Recently there have been several cases where courts have found in favour of trustees seeking to rectify their mistakes. The courts’ decision that the ‘law of mistake’ applied in some of these cases has meant that several trusts faced a major reduction in the tax liability owed.
Trustees have various “fiduciary duties” to act in accordance with the law, the terms of the trust, and in the best interests of the beneficiaries. They also owe an overriding duty of care to exercise such care and skill as is reasonable in all the circumstances, having particular regard to any special knowledge or experience they have or profess to have. A trustee will meet these duties when managing trust affairs if they act honestly and take any appropriate precautions which a prudent person would take in managing similar affairs of their own.
Breach of duty
Even the most conscientious of trustees can make mistakes, they are only human.
In the event of a breach, they can seek to have transactions set aside. When deciding if a trustee is in breach, the court will apply an objective test: they will ask what a reasonably prudent trustee would have done in the circumstances.
The rule in Hastings Bass
Trustees may well be familiar with the so-called rule in Hastings Bass which was succinctly surmised in Sieff v Fox as:
"Where trustees act under a discretion given to them by the terms of the trust, but the effect of the exercise is different from that which they intended, the court will interfere with their action if it is clear that they would not have acted as they did had they not failed to take into account considerations which they ought to have taken into account, or taken into account considerations which they ought not to have taken into account."
Following this judgement in 1975, this rule was relied on extensively for over 30 years until 2013 when it was closely scrutinised – and criticised – in the cases of Pitt v Holt and Futter v Futter.
Pitt and Futter
In these cases, the Court of Appeal and subsequently the Supreme Court held that the Hastings-Bass rule had been misapplied and that the law had taken ‘a wrong turn’. The Hastings-Bass rule was originally designed to protect beneficiaries against the improper conduct of trustees, but over time had become something of a ‘get out of jail free’ card for trustees.
In the case of Pitt however, the Supreme Court allowed the trust to be relieved from the unforeseen tax liability on the grounds of mistake.
In this case a discretionary trust had been set up for Mr Pitt for the receipt of damages that he was due as a result of a personal injury. It was designed to be tax-efficient, in line with legal advice sought. However, the advice failed to consider inheritance tax consequences, as a result of which the trust incurred a substantial tax liability.
The law of mistake
The Court held that the test for mistake in the context of a voluntary settlement requires a causative mistake of sufficient gravity that it must be unjust to leave the mistake uncorrected. Sufficient gravity requires a mistake as to the legal nature of the transaction or as to a matter of fact/law that is basic to the transaction. The mistake could relate to the transaction’s effect (object) or consequences.
In Pitt, ignorance as to the inheritance tax liability of the trust was sufficiently grave to lead to a mistake being established as there was nothing artificial or abusive in establishing the trust; had the tax consequences to the trust been identified to Mrs Pitt, the trust would have been settled differently.
Cases since Pitt and Futter
Following Pitt and Futter, although the Hastings-Bass rule can no longer be relied on to resolve mistakes made by trustees, trustees have, nonetheless, been successful in pleading mistake:
- Kennedy v Kennedy (2014): the court set aside part of a transaction on the basis of a mistake;
- Freedman v Freedman (2015): the claimant, having settled two properties on trust for herself for life triggering an unexpected inheritance tax charge, was successful in having it set aside on the basis of mistake;
- Der Merwe v Goldman (2016): the claimant’s transfer of property into an interest in possession trust triggered an IHT entry charge which he had not anticipated. He successfully argued mistake to have it rescinded;
- Bainbridge v Bainbridge (2016) the claimants, a father and son farming partnership, transferred land into a discretionary trust, without realising a CGT liability would arise. The transfer was set aside on the ground of mistake.
Cases in 2019
2019 was then rather a bumper year for cases on trustee mistake and the courts appear to be taking a softer approach.
Smith v Stanley
In this case the court intervened to correct the trustees’ mistake. The deceased left his estate in a life interest trust for his wife, with an overriding “power of appointment”. The trustees exercised this power, having been advised that it would be a potentially exempt transfer when in fact it turned out to be a chargeable transfer and so immediately subject to inheritance tax.
ABC v JKL
A deed drafted in 2010 to enable the trustees to extend a beneficiary’s life interest failed to do so and failed to include provisions enabling the trustees to provide for other beneficiaries, causing significant tax liabilities. The court accepted there was a mistake and the deed should be amended to reflect the original intention of the trustees.
Rogge v Rogge
In this case, the trustees were also successful in a claim for mistake.
Here, parents transferred nearly £15M into trust to buy and renovate a property to live in with their son who had extra care needs having suffered a brain injury. A disabled person’s trust was created because this type of trust had favourable tax rules both on entry and during the trust’s lifetime.
However, they had not appreciated the effect of the ‘gift with reservation of benefit’ rules which, to avoid, meant they would need to pay a full market rent (which would be significant in itself). On that rent the trustees would pay 45% income tax. Even if they did this, an inheritance tax liability would arise on their son’s death. Accordingly, they asked for the transfers into the trust to be set aside.
However, they were only successful in part because the transfers continued after they became aware of the mistake. The court decided that those transfers could not be rescinded.
Payne v Tyler
In this case the court set aside a deed of appointment made by the trustees of a discretionary trust of a lady’s late husband’s estate, whose professional advisers failed to appreciate the inheritance tax consequences, as it was completed within two years of the date of her husband’s death.
Price v Saundry
Mistake will not be available in every case. In this case, the claimant's application to amend her claim to include a claim to rectify two trust deeds failed. This was due to the evidence which did not persuade the court that there was a mistake that could be rectified.
Conclusions for practitioners
These case law developments are welcome news for trustees. They demonstrate a willingness by the courts to sanction the undoing of genuine mistakes. The courts are clearly adopting a more generous approach but Price v Saundry serves as a useful reminder that we have to be cautious when arguing mistake. The courts can only help where a mistake is rectifiable.
However, litigation of this nature is not easy, is costly, takes a long time to resolve, and there is no guarantee of success.
It is also interesting to note that HMRC has chosen not to take an active part in these proceedings, which is helpful for trustees but is a trend that probably won’t last. No doubt they are keeping as close an eye on the recent case law as we are. These four successful cases in 2019 alone will have cost HMRC a significant amount of lost revenue. It must be remembered that it was HMRC who fought hard in Pitt and Futter and procured a change, not just in the law but in the approach of the court.
It goes without saying that it would be preferable to avoid a mistake in the first place. It would be unwise to assume that the courts will continue to come to the rescue of trustees indefinitely, particularly if HMRC decides to challenge.
Originally written for Trusts & Estates Law and Tax Journal