Rectifying trusts – a Scottish perspective

The recent English Court of Appeal decision in the joint cases of Futter v Futter and Pitt v Holt [2011] EWCA Civ 197 (from which an appeal to the Supreme Court is now pending) has refocused attention on how to address the situation where trusts or decisions of trustees do not have the desired consequences, usually in relation to tax.

Previously, the courts had relied on what became known as “the Hastings-Bass rule” (Re Hastings Bass [1975] Ch 25), which offered protection to trustees and beneficiaries (and their advisers) in circumstances where the terms of a trust or an exercise of trustees’ powers had given or might give rise to unexpected tax consequences. In effect, the courts amended or revoked terms of faulty trusts or of the trustees’ exercise of their powers. However, the Court of Appeal in Futter v Futter and Pitt v Holt indicated that the appeals “provide examples of that comparatively rare instance of the law taking a seriously wrong turn, of that wrong turn being not infrequently acted on over a 20 year period, but this court being able to reverse that error and put the law back on the right course”.

Nevertheless, a recent experience of the treatment of such issues in the Scottish courts suggests that the process here can, in some circumstances, be more straightforward. Section 8 of the Law Reform (Miscellaneous Provisions) (Scotland) Act 1985 gives any party to a document the right to apply to the court to order that a document fails to express accurately the intention of the parties at the date when it was made. Such an application can be made in the sheriff court or in the Court of Session, and the court is given a wide discretion to order the document to be rectified in any manner that it wishes, to give effect to that intention.

Normally, s 8 is used to rectify contractual documents which purport – but fail – to record an agreement among the parties. But s 8(1)(b) says that “[where the court is satisfied that] a document intended to create, transfer, vary or renounce a right fails to express accurately the intention of the grantor of the document at the date when it was executed, it may order the document to be rectified in any manner that it may specify in order to give effect to that intention”. Trusts are not specifically mentioned, but the terms of the section are wide enough to apply to trusts and documents implementing decisions of trustees.

Two trusts to cure

We were instructed to rectify two separate trusts established by the same truster (settlor), Mr H, in 1997 and 1998. The later trust was set up to hold a house in which one of Mr H’s daughters lived with her children. The trust was intended to give the daughter a secure home as long as she required it, but subject to that the trust assets were to pass to her children at age 25. The terms of the trust however provided that the trust assets would pass to C, the eldest of the children, when she was 25, in such a way that her mother’s rights would be superseded. C’s younger brother and sister would receive nothing.

Rectification of this trust was purely a matter of adjusting the rights of these family members – there were no tax implications – and while C might well have thought it appropriate to object to the application, she chose not to.

The earlier trust was more complex. Mr H’s intention was to put into the trust, for the benefit of all his grandchildren, a substantial holding of shares in his plant hire company, and to do so in the most tax efficient way. He consulted solicitors who told him that what he wanted was an accumulation and maintenance (A&M) trust. It is unlikely that Mr H had ever heard this term, such trusts not being a topic of everyday conversation among many people outside the trust profession, but he accepted the advice and instructed the solicitors to prepare an A&M trust for him to sign. The solicitors prepared a trust deed which was actually titled “Accumulation and Maintenance Trust”, but the trust did not in fact meet the strict statutory conditions for an A&M trust.

Under the IHT rules which prevailed in 1997, trusts could essentially be of two types: (1) a liferent (interest in possession) trust, where one or more beneficiaries is entitled to the trust income; or (2) a discretionary (or “relevant property”) trust, where no beneficiary has an immediate right to the income: distribution of income and capital is left to the discretion of the trustees. Discretionary trusts are subject to an IHT regime which is generally less favourable than liferent trusts, with charges to IHT potentially arising when the trust is set up, on every 10th anniversary of the trust, and when assets leave the trust. The value of Mr H’s shares was substantial, and IHT would have been payable on each of these occasions.

The Inheritance Tax Act 1984 recognised, however, that a form of discretionary trust would be the most suitable trust to hold assets for children, so it created A&M trusts which would not suffer the same IHT charges as discretionary trusts, provided they satisfied certain conditions. Those conditions are set out in IHTA 1984, s 71, the relevant part of which in 1997 stated that it “applies to settled property if one or more persons (the beneficiaries) will, on or before attaining a specified age not exceeding 25, become beneficially entitled to it or to an interest in possession in it”.

The A&M issue

Many trusts have failed to qualify as A&M trusts because of the word “will” underlined above, and Mr H’s was one of them. The trust contained the following provisions:
(1) the trustees were to transfer each beneficiary’s share of the capital to them when they reached age 30;
(2) the trustees could accumulate income for up to 21 years, with a discretion to pay income for the maintenance of the beneficiaries in the meantime; after the 21 years but not before, the beneficiaries would have interests in possession;
(3) the beneficiaries were defined as all Mr H’s grandchildren, present and future, and gave the trustees power to exclude from benefit any beneficiary who had not yet reached age 30.

