Tax: Operative mistakes and unintended consequences 

Lawrence Hiller-Wood, a solicitor in our Will, Trust & Estate Disputes team and Richard Dew, barrister at Ten Old Square discuss the High Court’s current approach to setting aside mistakes in an article for Trusts and Estates Law & Tax Journal.

The recent High Court decision in Hopes v Burton is a helpful reminder of the circumstances in which the Court have been willing to exercise their discretion to set aside voluntary dispositions under the Supreme Court authority of Pitt v Holt. The case also demonstrates the tax pitfalls which private client practitioners should be aware of when entering into and, in particular when altering, trust instruments.

Background

The Deceased created the Skandia Life Policy Trust on 29 July 1992 (“the Policy”). A declaration of trust was executed in the company’s standard form which provided for the Policy proceeds to be held in four equal shares for each of the Deceased’s two children, a former partner of the Deceased and the former partner’s daughter ( “the Immediate Beneficiaries”).

The interests of the Immediate Beneficiaries were subject to the Trustees’ power to appoint, at their absolute discretion, both trust capital and income, for the benefit of a separate class of “Possible Beneficiaries”. The Possible Beneficiaries were a wide and varied class of individuals, charities and unborns (largely those who inherit under the Deceased’s Will). The Immediate Beneficiaries were automatically included within the class of Possible Beneficiaries, however the Trustees had a specific power to exclude members of the class.

In the circumstances, the existence of the Policy was not discovered until late 2012 (8 years after the Deceased’s death) when the Trustees were contacted by the Policy provider. The Policy fund was valued at roughly £2.15 million and the Trustees sought legal advice on the exercise of their powers given the 20 years which had passed since the creation of the Policy and the impact this might have on the relevant administrative considerations.

In May 2013, the Trustees resolved to exclude the Deceased’s former partner from benefitting from the fund. A Deed of Appointment was drafted, appointing the former partner’s interest onto a discretionary fund and excluding her from the underlying class of Possible Beneficiaries.

It was anticipated that the 2013 Deed would have the tax consequence of creating an immediate charge to IHT by terminating one qualifying interest in possession, however it was intended that the Policy would remain unaffected in every other sense, particularly as regards the interests of the other life tenants.

Unfortunately, the wording of the 2013 Deed did not achieve what the Trustees intended for the following reasons:

Issues with the 2013 Deed

•    The Deed was back-dated with the intention of removing the former partner’s vested interest in income arising from the trust. This was contrary to the express provisions of the trust which precluded the Trustees from exercising their powers so as to affect existing beneficial entitlements

•    Rather than terminating only the former partner’s interest in possession, the 2013 Deed contained different trusts on which the remaining life interests were to be held. This had the effect of revoking all the qualifying interests in possession and replacing them with non-qualifying interests in possession, incurring an immediate charge to IHT upon entry, and 10 year anniversary and exit charges under the Relevant Property Regime

•    The 2013 Deed had the unintended consequence of removing the Trustees’ power to appoint capital to the Possible Beneficiaries, creating a far narrower class of “Discretionary Beneficiaries” whose entitlement to receive capital would appear to be contingent upon their prior death. In other words, the life tenant could not receive any capital from their fund during their lifetime

•    The 2013 Deed was revocable, so did not effectively achieve the ultimate objective of excluding the former partner’s interests, but created a Gift with Reservation of Benefit for each of the 4 Immediate Beneficiaries

On 22 July 2014 the Trustees executed a further deed of appointment, in purported exercise of the powers conferred by the 2013 Deed, with the intention of reducing the interest belonging to the former partner’s daughter by appointing £100,000 of her fund onto a further discretionary fund for the Deceased’s children and grandchildren.

The 2014 Deed similarly suffered from drafting issues with unintended consequences, including:

•    The 2014 Deed was similarly backdated in contravention of the trust powers explicitly precluding this

•    As the 2014 Deed was revocable, it did not effectively exclude the daughter of the former partner from the appointed fund, but suffered from the same issues with the Gift with Reservation provisions.

Given the value of the fund was in excess of £2 million, the tax payable as a consequence of the 2013 and 2014 Deeds included an immediate charge of £365,000 plus interest of over £68,000. The loss of the trust’s qualifying status in the pre-2006 interest in possession regime would also have seen the trust incur uncertain future charges under the Relevant Property Regime.

As a result, the Trustees brought a Part 8 application for the 2013 and 2014 Deeds to be set aside on the grounds of mistake.

Rescission due to Mistake

The relevant ingredients for an application to set aside a voluntary disposition can be found in the Supreme Court decision of Pitt v Holt (summarised in Kennedy v Kennedy) as follows:

“(1) There must be a distinct mistake as distinguished from mere ignorance or inadvertence or what unjust enrichment scholars call a ‘misprediction’ relating to some possible future event. On the other hand, forgetfulness, inadvertence or ignorance can lead to a false belief or assumption which the court will recognise as a legally relevant mistake. Accordingly, although mere ignorance, even if causative, is insufficient to found the cause of action, the court, in carrying out its task of finding the facts, should not shrink from drawing the inference of conscious belief or tacit assumption when there is evidence to support such an inference.

