The Wolff at the door

A RECENT ITEM in the Readers' Forum ('Pre-owned assets and CGT', query T16,528, Taxation , 16 December 2004, p303) referred to the decision of Mr Justice Mann in the case of Wolff and another v Wolff and others [2004] STC 1633 . That case considered the circumstances in which a tax-avoidance scheme could be set aside so that the unintended consequences of entering into the scheme could be avoided. The querist had wondered whether the decision could be used to allow taxpayers to escape the imminent charge under FA 2004, Schedule 15 (the pre-owned assets legislation).

This article considers the scope of the rule in Wolff and how it and other cases might be used to allow taxpayers to avoid unwanted tax liabilities.

The facts of Wolff v Wolff

The facts of Wolff v Wolff provide a salutary warning to any practitioner whose client comes along wanting to enter into a tax-avoidance scheme in order to 'keep up with the Joneses'.

Mr Wolff had a friend who had entered into a reversionary lease scheme in order to avoid inheritance tax. The reversionary lease scheme was a variant of the scheme entered into by the late Lady Ingram (see The Executors of Lady Ingram v Inland Revenue Commissioners [2001] AC 293).

In that case, Lady Ingram had given her children the freehold reversion of her home after having carved out a 20-year lease for herself. Under the reversionary lease variant, the donor would retain the freehold of the home, but instead grant a long lease to his or her children which would take effect at some future date (typically twenty years later). The idea of both schemes was to ensure that the bulk of the value of the home fell outside the donor's estate, whilst allowing the donor, at least initially, the continued right of occupation.

Mr Wolff seemed to be sufficiently impressed with this plan. So his friend put him in touch with her solicitor who, in 1997, effected a similar scheme for Mr and Mrs Wolff, then in their early 60s. Under the scheme, the reversionary lease was granted to the Wolffs' two daughters.

Four years later, Mr and Mrs Wolff were discussing the proposed revision of their wills with a different solicitor instructed for this purpose. It was at this stage that Mr and Mrs Wolff first realised (or were first made aware of) the consequences of their actions in 1997. They learnt that, if they (or either of them) lived beyond 3 June 2017, they would no longer be entitled (as of right) to live in their home from that date. Furthermore, any actual occupation after that date would have to be subject to the payment of a market rent.

Not wishing to be at the mercy of their daughters, nor expecting to be able to afford to pay a market rent at that stage of their retirement, Mr and Mrs Wolff therefore sought to have the lease set aside.

The relevant law

Counsel for Mr and Mrs Wolff suggested that there were two lines of cases that might be appropriate in such circumstances — one dealing with situations where a transaction had been entered into under a mistake, the other where there had been insufficient explanation to, or a lack of understanding by, the person entering into the transaction. In the event, the judge suggested that he was not convinced about the continued existence of the second line of cases and thought that these cases, where appropriate, could be accommodated within the first.

This first line of cases was considered by Mr Justice Millett (as he then was) in the case of Gibbon v Mitchell [1990] 1 WLR 1304. That case considered the situations in which transactions could be set aside. The judge held at page 1309:

'[The earlier] cases show that, wherever there is a voluntary transaction by which one party intends to confer a bounty on another, the deed will be set aside if the court is satisfied that the disponor did not intend the transaction to have the effect which it did.

'It will be set aside for mistake whether the mistake is a mistake of law or of fact, so long as the mistake is as to the effect of the transaction itself and not merely as to its consequences or the advantages to be gained by entering into it.l [Spacing and emphasis added.]

In the case of the Wolffs, Mr Justice Mann stated that he had originally thought that the Wolffs' mistake fell on the wrong side of the boundary. His initial view was that ending up with the risk of being made homeless in 2017 constituted a consequence of entering into the scheme rather than the effect of the scheme. However, counsel had persuaded him that the intended gift was to confer the continued right of occupation of the property and therefore that the Wolffs' misunderstanding of the true legal position represented a mistake as to the effect of the transaction.

Effects or consequences

In any event, in AMP (UK) plc v Barker [2001] WTLR 1237, Mr Justice Lawrence Collins played down the importance of the distinction between 'effects' and 'consequences'. He suggested that the dichotomy came from a text-book dating from the 1920s and was 'simply a formula designed to ensure that the policy involved in equitable relief is effectuated to keep it within reasonable bounds and to ensure that it is not used simply when parties are mistaken about the commercial effects of their transactions or have second thoughts about them'. Mr Justice Lawrence Collins held at paragraph 70 of his judgment that:

'relief may be available if there is a mistake as to law or the legal consequences of an agreement or settlement'.

