FORM OR SUBSTANCE?
INVALIDITY OF TRUSTS (AND TRANSFERS ONTO TRUST)
Once a trust is completely constituted, the settlor is said to be no more than a matter of
historical record and will have no control over its administration, which will be in the hands of
the trustees. In the nineteenth century and before this did not matter, as the settlor would
chose a trustee who he knew and trusted and leave him to get on with it. These days, for
tax reasons, he will choose an offshore trustee who he does not know, who lives in a remote
and distant jurisdiction. The settlor will likely seek a high degree of control, achieved through
a tacit understanding, reservation of powers, appointing the settlor or his trusted lieutenant
as protector, a letter of wishes, or a combination thereof. Too much of this can be a bad
thing and lead to questions as to the validity of the trust in the first place – on the basis that
the trust itself (or transfers to the trustees) is a sham, there is an absence of certainty of
intention, or the trust is illusory. This paper focusses on sham, although the principles
outlined are probably of some relevance to whether the settlor had the necessary intention.
Illusory trusts are different as they do not depend on the settlor's state of mind; they are
therefore not considered.
The decision of the Royal Court in Jersey in Re Esteem1 held, in accordance with English
principles2, that for a trust to be a sham both the settlor and the trustee must have had, at
the time the trust was created, a common intention that it be a sham and to mislead third
parties. Deficiencies in the trust administration do not make an otherwise valid trust into a
sham (but are relevant to assess the parties' intentions at the time the trust was created).
Intention for these purposes refers to the parties actual or subjective intention rather than
one presumed or imposed by law upon objective facts. It is generally thought that parties'
motives for entering into the document are irrelevant3. Courts are reluctant to find sham
because it connotes a finding of dishonesty on the part of the trustee (and because the court
places great weight on the existence and provisions of a formal document). In practice the
threshold is high and the anxiety created by the earlier Jersey decision in Rahman4 abated.
There is a sense that form is more important than substance and the reality of the situation
and that those seeking to avoid revenue authorities and former spouses might have taken
advantage – leading to growing public disquiet which inevitably has touched the judiciary, as
1
Grupo Torras SA and another v Sheikh Fahad al Sabah and others 2003 JLR 188
In Snook v West Riding Investments Ltd [1967] 2 QB 786 per Diplock LJ "it means acts done, or documents executed by, the
parties to the ‘sham’ which are intended by them to give to third parties or to the court the appearance of creating between the
parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intended to
create"
3
As Knox J. stated in Chase Manhattan Equities Ltd v Goodman [1991] B.C.L.C. 897 at 921i “impropriety of motive alone will
not provide grounds for treating a transaction as a sham”. See also Megarry J. in Miles v Bull [1969] 1 Q.B. 258 at 264 “a
transaction is no sham merely because it is carried out with a particular purpose or object. If what is done is genuinely done, it
does not remain undone merely because there was an ulterior purpose in doing it.”
4
Abdel Rahman v. Chase Bank (C.I.) Trust Company Limited [1991] JLR 103
2
we saw in Lord Walker's obiter comments in Pitt v Holt that the tax planning undertaken was
"hardly an exercise in good citizenship" and that "in some cases of artificial tax avoidance
the court might think it right to refuse relief, either on the ground that such claimants, acting
on supposedly expert advice, must be taken to have accepted the risk that the scheme
would prove ineffective, or on the ground that discretionary relief should be refused on
grounds of public policy"5.
Has the time come for another case, like Esteem, that gives the courts an opportunity to
revisit the test for sham – allowing the courts to remove the dishonesty stricture – or switch
the focus away from the trustee and solely onto the intention of the settlor? It emerges from
a recent symposium involving some of the leading scholars, practitioners and judges that the
dishonesty stricture is relatively recent – and that sham used to have a much wider
application6 and was allied to the civil concept of fraus legis (fraud or abuse on the law) –
possibly providing a basis for a judicial rethink. Some of the cases cited in this paper were
considered at this symposium; they all suggest a move away from the sanctity of legal
arrangements towards the substance of the arrangement – a trend that seems likely to
continue at least in the tax and family sphere.