Mr H had three grandchildren by 1997 and two more were born subsequently; the eldest at that time (A) was five years old. It was therefore possible that the trustees might decide to exclude all the beneficiaries except the eldest and continue to accumulate the income for the full 21 years, by which time A would be 26. However unlikely this might be, it was a possible outcome of the wording of the trust, so the conditions in s 71 were not satisfied because no beneficiaries would definitely receive an interest in possession by age 25. Thus the trust was not an A&M trust.

This gave rise to two IHT issues:
(1) Mr H’s original transfer of shares to the trust would be a chargeable transfer and IHT would be payable on the value over the then nil rate band;
(2) a 10-year charge to IHT would have arisen in 2007.

Because Mr H’s intention was that the trust should be as efficient as possible in relation to tax (in particular IHT), the document failed to express accurately that intention. While this might have led to a claim for professional negligence against the previous advisers, the decision was taken to attempt to rectify the terms of the trust to ensure that they now accurately reflected Mr H’s intention at the time it was set up. Specifically, we sought to create the interests in possession when each beneficiary reached age 25, not 21 years after the trust was created. We are not aware of any other cases where s 8 of the 1985 Act has been used to rectify the terms of a trust or trustees’ decision.

Procedural hurdles

By the time these issues were identified, Mr H was elderly and in poor health, so detailed affidavits were prepared and signed by him confirming his intentions for the trusts. Applications were made to Glasgow Sheriff Court to rectify both trusts but, shortly after this was done and before the applications could be served on all the beneficiaries and other interested parties, on Christmas Day 2009 Mr H died. We then had to decide in what form any application could proceed and whether the affidavits would be sufficient evidence of Mr H’s intention.

Section 8 of the 1985 Act allows the court to have regard to all relevant evidence, whether this is written or oral. Accordingly, if a proof was required it could include the leading of affidavit evidence. Indeed, when the applications were first put before the sheriff he indicated that, once service had been effected and assuming no objections were lodged, it was likely that he would wish the action to proceed as an undefended proof by way of affidavit.

The applications had to start again, now at the instance of Mr H’s executors on the basis that they were the people who were entitled to deal with Mr H’s estate and as such could seek to give effect to his true intentions.

The applications were intimated to all the beneficiaries of the trusts, to the trustees, and also to HM Revenue & Customs given the impact on the tax liabilities of Mr H and the trustees. The sheriff also ordered that the import of each of the applications be advertised so that any interested party could lodge a notice of intention to defend.

In such circumstances, we had to ensure that all the beneficiaries were apprised of the action, and indeed that they were content that the trust could be rectified as proposed. This was simpler for the A&M trust than for the later trust, as the rectification did not change the beneficiaries’ rights significantly but merely avoided the adverse tax consequences. Under the 1985 Act, the court will only order rectification where it is satisfied that either all people who would be affected by the rectification have consented to it, or that their interests would not be adversely affected to a material extent by rectification. If any of the beneficiaries or HMRC had lodged a notice of intention to defend the application, oral evidence would probably have had to be led that there would be no such material adverse effect. This would have led to uncertainty in relation to whether any changes were indeed material.

However, no notices of intention to defend were lodged for either application, so we could minute for decree. At this stage, the papers were put back before the sheriff and, presumably having satisfied himself that the requirements of the 1985 Act were satisfied, he indicated that he was happy for decree to be granted without the need for evidence to be led by way of affidavit. However, given that there was the possibility of a proof by way of affidavit being required, it was important to ensure both that the affidavits were sufficiently detailed to evidence the truster’s intention, and also that the wording of the applications mirrored the terms of the affidavits.

Further observations

Three curious final points are worth noting:

(1) Although the 1985 Act allows rectification of unilateral documents such as trusts, s 8(6) specifically excludes wills and other testamentary documents. This contrasts with the position in England, where wills can be rectified under the Administration of Justice Act 1982, s 20, but there is no statutory power to rectify trusts and related documents – what remains of the Hastings-Bass rule exists under common law and equity.

(2) Rectification of the trust to a “true” A&M trust could have had a CGT downside, as the transfer of the shares by Mr H to the trust could not then benefit from holdover relief under the Taxation of Chargeable Gains Act 1992, s 260 (gifts); this potential problem was avoided as HMRC accepted that the shares qualified for holdover relief under TCGA 1992, s 165 (business assets), even although the company was in the process of becoming a property investment rather than a plant hire company.

(3) By the time the applications were lodged and the A&M trust was rectified, the Finance Act 2006 had effectively abolished A&M trusts. The A&M trust found itself within the relevant property regime anyway, but the initial IHT charge when Mr H created the trust and the 10-year charge in 2007 were still avoided. 2017 will be a different matter.

These applications point out a useful tool for the Scottish trust practitioner if things go awry when a trust is being set up or when trustees are making important decisions. It is all too easy to be distracted by the extensive coverage of important decisions in England and elsewhere, but the distinct concepts, sources of law and statutory rules north of the border must not be forgotten. In Scotland at least, all may not be lost, but it is important to gather detailed evidence of the original intention and to reflect that carefully in the application to the court. All interested parties must be advised, and the possibility of intervention by HMRC should not be discounted.