Timeo Danaos …

ANDREW COCKMAN LLM, FTII, TEP of Deloitte & Touche warns that the Court of Appeal decision in Melville v Commissioners of Inland Revenue may be a Trojan Horse for non-United Kingdom domiciled settlors and their advisers.

THE COURT OF Appeal's decision in Melville v Commissioners of Inland Revenue [2001] STC 1271 is likely to have far-reaching implications for non-United Kingdom domiciled settlors, their trustees and their advisers. Barry McCutcheon touched upon some of these in his article 'The Tip of an Iceberg' (Taxation, 5 October 2000) following the earlier decision of Mr Justice Lightman in the High Court. As it is understood that no further appeal is envisaged, this is a good time to take stock of the Court of Appeal's decision.

Background

Melville was concerned with inheritance tax planning involving assets that did not fall within section 165, Taxation of Chargeable Gains Act 1992 (relief for gifts of business assets). In order to avoid the charge to capital gains tax that would otherwise apply, it was necessary to be able to rely upon the availability of holdover relief under section 260(2)(a), Taxation of Chargeable Gains Act 1992 (gifts on which inheritance tax is chargeable, etc.). Holdover would be applicable under this subsection (inter alia) where there was 'a chargeable transfer within the meaning of the Inheritance Tax Act 1984 … and is not a potentially exempt transfer …'.

The solution hit upon in this instance was for the settlor to retain a power under the terms of the trust deed enabling him to direct the trustees to exercise any one or more of their discretionary powers of appointment. This included being able to direct a transfer of all or part of the trust fund back to the settlor. This right of direction arose after the end of 90 days after the date of the settlement, and amounted to a general power of appointment.

The art is to balance the value of the assets transferred into trust with the value of the right retained, so that the overall value of the transfer is sufficiently small so as to fall within the nil rate band.

The Revenue's approach

The easiest way of countering this arrangement was to tax the transfer of value made on the gift to the trustees, without taking into account the right of direction reserved to the settlor under the terms of the trust. Accordingly, Michael Furness QC for the Crown, had to argue that right of direction was not 'property' and so did not fall within the estate of the settlor. He also raised a number of other arguments, including one on policy grounds, that a contrary argument could result in multiple taxation.

Lord Justice Peter Gibson, giving the judgment of the Court of Appeal, put it this way:

'Mr Furness rightly draws attention to the clear possibility, if the taxpayers are right, of double taxation in the form of two individuals taxed by reference to the value of the same property. Thus he instanced the case of a trust for A for life, with remainder to B but with a general power of appointment in C. On the taxpayer's construction, not only is the settled property treated as belonging to A but also C has an asset of a value equal to the settled property. If C dies, his estate will be liable to pay tax on the value of the general power and if A then dies, tax will be paid on the value of the settled property. … [which conjures] … up the spectre of more than 100 per cent taxation...'

The Court of Appeal judgment

This argument did not find favour with the Court, nor the Crown's attempt to assimilate the general treatment of a holder of a general power of appointment with that of a reversionary interest. It held that a general power of appointment was indeed a separate asset for inheritance tax purposes, and now as a result the prospect of double taxation is real.

Relevance for offshore trusts

It is far more common than might have otherwise been thought to be the case for settlors and beneficiaries of non-United Kingdom resident settlements to retain powers to deal or direct what is to happen with trust property.

The retention of these rights might be occasioned by the settlor's own tax requirements under the law of his nationality or domicile. Alternatively, it might be as the result of the settlor's concern over the width and scope of the powers that his trustees might otherwise possess.

Before identifying those settlors and beneficiaries most at risk, it is worth considering firstly what amounts to a general power of appointment under English law, and what types of powers under an offshore trust might come within this definition. The position will be more difficult to identify in practice, as non-United Kingdom resident trusts are often subject to a foreign law which governs the rights and powers of the parties.

What is a general power?

Under section 5(2), Inheritance Tax Act 1984 a general power is defined in the following terms:

'"general power" means a power or authority enabling the person by whom it is exercisable to appoint or dispose of property as he thinks fit.'

This means that if the holder of the power of appointment can exercise it in favour of a class of persons including himself, or his executors, the power will be a general power of appointment. If he can only exercise it in favour of a class that does not include himself, this is known as a special power of appointment.