This clarification of the boundary gave Mr Justice Mann additional reassurance that the Wolffs' mistake fell on the right side of the boundary.

Tax effects or consequences

It would appear from Mr Justice Mann's judgment, however, that tax charges arising from a transaction would fall on the wrong side. In the Wolffs' case, arising before the spectre of the pre-owned assets charge, the inheritance tax charge was purely hypothetical. It would have been a problem only if the Wolffs survived the 20-year period and continued to occupy their home rent-free.

In the situation referred to in the Readers' Forum query, it was the imminent and very real charge under FA 2004, Sch 15 that caused the concern. Both published responses suggested that such a charge represented a 'consequence' rather than the 'effect' of the transaction and, correctly in my opinion, advised the querist that the law as it currently stands does not permit transactions to be set aside for that reason alone.

Obviously, there is always the possibility that the High Court might in future extend the scope of the rule so as to allow transactions to be set aside in cases where a transaction is caught by a tax charge that is not announced until some later date, albeit with retrospective effect. However, such an extension of the rules is by no means certain and, to be frank, is not very likely. And, in any event, the court would have to be sure that to make such a ruling in a particular case would not prejudice the other parties to the transaction. It would also be open for the Inland Revenue to contest any such application.

There will alternatively be cases where a tax charge arises as a direct consequence of entering into a transaction. Such a charge could have been foreseen when the transaction was entered into. For example, this could be a capital gains tax liability as a result of a disposal or a charge under Schedule 15 in respect of a transaction entered into after 9 December 2003 (i.e. once the pre-owned asset rules were announced). However, once again, it is my view that such a tax charge would represent a consequence of the transaction rather than its effect. As a result, subject to any change in the law, one could not rely upon the Gibbon v Mitchell and Wolff cases to enable tax charges to be avoided where the only mistake made concerns the tax charge itself.

The last resort

In summary, the Wolff case is a reminder that, in certain cases, transactions can be set aside when they have been entered into under a mistake. However, an unexpected tax liability will not generally constitute a mistake for these purposes.

This would seem to accord with normal principles that one has to live with the consequences of one's actions. For example, many tax advisers will not have the opportunity to review their clients' capital disposals until after the end of the tax year in question. By that stage, it is too late to tell the client that a disposal should have been:

• brought forward to the previous year so as to take advantage of the previous year's annual exemption (or to avoid losses being wasted); or

• deferred for similar reasons or to allow an extra tranche of taper relief to be claimed.

(This ignores the fact that hindsight can also tell the adviser and the client how a better price might have been obtained on the disposal!)

However, this does not mean that an unexpected tax bill is inevitable when a mistake is made. This is because there is a separate line of cases which indicate that, in certain circumstances, the courts will intervene.

This line of cases uses what is known as the ' Hastings-Bass principle' following the case of Re Hastings-Bass (deceased), Hastings and others v Commissioners of Inland Revenue [1974] 2 ALL ER 193. The principle was discussed in Malcolm Gunn's article ' Turning The Clock Back ' ( Taxation , 28 March 2002, p634) and might be available as an option of last resort. In short, it applies in cases where trustees have used discretionary powers, but make an error when doing so. The scope of the principle was expressed by Lord Justice Buckley in Mettoy Pension Trustees v Evans [1990] WLR 1587 to be as follows.

'Where a trustee acts under a discretion given to him by the terms of the trust, the court will interfere with his action if it is clear that he would not have acted as he did had he not failed to take into account considerations which he ought to have taken into account.'

A beneficiary's tax bill following a transaction has been held to be such a consideration ( Green v Cobham [2002] STC 820 ). In other words, if a trustee's negligence (or oversight) lands a beneficiary with an unnecessary tax bill, then the courts will often intervene.

Another example of the application of this principle in a tax context is the case of Abacus Trust Co (Isle of Man) Limited v National Society for the Prevention of Cruelty to Children [2001] STC 1344 . That case concerned an attempt to use a scheme (now blocked by legislation) known as the 'flip-flop' scheme. The scheme (recently held by the House of Lords to have been ineffective in any event) required transactions to be staggered so that they were carried out in different tax years. Unfortunately, the trustees carried out both transactions in the 1997-98 tax year — the second transaction being carried out on 3 April 1998 (three days too early). This would have led to what was assumed to have been a wholly avoidable capital gains tax liability arising on the settlor of the trust involved. Having reviewed the authorities applying the Hastings-Bass principle, Mr Justice Patten held:

'The financial consequences for the beneficiaries of any intended exercise of a fiduciary power cannot be assessed without reference to their fiscal implications. The two seem to me inseparable. Therefore if the effect of an intended appointment is likely to be to expose the fund or its beneficiaries to a significant charge to tax that is something which the trustees have an obligation to consider when deciding whether it is proper to proceed with the appointment.'

