In this, the final of our thought leadership papers for the Bermuda conference, we reflect upon the current political and judicial environment for trusts, and ponder how the future might look for trusts and consider some of the challenges. Will there be a schism between the "onshore" and "offshore" jurisdictions?
Trusts have a long history, reportedly having had their origins in the Crusades when knights required a means of leaving their property in the hands of trusted individuals. Over the years things have moved on and the rationale for trusts has moved through estate planning (and the preservation of landed estates) to the principal modern day drivers: tax, succession planning, privacy and asset protection. However, with a changing political mood, trusts face new challenges. Trusts are often seen as being linked with tax and the public attitude, in Europe at least, has moved against aggressive tax planning. Multinationals have primarily been in the firing line, but so too has the use of trusts for tax planning by individuals. The use of charitable trusts by the failed UK bank, Northern Rock, also made headlines. This has resulted in changes to the regulatory landscape. At the same time, there appear to be changing trends in the case law. It is fair to say that much of the media (and judicial) attention has resulted from those who have misused trust structures; but the consequences might well sound more widely for the industry.
In the UK at least, the media has, over the past few years, taken a much greater interest in trusts and their perceived use as vehicles for tax evasion. This has resulted in, for example, increased scrutiny by HM Revenue and Customs ("HMRC") of offshore structures and HMRC recently announced the creation of a dedicated "Offshore Co-ordination Unit" to counter offshore tax evasion. There have also been significant changes which have reduced the attractiveness of trusts for tax planning.
Apparently as a result of this, the use of trusts by UK taxpayers has fallen: last year it was reported that the number of trusts which were required to declare their income to HMRC had declined by almost one fifth between the 2008/2009 tax year and the 2012/2013 tax year.1 This is likely due not only to the reduced advantages of a trust, but also a concern that having a trust, even if it is for legitimate purposes, might attract increased scrutiny from HMRC.
Whilst tax planning does not necessarily involve trusts, and not all trusts are used for tax planning purposes, there is a clear perception that trusts are used as vehicles for tax avoidance (or, in some cases, evasion). Whilst historically the courts took the view that "every man is entitled if he can to order his affairs so that the tax … is less than it otherwise would be"2, it seems that the tide has turned somewhat and tax avoidance is now the subject of adverse comment.
For example, in the UK Supreme Court in Futter v Futter, Lord Walker described the tax avoidance scheme which Mr Futter had adopted as being "by no means at the extreme end of artificiality … but it was hardly an exercise in good citizenship".3 Lord Walker went on to comment that there is "[a]n increasingly strong recognition that artificial tax avoidance is a social evil which puts an unfair burden on the shoulders of those who do not adopt such measures".4 This was in the context of the court considering whether to grant equitable relief to a trustee and, whilst no principles were established, it is possible that in extreme cases where trustees are seeking to rely upon equitable remedies, the English court might be unwilling to grant such relief on the basis of public policy considerations relating to tax avoidance. This would be a marked development, and would no doubt be the subject of challenge, but would also likely lead to a divergence between practices in England and the offshore world (where the same public policy considerations relating to tax may not be as significant).
Thus, whilst of course, not all trusts are used for tax avoidance, it might be that the tax motivation for the creation of trusts becomes of less significance to certain settlors in the future. Additionally, it might be the case that the use of aggressive tax schemes in relation to trusts has consequences for the trust at a later point if, for example, a trustee needs to seek equitable relief. Of course, the United States has for years "looked through" trusts and sought to tax beneficiaries: that has not resulted in the end of trusts, but it does seem that one of the primary drivers for the creation of trusts might be diminished.
That said, whilst the comments of Lord Walker should not be overlooked, the Supreme Court decision has already been applied to tax mistakes in at least two first instance decisions: Kennedy v Kennedy5 and Freedman v Freedman6, and in both those cases the court was willing to grant the relief to avoid adverse tax consequences (although the court seems to have been satisfied these were not cases of artificial tax avoidance).
The courts and legislatures in offshore jurisdictions have also responded to the Supreme Court. Not only have certain jurisdictions introduced legislation, but in some instances the judiciary have indicated that they will resist aggressive moves by HMRC. See, for example, Sir Philip Bailhache in Re the S Trust7:
"in Jersey it is still open to citizens so to arrange their affairs, so long as the arrangement is transparent and within the law, as to involve the lowest possible payment to the tax authority. We see no vice in this approach. We accordingly see no reason for adopting a judicial policy in this country which favours the position of the tax authority to the prejudice of the individual citizen, and excludes from the ambit of discretionary equitable relief mistakes giving rise to unforeseen fiscal liabilities. We see no fairness in such a policy."
At the same time, the English courts appear to be reacting to what is sometimes seen as the abuse of asset protection trusts. There is nothing improper with asset protection trusts: they simply allocate risk as between parties and in many cases commercial counterparties can protect themselves by undertaking due diligence and taking appropriate security. However, there have been a number of cases in which individuals who have lived a lifestyle consistent with being extremely wealthy, and operated businesses as if they were their own, have, when faced with litigation (and in particular freezing orders) claimed that all their assets are held in discretionary trusts over which they have no control.