Australia: Raftland Pty Ltd v Federal Commissioner of Taxation7
Australian courts frequently cite the decision of Diplock LJ in Snook with approval, and thus
adhere to the narrow approach to sham. If the Hon Justice Michael Kirby AC CMG is
anything to go by, judicial attitudes are changing. His paper titled "Of 'Sham' and others
lessons for Australian Revenue law" published in the Melbourne University Law Review
criticises the general reluctance of Australian courts to embrace a wider approach to sham.
His Honour suggests that the decision of the Federal Court in Raftland Pty v Federal
Commission of Taxation provides a slight ray of hope.
The facts in Raftland were complex. Briefly, at the risk of oversimplification, the Raftland
Trust was established by Brian, Martin and Stephan Heran who owned or controlled a
property development company. One of its beneficiaries, the E&M Unit Trust, was connected
with Mr and Mrs Thomasz who had no connection with the Herans, other than the fact that
the E&M Unit Trust had deductible carried forward losses of approximately $4 million which
could be used by the Herans to offset profits from their property business. The taxable
profits of the Heran group companies were distributed to Raftland Pty Ltd (the trustee of the
Raftland Trust and connected with the Heran family) on 30 June 1995. The same day,
Raftland Pty Ltd passed two resolutions. The first resolution distributed $250,000 paid by
cheque to representatives of the Thomasz family. The second resolution distributed the
balance of the income for 1995 to the E&M Unit Trust, where was set off against carry
forward tax losses, apparently reducing the taxable income to nil. Apart from the cheque for
$250,000, the balance was never paid to the E&M Unit Trust. Instead, Raftland Pty Ltd
5
[2013] UKSC 26 at 135
Mike Macnair: "Sham: Early Uses and Related and Unrelated Doctrines" published in "Sham Transactions" edited by Simpson
and Stewart and published by OUP.
7
(2008) 238 CLR 516.
6
applied the balance to subscribe for shares in a new company in the Heran group. Neither
the trustee of the E&M Unit Trust nor the Thomasz ever called for the balance of the funds.
A similar procedure of resolving to distribute profits to the E&M Unit Trust was followed in
subsequent years. Significantly, once the losses had been exhausted, no further resolutions
were made by the Raftland Trust, even though the E&M Unit Trust remained a beneficiary.
To protect the Herans' interests in the property, Raftland Pty Ltd became Trustee of the E&M
Unit Trust, but the Thomasz remained beneficiaries of the E&M Unit Trust. The ATO
suggested these resolutions were a sham to get out of paying tax. It was contended by
Raftland Pty Ltd, the shammer, that the resolutions were valid. It relied on the fact that this
was necessary to achieve the desired tax outcome, and the change of control of E&M Unit
Trust would not have been necessary if the resolutions from the Raftland Trust had not been
effective according to its terms.
The trial judge, however, found the resolutions to have been a sham. The High Court upheld
the judge's decision. It said:
"The Heran brothers, and Mr and Mrs Thomasz, were business people, not lawyers.
It is unlikely that they applied their minds with care to the detail of the documents that
were prepared by Mr Tobin. That does not mean, however, that their intentions were
irrelevant. It may mean, as a matter of factual inference, that they had no intentions
inconsistent with the documents prepared by Mr Tobin and that, therefore, there is no
reason to take those documents other than at face value. It may mean (as the Full
Court, in substance, found) that they intended to do whatever was regarded by Mr
Tobin as necessary to secure the fiscal objective of the exercise. On the other hand,
the respondent argued, and Kiefel J held, that the Heran brothers and Mr and Mrs
Thomasz had a common intention that was inconsistent with the creation and the
enforcement of the entitlement of the E&M Unit Trust as a beneficiary of the Raftland
Trust. It is, therefore, necessary to examine the findings of fact made by Kiefel J.
Central to her Honour's reasoning was the $250,000 paid to the Thomasz interests
as the “price” for the E&M Unit Trust. It was, her Honour held, the intention of the
Herans, and Mr and Mrs Thomasz, that the Thomasz interests were to receive that
amount and no more. Following such receipt, they were to make no further claim on
the Raftland Trust.8"
Their Honours went on to conclude that there was an inconsistency between what would
ordinarily be expected – that the default beneficiary of the Raftland Trust (i.e. the E&M Unit
Trust) would benefit – and "the fiscal and the financial objectives of the transaction”9. It
concluded that the evidence as a whole justified the finding of the primary judge that the
intention of the relevant people had been that only $250,000 was ever to be received by the
beneficiaries of the E&M Unit Trust at the time the distribution was made.