(2) A mistake may still be a relevant mistake even if it was due to carelessness on the part of the person making the voluntary disposition, unless the circumstances are such as to show that he or she deliberately ran the risk, or must be taken to have run the risk, of being wrong.

(3) The causative mistake must be sufficiently grave as to make it unconscionable on the part of the donee to retain the property. That test will normally be satisfied only 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. The gravity of the mistake must be assessed by a close examination of the facts, including the circumstances of the mistake and its consequences for the person who made the vitiated disposition.

(4) 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. The court must consider in the round the existence of a distinct mistake, its degree of centrality to the transaction in question and the seriousness of its consequences, and make an evaluative judgment whether it would be unconscionable, or unjust, to leave the mistake uncorrected.”

In the immediate case, the Trustees were not aware (nor were they advised) of the substantive effect of the appointments they were making. The correspondence passing between the Trustees and their advisors made it clear that the Trustees considered themselves to be exercising their powers to exclude the former partner only and did not wish to alter the remaining interests or powers. The Trustees continued to make capital appointments to the Immediate Beneficiaries, including the purchase of a house and covering other expenses, under the standard form trust powers.

Additionally, the Trustees were not advised of the tax consequences of the 2013 Deed. IHT had only been declared and paid on behalf of the former partner’s appointed share as opposed to the whole fund, and the question of reservation of benefit was not considered at all.

The consequences of the qualifying interests in possession being revoked and settled on Relevant Property trusts, together with the removal of capital entitlement during the lifetime of the remaining Immediate Beneficiaries, led the Court to conclude that the interests were radically different after the execution of the 2013 Deed, that this was not intended where the Trustees believed themselves to be entering into a “vanilla” transaction, and that the mistaken belief of the Trustees as to the effect and tax consequences of the 2013 Deed was sufficiently serious so as to make it unconscionable not to set aside both appointments (the 2014 Deed being predicated on the validity of the 2013 Deed).

Mistake as to tax

Arguments were raised on behalf of the minor defendants that the 2013 Deed did not in fact revoke the qualifying interests as, at all material times, the relevant beneficiaries retained a 25% interest in the trust fund. This argument was rejected by the Court, which held that the Trustees, in exercise of the power of appointment given to them, had terminated the existing interests and created new ones, even where re-appointed on effectively the same terms. The Court was guided by recent authorities in reaching this conclusion:

RBC Trustees (CI) Ltd v Stubbs

This case concerned a family settlement which was amended in 2004 to create (qualifying) successive life interests to each of the Settlor’s children, and then on to their surviving spouses. Following the breakdown of the respective children’s marriages in 2008 and 2014, however, it was decided that the successive interests should be revoked. The drafting solicitors used the pre-2006 Deed as a precedent and failed to remove previously innocuous wording which terminated the existing interests before re-appointing them without the successive interests. The second child suffered the same fate in 2014 when the 2008 Deed was again used as a template, carrying the same catastrophic consequences of engaging the Relevant Property Regime.

Ware v Ware

The Deceased died in 2003, leaving his residuary estate to his wife absolutely. By deed of variation in 2005, two distinct trusts were set up such that the son of the family received a life interest in a property and residue. In 2013, the trusts were amended to insert additional beneficiaries, however this had the unintended effect of terminating the existing interests in possession, appointing new ones within the Relevant Property Regime.

Mistake as to risk of tax

The Court went on to say that, even if the potential adverse tax consequences had not in fact arisen, there was at least a risk that they would do, with a complex and potentially litigious dispute with HMRC. The mistaken belief as to that risk would be sufficiently serious to justify set aside in the circumstances.

Conclusion

While it may seem obvious, the key lessons for practitioners arising from the immediate case are that:

•    Care should always be taken when dealing with or amending pre-2006 interests in possession to ensure that there are no unintended or costly consequences. It is very easy to draft in such a way as to inadvertently terminate or alter existing qualifying interests in possession

•    Tax is always a relevant consideration, no matter how small or common the transaction

•    Drafting from precedents (even those within the same trust) should be avoided wherever possible

•    Trustees should document their intentions and objectives when exercising their trust powers.

When mistakes are made, the case shows that the Court is willing to set aside (and in other circumstances, rectify) to correct mistakes. It is now relatively standard to treat the inadvertent termination of a qualifying interest in possession as a mistake justifying the setting aside of an appointment, provided the tax consequences are sufficiently serious.

Cases Cited

Hopes v Burton [2022] EWHC 2770 (Ch) (9 November 2022)
Pitt v Holt [2013] UKSC 26
Ware v Ware [2021] EWHC 694 (Ch)
RBC Trustees (CI) Ltd v Stubbs [2017] EWHC 180 (Ch) 

Written by Lawrence Hiller-Wood, Solicitor, Contentious Trusts and Probate, Thomson Snell & Passmore LLP & Richard Dew, Barrister, 10 Old Square. Both acted for the successful Claimants in the immediate case.