Having concluded that the trustees ought to have considered the tax consequences on the settlor, and that, had the trustees done so, the trustees would not have made the appointment they did on 3 April 1998, then the judge held that the appointment was void. As a result, the tax charge was circumvented.

Further developments

Malcolm Gunn's article referred to one aspect of the Hastings-Bass principle that was at the time undecided. This is whether it is necessary for the trustees to show that they would have acted differently had they taken into account the relevant considerations, or whether it is sufficient for them to show that they might have acted differently. To date, this debate has not been resolved.

Abacus v Barr

However, since Malcolm's article, there has been one significant development relating to the Hastings-Bass principle: this is the course taken by Mr Justice Lightman in Abacus Trust Co (Isle of Man) v Barr [2003] Ch 409. That case concerned an instruction by the settlor of a trust to the trustees to appoint 40% of the trust fund to discretionary trusts for the benefit of the settlor's sons with the settlor retaining the remaining 60%. However, the trustees misunderstood the instruction and appointed 60% to the sons' trusts.

The settlor first decided to do nothing about the error. Two years later, having had the benefit of legal advice, he came to the same conclusion. However, a further seven and a half years later he reconsidered the matter and decided that he would seek to have the appointments set aside.

Mr Justice Lightman referred to a lecture that was given by Sir Robert Walker (now Lord Walker of Gestingthorpe) reported in Private Client Business at [2002] PCB 226. He distinguished cases where trustees made no decision at all and cases where a decision was made, albeit one which was flawed and open to challenge. Having reviewed the authorities, Mr Justice Lightman held that the trustees' error in the case before him fell in the latter category and was therefore voidable. (He did not proceed to determine whether the appointment made by the trustees in that case should actually be avoided as he had not heard any argument on the matter. Whilst he invited the parties to present such arguments at a future hearing, the judgment made it clear that such a course of action was not necessary and that the parties could resolve the issue between themselves. I understand that the parties did indeed resolve the issue several weeks after the judgment.)

Void or voidable

To a non-lawyer, the distinction between these two terms is not immediately obvious. However, a court would ordinarily declare something void if it was not lawfully done in the first place (for example, the trustees did not act within the terms of the trust). Such a declaration would be made without the court considering the wider consequences of such a decision. Such a declaration is retrospective so that any consequences of the voided event (for example any tax charges arising) are similarly deemed not to follow.

If something is merely voidable, however, the courts will not automatically grant the relief sought (i.e. avoiding a transaction), even if the primary conditions are met. This is because avoiding a transaction is an equitable remedy and therefore the courts have the discretion whether or not to grant it. They will then consider factors particular to the case in question — such as fairness to other parties. In the Abacus v Barr case what would have been particularly relevant were the almost ten-year delay in making the application for the relief and the settlor's previous acquiescence to the trustees' mistake.

It has been suggested that the Abacus v Barr decision might now mark the end of the rush of cases seeking to apply the Hastings-Bass principle. In the past, funding an application to the court was a relatively inexpensive way for a trustee to escape a negligence action commenced (or about to be commenced) by a disgruntled beneficiary. Now, there is no guarantee that the remedy sought would be granted. As a result, a trustee might be less willing to admit having been negligent in the first place. I am aware of only one case post Abacus v Barr that has sought to apply the Hastings-Bass principle; that is the recent case of Gallaher Limited v Gallaher Pensions Limited [2005] EWHC 42 (Ch) heard by Mr Justice Etherton in the High Court. The judge, however, was able to determine that case on other grounds and therefore offered no further insights into the status of the rule in Hastings-Bass (see paragraph 171 of the judgment).

Conclusion

The Wolff decision is a useful reminder that some transactions can be undone, but only in limited circumstances. And the rule cannot be used simply to enable parties to avoid the tax consequences of the original transaction.

Where trustees wrongly exercise their discretion, the Hastings-Bass principle should not be overlooked, although its future value is currently in doubt.

Keith Gordon is a barrister, chartered accountant and tax adviser.

Issue: 3998 / Categories: Comment & Analysis