This has apparently caused some discomfort amongst the English judiciary, as shown most starkly in the Pugachev litigation in which the Court of Appeal commented that "sophisticated and wily operators should not be able to make themselves immune to the courts' orders".8 This is not to say that the use of trusts for asset protection purposes is wrong: rather it is the use of trusts where the beneficiary or settlor appears to retain control that has caused difficulties and discomfort.
Taking the Pugachev litigation as an example, Mr Pugachev was described in the press as a billionaire and successful businessman. A claimant sued him, and obtained a worldwide freezing order against him pursuant to which he was required to disclose his worldwide assets including “any interest under any trust or similar entity including any interest which may arise by virtue of the exercise of any power of appointment, discretion or otherwise howsoever”.9
This resulted in five New Zealand discretionary trusts being disclosed which Mr Pugachev said he was the protector and a beneficiary of, but that he had received no income from. One of the trusts did, however, own Mr Pugachev's principal residence in London. The claimant therefore applied to extend the worldwide freezing order to the trusts on the basis that there was a ‘good arguable case’ that the assets held by the trusts were in reality the assets of, or under the control of, Mr Pugachev. Whilst the application was initially dismissed, the Court of Appeal extended the freezing order expressly to cover the trusts, even though these were apparently valid trusts and therefore the starting point would be that assets of the trust were not assets of Mr Pugachev.
The Court of Appeal granted the order in part on the basis of the jurisdiction to make an order against a third party who is holding assets on behalf of a defendant where there is a good arguable case that the assets are under the defendant’s control (known as the ‘Chabra’ jurisdiction). In doing so, the Court acknowledged that there was at least a possibility that the claimant would be able to enforce any judgment it might obtain against Mr Pugachev against the trusts.
The Court appeared to be keen to help and to make orders that, on the face of it, ignored the very nature of discretionary trusts. As part of its explanation for its decision, the Court of Appeal referred to a previous judicial comment that “…the court will, on appropriate occasions, take drastic action and will not allow its orders to be evaded by the manipulation of shadowy offshore trusts and companies formed in jurisdictions where secrecy is highly prized and official regulation is at a low level”.10
There have also been developments in other jurisdictions. For example, the New Zealand Supreme Court has very recently released its judgment in Clayton v Clayton11 (notwithstanding that the parties had already settled). In what some commentators have described as a 'landmark' decision, the New Zealand Supreme Court considered a discretionary trust in which very wide powers were granted to Mr Clayton, as settlor, trustee, and a beneficiary, including the power to pay the capital to any beneficiary, to determine the vesting day, and to resettle the trust fund upon the trustees of any other trust which includes at least one of the beneficiaries of the present trust. The Court held that Mr Clayton was not constrained by any fiduciary duty when exercising these powers in his own favour which meant that he effectively had the power to appoint the property of the trust fund to himself (or anyone else of his choosing).
The New Zealand Supreme Court held that the powers vested in Mr Clayton were property rights and could be treated as relationship property for the purposes of a divorce settlement. In doing so the court referred to TMSF v Merrill Lynch Bank and Trust Company12, a Privy Council case which had held that a power of revocation over a trust was property (and therefore permitted the appointment of a receiver over that power). It would presumably follow by analogy that a trust giving equivalent powers to those in Clayton v Clayton would also be capable of having a receiver appointed over those powers. In this respect, therefore, the Court has apparently widened the ability of creditors of a beneficiary/settlor, in certain circumstances, to enforce judgments against assets within a trust fund.
Additionally, in the context of matrimonial disputes, the English Court has been increasingly willing to include trust assets in the definition of "matrimonial assets" and use its powers against parties within the jurisdiction to obtain cooperation from trustees outside the jurisdiction. This demonstrates how the Court can look behind trust structures upon divorce and the Court retains the power, in certain circumstances, to vary a trust made as a nuptial settlement under Section 24(1)(c) of the Matrimonial Causes Act 1973.
Does that now mean, then, that asset protection is gone? Is the balance now in favour of protecting creditors? Almost certainly not: if a trust is properly formed and operated, without the settlor or beneficiaries retaining control, then, absent the usual routes to access trust property (e.g. proprietary claims, insolvency related actions), the trust should be effective and its assets fall outside the estate of a judgment debtor. However, in cases where there are doubts as to the level of control exercised by a beneficiary, the Court might be more willing that it had previously, at least for the purposes of granting freezing relief, to freeze trust assets and, depending upon the terms of the trust deed, there might also be means of enforcing against trust assets.
This raises potential issues for those drafting trust deeds. It also raises issues for beneficiaries and protectors: do they need to be more disciplined in the manner in which a trust is operated? Can they no longer assume that the fact that there is a trust is protection enough?