8
9
Ibid, 536. [Emphasis added]
Ibid, 538 [58].
The outcome in Raftland was not based upon a rejection of the evidence that those making
the appointments intended them to be legally effective to achieve its objectives, nor the
rejection of the evidence that they thought that the resolutions had been legally effective,
but, rather, that that evidence of the actual intention needed to be determined in light of all of
the other evidence about intention, including the objective consequences of what the
resolutions would ordinarily have achieved and a comparison of that with what the resolution
in question did achieve. A comparison between that which might ordinarily be expected by
the resolutions with what was in fact achieved may, broadly speaking, be what lead to the
finding that the intention of the parties had been to create a sham.
US: Gregory v Helvering10: The economic substance doctrine
The US has a long-established doctrine of "economic substance", which finds expression in
the well-known case of Gregory v Helvering.
Evelyn Gregory was the owner of all the shares of a company called United Mortgage
Company (“United”), which in turn held 1,000 shares of a company called Monitor Securities
Corporation (“Monitor”). On 18 September 1928 Gregory created the Averill Corporation
("Averill") and three days later United transferred the 1000 shares in Monitor to Averill. On
24 September 1928 she dissolved Averill and distributed the 1000 shares in Monitor to
herself. No other business was transacted, or intended to be transacted, by Averill. On the
same day Gregory sold the shares for $133,333.33. She claimed there was a cost of
$57,325.45 and that she should be taxed on a capital net gain on $76,007.88. The issue in
the case was whether what had taken place amounted to a “reorganisation” within the
meaning of a taxing provision. The Commissioner of Internal Revenue argued that the
attempted reorganisation was without substance and must be disregarded.
The Supreme Court agreed with the Commissioner, placing emphasis on the absence of a
business or corporate purpose to the transaction (rather than the motive for the transaction),
which might otherwise have appeared to come within the letter of the statute:
"Putting aside, then, the question of motive in respect of taxation altogether, and fixing
the character of the proceeding by what actually occurred, what do we find? Simply an
operation having no business or corporate purpose – a mere device which put on the
form of a corporate reorganisation as a disguise for concealing its real character … the
transaction upon its face lies outside the plain intent of the statute. To hold otherwise
would be to exalt artifice above reality and to deprive the statutory provision in
question of all serious purpose." 11
The economic substance doctrine was codified by the Health Care and Education and
Reconciliation Act 2010 as section 7701(o)(1). This provides that, in the case of any
transaction to which the economic substance doctrine is relevant, the transaction shall be
treated as having economic substance only if: (i) the transaction changes in a meaningful
10
11
293 U.S. 465 (1935)
293 US 465, 468-470 (1935).
way (apart from Federal income tax effects) the taxpayer's economic position; and (ii) the
taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into
the transaction. Importantly, "economic substance doctrine" is defined as the common law
doctrine, and the applicable guidance confirms that the determination of whether the
economic substance doctrine is relevant shall be made in the same way as if section 7701
had never been enacted.
The US also has a concept of sham, which sits alongside the economic substance doctrine
and often seems to be applied concurrently – lack of economic substance may be an
indicator that the relevant transaction is a sham12. The test is both less clearly defined and
more wide ranging than the Snook test – and extends to abusive behaviour of taxpayers –
which includes their use of offshore trusts (under their control) to conceal income from the
Internal Revenue Service.13
Switzerland: the Credit Suisse case
Credit Suisse AG entered into a plea bargain with US prosecutors, paying a fine reportedly
of £2.6 billion and entering into an agreed Statement of Facts filed in criminal proceedings in
the United States District Court14. The Statement of Facts acknowledged the involvement of
Credit Suisse AG in setting up and running sham trusts – which appeared to be under the
control of Fides, but in reality were controlled by the US tax payer, the only purpose of the
structure being to evade US income tax. This case should be viewed in the context of the
US's wider concept of sham, described earlier. It is worth quoting extracts from the
Statement of Facts:
"The Parties stipulate that the allegation in Count One of the Information and the
following facts are true and correct, and that had the matter gone to trial the United
States would have proven them beyond reasonable doubt:
4.
