The battle of Hastings-Bass

With the new coalition government throwing the spotlight on possible capital gains tax and income tax rate increases, while freezing the current inheritance tax threshold, it is important to seek advice on the interaction of all taxes when setting up trusts for the disabled.

The recent case of Pitt v Holt [2010] EWHC 45 Chancery serves as a reminder to those receiving damages in a personal injury or clinical negligence action to consider not only capital gains tax and income tax but also inheritance tax (IHT) and trust advice when transferring such awards to a settlement.

Under section 89 of the Inheritance Tax Act 1984 (IHTA), there are various kinds of trust provisions for disabled people, including the special IHT, capital gains tax and income tax dispensations.

Transfers into section 89 or 89A disabled trusts are potentially exempt transfers and do not therefore suffer an entry charge unless the transferor dies within seven years of making the transfer. Such a trust would not be subject to the relevant property rules and would therefore escape the ten-yearly and exit charges.

The claimant, Mrs Pitt, was the receiver for her husband who had suffered serious brain injuries as a result of which he was unable to manage his affairs.

Mr Pitt received damages of £1.2m. On the advice of independent financial advisers, the lump sum was put into a discretionary trust.

The class of discretionary beneficiaries included Mr and Mrs Pitt, their children and remoter issue. An application was made to the Court of Protection to authorise the making of the settlement. The Court of Protection granted the order, authorising Mrs Pitt as Mr Pitt's receiver and in his name, to execute a settlement in a form approved by the Court of Protection. The settlement was not a trust for the disabled under section 89 of the Inheritance Tax Act 1984 and as a consequence IHT was due on creation of the settlement and on ten-yearly anniversaries. Neither the Official Solicitor, who represented Mr Pitt before the Court of Protection, nor the financial advisers had considered the impact of IHT on creation of the settlement, although they did address income tax and capital gains tax considerations.

Mrs Pitt argued that the settlement and assignment should be set aside on either or both of two grounds: the Hastings-Bass rule and that it was a mistake.

Hastings-Bass and fiduciary relationship

Robert Engleheart QC, sitting as a deputy judge of the Chancery Division, concluded that the rule in Hastings-Bass did apply and the settlement should be set aside for that reason, although not on the basis of mistake. Under the existing case law, the relevant test is whether if the trustees 'had not misunderstood the effect that their actual exercise of the discretionary power would have, they would have acted differently'.

It was held that in principle there was no material distinction between a trustee exercising a power for the benefit of a beneficiary under a trust instrument and a receiver exercising a power for the benefit of a patient under the Mental Health Act 1983. In each case the power was a fiduciary one and the person exercising the power was doing so in the interests of another but not on their instructions.

Mistake

The court concluded that the settlement could not be set aside on the ground of mistake. First, it held there was no mistake at all '“ Mrs Pitt had not been mistaken as to the IHT implications because she had never thought about it at all. And second, the judge decided that if there was a mistake it was not the sort that would justify the court's intervention.

Engleheart QC relied on the test laid down in Gibbon v Mitchell [1990] 1 WLR 1304, expressing that in his view there was no divergence between what Lindley LJ said in Ogilvy v Littleboy and what Millet J said in the Gibbon case.

Taxing issue

The court also confirmed that a failure to take tax consequences into account would justify the application of the Hastings-Bass rule. The court rejected HMRC's argument that mistakes as to tax consequences should be regarded as irrelevant.

As Engleheart QC noted in the Pitt case, had the settlement fallen within section 89 of the IHTA Act 1984, then the making of the trust would not have triggered an IHT liability. This could have been achieved by including a clause to the effect that at least one half of the trust fund would be applied for Mr Pitt's benefit during his lifetime.

At the time of Mr Pitt's death, only £6,259 remained within the settlement. Had the clients sought proper tax and trust advice, the question of applying the Hastings-Bass rule would not have arisen.