Another of the perceived benefits of using trusts is privacy. However, this is an area that is also under attack. Against the backdrop of media criticism and political pressure, David Cameron introduced what he has described as "much more transparency" in relation to the beneficial ownership of companies.13 He justified this, in part, on the grounds that "when you have companies whose ownership isn’t known you allow a shroud of secrecy behind which people can do bad things, sometimes terrible things, with no accountability”.
Whilst there is nothing inherently wrong with privacy, it appears that transparency is now in fashion. What does this mean for trusts? In England it means that from 6 April 2016 all private companies and LLPs will need to keep a publicly accessible register14 detailing all persons with "significant control over the company" ("PSCs").
In effect there is an obligation on companies to work up the chain of ownership until an individual or registrable legal entity15 is identified. If a trust is within the chain of ownership, and if the trust holds more than 25% of the share capital of a UK company, controls more than 25% of the vote at general meetings, can control the appointment/removal of board members or exercises significant influence or control over the company, then the trust will be caught by the PSC regulations. In that case the company must then establish all individuals or legal entities that actually exercise or have the right to exercise significant influence or control over the trust itself. Those individuals or legal entities must be entered into the register as a PSC.
The statutory guidance states that any person that has the right to direct the running of the activities of the trust, for example by having an absolute power to appoint or remove trustees, direct the distribution of funds, amend the trust deed or revoke the trust, will have the right to exercise influence or control. It then states that a person who acts as trustee, or who has issued instructions as to the activities of the trust (for example an active beneficiary) will actually exercise influence or control over the trust.
Therefore in most situations a trustee will be a PSC and in many cases a protector, and potentially beneficiaries could be deemed to exercise significant influence or control over the trust and therefore would need to be entered onto the company's register as a PSC.
This legislation does not prevent the use of trusts, but it does potentially remove one of the key benefits of trusts: privacy. No doubt there will be many individuals who having created a trust for reasons of privacy, would not wish themselves or the beneficiaries of that trust to be identified on the register of PSCs. It will remain to be seen how the PSC legislation operates in practice given that (a) many trusts will be offshore and (b) a company does not usually have any means of obtaining information on its ultimate owners. However, the obligation is binding on the company and a failure to take reasonable steps to identify a PSC is a criminal offence on the part of the company and/or its officers. Furthermore, anyone who is aware that they are (or may be) a PSC has an obligation themselves to inform the company of their interest. These rules therefore cannot be ignored.
The use of a wholly offshore structure would avoid this problem. However, the offshore jurisdictions are also coming under some pressure (in particular from London) to introduce similar measures. Furthermore, there may be situations where it is not possible to avoid having an English company in the structure, for example where an operating business is involved. This may not therefore always be practical.
Similarly, if beneficiaries or protectors have no control or influence over the trust, then they are unlikely to be PSCs and the draftsmen of trust deeds will need to consider this when preparing trust deeds. It might be possible to address the transparency issue, but this might not achieve the other objectives of settlors, such as giving a protector wide powers.
CONCLUSION: THE FUTURE
In conclusion, there does appear to be a shift in landscape for trusts with the primary benefits of privacy, asset protection and tax efficiency potentially being curtailed. Does this mean the end of trusts? Almost certainly not: the history of trusts demonstrates that they are inherently flexible and able to adapt to changing situations. It may well be that the future for trusts now primarily lies in one of its original purposes – succession planning. Trusts provide a useful and flexible means for family shareholdings to be kept together and trusts are being used for this purposes in parts of the world that did not historically use trusts (in particular Asia).
It does, however, appear from the points above that the attempts by settlors to seek to retain influence over trusts, or beneficiaries who appear to exercise too much control over trust assets so as to be able to use them as their own, might find their trusts much more susceptible to attack or freezing orders, and may well fall within disclosure obligations such as the UK PSC legislation. This potentially creates an interesting question as to the future consequences of the trend in a number of offshore jurisdictions to introduce reserved powers legislation. Whilst reserved powers legislation might protect trusts from attacks based upon 'sham trusts', there may be significant consequences for the effectiveness of the trust for asset protection, as well as potentially undermining any attempts to make the trust private.
Furthermore, the potentially more hostile environment onshore to trusts, might prompt offshore jurisdictions to take action to preserve their own trust industries. A number of legislatures have moved to plug the hole left by Pitt v Holt/Futter v Futter.16 Moreover, firewall legislation is now in place in many of the major offshore jurisdictions: for example, Gibraltar has recently introduced firewall legislation, which seeks to protect trusts in those jurisdictions (although if the underlying assets are onshore, this might be of limited benefit). It will remain to be seen whether there will be a divergence in jurisprudence in offshore jurisdictions.
Notwithstanding all this, in our view trusts are likely to remain popular. They provide a flexible, and well established, structure for holding assets. They can be easily created, and enable individuals to plan inter-generationally and to provide different, and changeable, interests to different parties. But, it will be important for the industry to recognise these shifts in trends and to ensure that settlors, protectors and beneficiaries are disciplined in the way trusts are operated.