12
U.S. citizens, resident aliens, and legal permanent residents have an
obligation to report all income earned from foreign bank accounts on their tax
returns and to pay the taxes due on that income. For the tax year 1976
forward, U.S. citizens, resident aliens, and legal permanent residents had an
obligation to report to the Internal Revenue Service ("IRS") on the Schedule B
of a U.S. individual Income Tax Return, Form 1040, whether that individual
had a financial interest in, or a signatory authority over, a financial account in
See Frank Lyon Co v United States 435 US 561 (1978); Rice's Toyota World, Inc v Commissioner 752 F.2d 89, 91 (4 th Cir.
1985) ("To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purposes other
than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no
reasonable possibility of a profit exists." ); ACM Pship v Commissioner 157 F.3d 231, 247 (3d Cir. 1998) (In determining
whether a transaction is a sham for tax purposes "these distinct aspects of the economic sham inquiry do not constitute
discrete prongs of a "rigid two-step analysis", but rather represent related factors both of which inform the analysis of whether
the transaction had sufficient substance, apart from its tax consequences, to be respected for tax purposes"); and Melnik v
C.I.R., 91 T.C.M. (CCH) 741 (T.C.2006)
13
See US v Vallone, No. 04CR372, 2008 WL 4877008 (N.D. Ill. Aug. 11, 2008); Zmuda v. C.I.R., 731 F.2d 1417 (9th Cir. 1984);
Bodor v. C.I.R., 66 T.C.M. (CCH) 928 (T.C. 1993); and United States v. Gaskill, 232 F.3d 897 (9th Cir. 2000)
14
United States v. Credit Suisse AG, (2013) US District Court, Eastern District of Virginia, Alexandria Division, Criminal No
1:14-CR-188, Document 14 (filed 19 May 2014)
a foreign country in a particular year by checking "Yes" or No" in the
appropriate box and identifying the country where the account was
maintained…
6.
An "undeclared account" was a financial account owned by an individual
subject to US tax and maintained in a foreign country that had not been
reported by the individual account owner to the US government on an income
tax return and an FBAR…
OVERVIEW OF THE ILLEGAL U.S. CROSS-BORDER BUSINESS
9.
For decades prior to and through in or about 2009, … Credit Suisse operated
an illegal cross-border banking business that knowingly and wilfully aided and
assisted thousands of U.S. clients in opening and maintaining undeclared
accounts and concealing their offshore assets and income from the IRS.
Credit Suisse, through certain of its managers, employees, and others,
solicited US clients to open undeclared accounts because Swiss bank
secrecy would permit them to conceal the U.S. clients' ownership of accounts
at Credit Suisse. Credit Suisse used a variety of means to assist US clients in
concealing their Credit Suisse undeclared accounts, including by:


assisting clients in using sham entities as nominee beneficial owners of
the undeclared accounts;
soliciting IRS forms that falsely stated under penalties of perjury that the
sham entities beneficially owned the assets in the accounts; …
THE USE OF SHAM ENTITIES
21.
From in or about 1910 to at least in or about 1997, Credit Suisse operated a
wholly owned subsidiary that, among other things, formed, managed and
maintained structures for clients with accounts at Credit Suisse or Clariden
Leu. This subsidiary was variously known as Credit Suisse Fides Trusts,
Fides Holdings, Fides Trust AG, Fides Trust SA, Fides Trust Limited and/or
Credit Suisse Fides (collectively "Fides").
22.
Credit Suisse aided and assisted U.S. clients with undeclared accounts at
Credit Suisse to evade their income taxes by placing their assets into
accounts held in the names of structures formed, maintained, and managed
by Fides. The structures included but were not limited to foundations, trusts
and offshore companies. By the operation of Swiss bank secrecy laws, the
U.S. client's ownership would not be disclosed to U.S. authorities. Because
Credit Suisse owned and controlled Fides, a U.S. client with an undeclared
account at Credit Suisse knew that he or she would retain ultimate control
over the assets in the undeclared account…
26.
… Credit Suisse sought to create the appearance that the structures were
legitimate entities operating independently of both Credit Suisse as well as
the US person who owned the assets in the undeclared account…
27.
