Not in my backyard

Thanks to all of you who took the time to reply to last week’s note – Pugachev to Assist Tax Authorities.

The most common feedback, which I would like to address in this note, was ‘the Pugachev case will not affect trusts governed by my jurisdiction’. This comment came from readers in Cayman, Jersey, and Guernsey.

These jurisdictions, as well as many more: Bermuda, BVI, Isle of Man and Bahamas, have enacted local legislation which states that any action against the validity of any trust due, for example, to the settlor’s reservation of powers or powers reserved to a Protector in the Trust Deed, will not invalidate the trust. Furthermore, any foreign judgement presented to a court within that jurisdiction will not be recognised.

This has been upheld. In fact, local courts have gone one step further, such as in the Cayman case of RBS Coutts Cayman Ltd v W [2010] which directed the trustees not to comply with such an order.

So the question is, for example, what will a tax authority do, armed with evidence from CRS that a  trust which was set up by a Settlor resident in its jurisdiction do when it has information that the trust

·      has a Protector,

·      owns family businesses and or private shares in one or more joint venture businesses, and

·      is governed by a jurisdiction which has ‘firewall legislation’

We know from the tax manuals written to tax inspectors that the first step for them is to approach the trustee for a copy of the trust deed on suspicion of tax evasion.

On receipt of the trust deed it will look to see if, in accordance with the Pugachev case, the trustee has any autonomous power. If consent is needed for the exercise of most of its powers it needs the tax authority could that the Protector’s powers are personal and not fiduciary.

On this basis, it could issue a claim against the Settlor direct, for tax on all the trust’s assets as if the trust were a bare trust.  This approach does not need to take the case to the jurisdiction in which the trust is resident or governed, thereby neatly by-passing any firewall legislation.

This is what is commonly done by a disgruntled spouse faced with a family trust in a jurisdiction which has ‘firewall legislation’.

In order to succeed the court in the jurisdiction in which the claim is brought will look at the terms of the Trust Deed, what powers were reserved and to whom. It will then look at the Letter of Wishes to see whether this sets out the purpose of the trust, and most critically it will look at the correspondence between the Settlor and the Trustee, in particular immediately before the trustees make a distribution or invest or dispose of trust assets.  – Is the Settlor using the trust fund as his/her own piggy bank?

Given that the many professional trustees owning, in whole or in part, family businesses or other private shareholdings, frequently rely on the experience and knowledge of the Settlor in making its decision as to which investments to keep and which to sell, this guidance could give the tax authority the evidence it needs to tax the underlying assets. The  order sought would be to tax the Settlor as if the trust assets were held by him/her personally on the basis that the trust was a bare trust and the trust assets were held to the order of the Settlor.

This has been a well-worn path trodden by many spouses seeking to claim against trust assets. If a spouse is then unable to pay without access to the trust fund, he or she is left to ask the trustee for a distribution. If the trustee refuses, then the Settlor could face bankruptcy or a custodial sentence for contempt of court.

It is what many call rough justice.

In my personal experience, most Settlors who find themselves in such a situation demand that the trustees make a distribution. If they do so, then that is proof that the trustees simply do what they are told, if however, they do not – could they be accused for not acting in the best interests of the beneficiaries by allowing him/her to go to prison for want of a distribution.

The fact that the trust may have a clause in the deed such that such an action will make the Settlor an excluded person may have some influence on the court but depending on the wording, that it is likely to be at the discretion of the trustees, will be unlikely to affect the decision of the court.

We live in an age where tax authorities now have the information they need to attack and they will use any and all the existing case law to – make the best possible case to secure their goal; to tax the underlying trust assets.

Trustees may wish to ignore how and when tax authorities will use the information they are about to or already have in their possession, but to do so when there are robust and safe alternatives is do so at the risk of alienating their best clients and business.

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