This interpretation was supported by Mr Justice Luxmore, when he commented on similar provisions in the Finance Act 1894 in Re Penrose ([1933] ch 793). There he held:

'If under a power the donee can make the whole of the property subject to it his own, he can, by exercising the power in his own favour, place himself in the position to dispose of it as he thinks fit. The power to dispose is a necessary incident of the power to acquire the property in question. In my judgment, the word "power" in the phrase "a power to appoint or dispose of as he thinks fit", is not used in the definition section in the strict legal sense attaching to it when used with reference to a power of appointment, but in the sense of capacity, and I think this is made clear by the use of the words "or dispose of" in addition to the words "to appoint".'

For inheritance tax purposes the holder of a 'general power' is treated as 'beneficially entitled to the property or money' over which the power is exercisable, (section 5(2), Inheritance Tax Act 1984).

This means that the lifetime exercise of such a power may have immediate inheritance tax consequences. But if the holder dies without exercising the power, the value of the property will be included in his estate on death. Whether any tax is payable depends largely on whether the holder is treated as being United Kingdom domiciled for inheritance tax purposes and, if not, on the place where the property is treated as being located.

Section 5(2) only deals with general powers of appointment in respect of 'any property other than settled property'. However, the Court found that this did not preclude such powers being property for the purposes of section 272, Inheritance Tax Act 1984. Here 'property' is held to include 'rights and interests of any description'. So powers of appointment over settled property are assets under general principles where they have the characteristics of a 'general power'.

Given this background, the type of powers that will need to be identified which can be exercised by a beneficiary or a settlor include the following:

• a power of revocation;
• a power of direction;
• a power of appointment.

Where the powers arise under a trust instrument subject to a foreign law, it will be necessary to take legal advice to establish the true characteristics of the power concerned. Thereafter it is a question of United Kingdom law to decide if the power does indeed fall within the definition of a general power and hence is an asset for inheritance tax purposes.

Who is at risk?

The holders of these powers will be generally either beneficiaries or settlors of the trust concerned. If they are non-United Kingdom domiciled for inheritance tax purposes, the place where their power is treated as being located will be central to their liability to inheritance tax. This is unlikely to be a straightforward issue, and may depend upon whether the governing law treats the power as being personal property or a legal right enforceable before the courts of the relevant offshore location. The former would be United Kingdom situs when the holder was present in the United Kingdom, and the latter is thought to be non-United Kingdom situs where it was enforceable outside the United Kingdom.

The problem will become much more pronounced once the holder of the power becomes deemed domiciled for inheritance tax purposes. The property held by the offshore trustees will be excluded property provided the settlor was non-United Kingdom domiciled for inheritance tax purposes at the time the property was settled, and the trustees own only non-United Kingdom sited assets. By way of contrast, the general power held by the deemed domiciled holder would be fully taxable irrespective of where it is treated as being located.

A further category of taxpayer at risk is where the holder of the power under an excluded property trust always has been United Kingdom domiciled. Here he is already affected, without being caught out by effluxion of time under the deemed domiciled rules. The general power will be fully taxable irrespective of where it is treated as being located.

Wider issues

It is very common for trusts established by United States settlors to contain a power of revocation within the grantor trust rules. Such trusts are clearly vulnerable as a result of the Melville decision. However, it does not stop there. There will be a number of other offshore trusts where the settlor or the beneficiary may also be caught. The effect of the Melville decision may be to reduce the attraction of the United Kingdom for a number of its wealthier residents. This is clearly unfortunate, and highly undesirable.

Peter Twiddy, a senior technical adviser at the Capital Taxes Office is inviting representations from interested parties in order to see if further provisions should be introduced to avoid unnecessary double taxation. If this is an area that affects you or your clients, please write to him as soon as possible setting out your views. His address is: Capital Taxes Office, Ferrers House, PO Box 38, Castle Meadow Road, Nottingham NG2 1BB.

• Finally, for those of you who were puzzled by the title of the article, it comes from Timeo Danaos et dona ferentes, which I translate as meaning 'I am frightened of the Greeks, even when they come bearing gifts'.

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