised that in many cases beneficiaries may have difficulty establishing a breach of trust because there may be a robust trustee exoneration provision. Where a trustee has simply, but reasonably, relied on the professional advice they have received, the trustee may not be liable for a breach of trust and the beneficiaries will now have no ability to set aside the trustee's action and reclaim the tax. The trustee may be able to sue its professional advisers for loss but that may not be straightforward nor may it secure the same advantages as having the trustee action declared void.

In the case of a mistake made by a donor or settlor who has made a gift, either outright or into a trust, the CA has confirmed that there are now two limbs that need to be satisfied before their action will be set aside:

• First, as was the case prior to the CA's ruling, the settlor must have made a sufficiently serious mistake of fact or law which renders it unjust for their gift to be upheld; and
• Secondly, the important ingredient which has been added to the test is that the settlor's mistake must be as to the 'effect' of what they did and not as to the 'consequences' of doing what they did. The distinction between 'effect' and 'consequence' in this context is difficult, but it is considered that a tax liability arising from the creation of the trust will be a 'consequence' and not an effect. Therefore a settlor who is mistaken as to the tax consequences of making lifetime gifts, or establishing a trust, or adding property to a trust, will not now be able to have their action declared void and the tax repaid.

In Pitt v Holt, the settlor of the trust sought advice from tax advisors before settling the assets. The tax advice overlooked the inheritance tax implications of the trust. Since the mistake concerned the tax consequences (rather than legal effect) of the trust, it could not be set aside.

Why is the ruling important?

The practical impact of the CA decision in Futter and Pitt, for trustees, settlors and beneficiaries, and those advising them, is likely to be:

• An increase in hostile claims having to be brought by trustees against their legal or accountancy advisers, where they have got the advice wrong.
• More "hostile" claims brought by beneficiaries of trusts who will now have to allege a breach of trust in order to render a trustee action void and have the unintended tax consequences unwound.
• More applications to court by trustees for directions as they seek to obtain the court's blessing (and the beneficiaries' views) on a proposed course of action in order to prevent claims being brought in the future.
• Greater scrutiny, and potentially failure, of court applications where settlors seek to undo the creation of a trust because they made some mistake at the time it was set up.

It seems inevitable that the English Court of Appeal's decision will have to be considered and almost certainly adopted in future in the offshore courts. Indeed, HMRC will have the chance to insist that it is followed in a forthcoming case in the Royal Court in Guernsey, where HMRC successfully applied to be joined as a party to the proceedings.

These are taxing times indeed for trustees and settlors, and their advisers, and where unforeseen tax charges have arisen, the focus now will be on finding some breach of trust or technical default in the exercise of a power in order to get the tax back.

Lawyers Steven Kempster