Trustees’ mistake and tax consequences – is there a remedy?
Trustees’ mistake – Kennedy v Kennedy  EWHC 4129
This case is the first to consider whether a mistake by trustees can be corrected following the Supreme Court decision in Pitt v Holt and Re Futter  WTLR 377. Before that case the equitable doctrine of mistake was restricted to putting right mistakes as to the effect of a transaction rather than mistakes as to the consequences of an action; which largely prevented mistakes resulting in more tax being payable to be outside the scope. Perhaps as a result the rule in Hastings-Bass, a case originally heard in 1975, developed particularly during the first decade of the 21st century, in such a way as to provide trustees with the ability to ask a court to correct their mistakes, including ones where the fiscal outcome was unwelcome.
Lord Walker in Pitt took the opportunity to re-think the rule in Hastings-Bass by limiting it to the relief of the outcome of a trustee’s breach of fiduciary duty in circumstances where the trustee acted outside his powers. It no longer affords relief where the trustee sought and acted upon proper professional advice which later proves to be wrong.
However, the Supreme Court did also remove the difficult distinction in the doctrine of mistake between the ‘effect’ and ‘consequence’ of an action saying that
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“the true requirement is simply for there to be a causative mistake of sufficient gravity; and, as additional guidance…. that the test will normally be satisfied only where when there is a mistake either as to the legal character or nature of the transactions, or as to some matter of fact or law that is basic to the transaction.”
This has therefore left open a door for mistakes by trustees which result in unexpected tax consequences to be remedied. Such was this case.
Brian Kennedy created a settlement dated 16 December 2003 under which he was the sole trustee and had a life interest in possession. The settlement contained a power of appointment exercisable in favour of Mr Kennedy, his children and remoter issue; in default of appointment the capital was held on trust for his children.
Mr Kennedy is an entrepreneur who settled shares in four home improvement and property companies into the trust. He also added further acquired shares in another company to the trust later. As a result of various activities with his holdings and with the companies there were ‘banked’ gains for Capital Gains Tax (CGT) in the trust; over £42 million in cash and some unrealised losses for CGT of about £7 million.
The FA 2006 changes to trust taxation posed serious adverse tax consequences for the trust and Mr Kennedy took advice from his accountants and lawyers over what might be done to secure his inheritance for his children and grandchildren. The advice was to create a Transitional Serial Interest (TSI) in the transitional period ending on 5 October 2008 by appointing some of the assets in the settlement on trusts for his children and grandchildren and some absolutely to himself.
Unfortunately, for some of the time following the initial discussions as to what might be done his lawyer was absence from work recovering from a serious operation. During that time the unrealised losses were utilised against other gains.
At the 11th hour, just before the expiry of the transitional period, the law firm produced two documents – a Deed of Appointment of new trustees to appoint Mrs Kennedy and one of the partners in the firm as additional trustees; and a Deed of Appointment of certain assets in the trust to (1) a new fund for the children for life on protective trusts (2) some assets onto discretionary trust for a class of children and remoter issue and (3) an absolute appointment of the remainder to Mr Kennedy absolutely.
The effect of (3) was to generate a significant CGT liability of approximately £650,000.
The three trustees had difference reasons for their mistaken understanding of what happened:
- The lawyer had not appreciated the CGT losses had been used already and so were not available to set against these gains
- Mr Kennedy believed the ‘remainder of the trust fund’ which was appointed to him related only to cash and was not aware that it included some shares still as the assets appointed were not listed
- Mrs Kennedy understood the appointment was to be for the benefit of her children and gave effect to Mr Kennedy’s intention and instructions
The claimants sought:
- To set aside the transfer of the relevant shares to Mr Kennedy; or
- An order setting aside the whole appointment to Mr Kennedy; or
- Rectification of the appointment to Mr Kennedy so that he received only the cash and not the relevant shares
HMRC served a defence which put Mr & Mrs Kennedy to proof of their particulars of claim.
Sir Terence Etherton considered whether or not the claimants were entitled to rescission for their equitable mistake and referred to the judgement of Lord Walker in the Supreme Court in Pitt summarising the points as follows:
- There must be a distinct mistake as opposed to mere ignorance or inadvertence
- A mistake may still be a relevant mistake even if it was due to carelessness unless circumstances show that he or she was deliberately reckless
- The causative mistake must be sufficiently grave as to make it unconscionable to leave it without remedy – which is assessed by a close examination of the facts
- The injustice or unfairness of leaving the mistaken disposition uncorrected must be evaluated objectively but with an intense focus on the facts.
In considering the three heads of claim Sir Terence considered the following:
As to (a), the Appointment effected a disposition of “the remainder of the Trust Fund” and to change this so it does not include the relevant shares would require rectification of the clause and a partial rescission of the disposition of ‘the remainder of the Trust Fund’. To suggest otherwise assumes that mistakes made by the trustees had the consequence of making the transfer of the shares to Mr Kennedy void. In fact, mistake makes the voluntary disposition voidable in equity only not void in law.
As to rescission, although there was case law that partial rescission of a contract is not allowed (De Molestina v Ponton  1 LL Rep 70) Sir Terence could see no reason why this principle, of not being able to change the bargain between the contracting parties, should apply to a self-contained and several part of a non-contractual voluntary transaction.
The Judge therefore concluded that, despite being angry at the absence from the Court of Mr & Mrs Kennedy, there was causative and serious mistake here made by the trustees, albeit that each trustee was operating under a different mistake. It was a fundamental feature of the TSI planning that the appointment should not give rise to a CGT liability. The mistake did not arise as part of some artificial tax avoidance scheme but it was part of executing a plan expressly provided for in the FA 2006.
He dismissed the proposition that the remedy of rectification could apply as this was not supported by the evidence but he favoured a partial rescission of the voluntary arrangement by removing the whole of the self-contained and severable clause which dealt with the remainder of the fund being appointed in favour of Mr Kennedy.
- Always try to minimise the risk of such mistakes by ensuring that all trustees understand the effect of a document that is prepared before it is concluded. It is acknowledged that this is difficult when up against a deadline but it is particularly relevant when a main person has been absent from the discussions at a critical time as here.
- Whilst we have lost the protection for trustees afforded by the earlier decisions using the Hastings-Bass rule we have gained a generous re-definition of the law of mistake which this case has applied constructively to a situation where each trustee was labouring under a different but equally compelling and serious mistake.
- However, it may not produce the ideal result that we seek, for example no doubt on the facts of this case the claimants would have preferred to have rectified the document to enable the cash appointed to Mr Kennedy to remain with him rather than have to return it to the settlement. Instead they had to accept partial rescission of the appointment to Mr Kennedy of the relevant shares which caused the CGT liability. At least it absolved them of that tax cost but it has meant that the original trust still will contain all the funds returned by Mr Kennedy which will have to be administered or appointed in the future.
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