… the U.S. person who beneficially owned the assets in the undeclared
account continued to exercise direct control over the assets in the undeclared
account by communicating directly with the manager of the undeclared
account. Further, managers at Credit Suisse represented to individuals with
undeclared accounts that Dörig Partner15 would not take any action as to the
undeclared account without the permission of the Credit Suisse manager…
CREDIT SUISSE SUBVERTED THE QI AGREEMENT
32.
… certain managers suggested that U.S. clients with undeclared accounts
transfer their assets to newly created accounts held in the name of sham
offshore entities. In connection with these newly created accounts, Credit
Suisse managers knowingly accepted and included in Credit Suisse account
records IRS forms W-8BEN (or Credit Suisse's substitute forms) provided by
the directors of the offshore companies which represented under penalty of
perjury that such companies were the beneficial owners, for U.S. federal
income tax purposes, of the assets in the Credit Suisse accounts in certain
cases, the IRS forms W-8BEN (or Credit Suisse's substitute forms) were false
or misleading in that the U.S. taxpayer who owned the offshore company
actually directed and controlled the management and disposition of the assets
in the company accounts and/or otherwise functioned as the beneficial owner
of such assets in disregard of the formalities of the purported corporate
ownership."
Since then, investigations have been launched into HSBC and Coutts.
Switzerland: the Rybolovlev case
On 13 May 2014 Mr. Dmitry Rybolovlev, a Russian billionaire and owner of the French
Football club AS Monaco, was ordered by the Geneva divorce court to hand over half of his
fortune to his ex-wife Elena, a sum that the Geneva judge ruled to be precisely CHF
4'020'555'987, approx. $4.5 billion. The significance for the purpose of this paper was that
the Swiss court included the wealth held in offshore trusts. In common with other civilian
jurisdictions the Swiss civil code provides for community property. At the risk of
oversimplification, the effect of this is that property acquired after the marriage falls within the
community. The community ends on divorce and what's in the common patrimony is then
divided equally. During the marriage the husband had acquired shares in commodity
businesses in Russia, which he settled onto trust in 2005, long before the divorce. An antiavoidance provision applies to transfers to third parties within five years16. The divorce was
15
16
A company established by a former employee of Fides
Art 208 of Civil Code
in 2008 – and therefore the husband accepted that this provision applied to the transfers
onto trust made in 2005. He said that these assets should be valued as at the date of the
transfer (2005) as is normal. The wife complained that the assets had grown in value very
significantly. The 2005 value was CHF 1,912,700,000.00 and the value at 31 December
2009 was CHF 12,202,000,000.00. She said that the court had discretion under the Code to
use either the 2005 values or the current values, and that to use the 2005 values would be
an abuse of law and contrary to the overriding requirement in the Swiss Civil Code of good
faith. She said this because the husband would benefit from this capital gain since 2005 –
as he was interested in the trusts as a beneficiary (and had received very substantial
distributions). He had control over the trusts by virtue of his position as protector (which
gave him power to hire and fire trustees) and his position as director in underlying
companies held through the trusts (there was an anti-Bartlett type provision which meant
that the trustees weren't expected to interfere in the business of the companies but to leave
Mr Rybolovlev as director to act as he thought best). The Swiss court agreed with the wife
and said that the values should be based on the date of division, not the 2005 values.
England and Wales: R v Allen17
In the case of R v Allen, the House of Lords upheld a seven year prison sentence on Mr
Allen for cheating the public revenue of income tax and corporation tax by concealing or
failing to disclose profits made by offshore companies which were in practice managed and
controlled by him in the United Kingdom.
It was the prosecution's case that Allen's income and assets were held by offshore
companies, which were used to buy and sell the properties in which he lived and to pay for
his personal expenditure, including holidays, school fees and ordinary household expenses.
They alleged that Allen managed and controlled the companies in the United Kingdom and
that he was therefore a shadow director of the companies. HMRC's enquiries had uncovered
a wide range of evidence to support this claim, for example: Allen held blank cheques on
various offshore companies signed by the authorised signatories; Allen used credit cards on
the offshore companies for obvious personal uses; and correspondence indicated that a
Jersey accountant, Mr Dimsey, was being instructed by Allen as to how he should deal with
various property investments owned by the offshore companies.
One part of Mr Allen's defence was that the share capital of the various offshore companies
had been properly omitted from his schedule of assets, as these shares were held by two
discretionary trusts – the Rock Settlement and the Burberry Settlement. The only
beneficiaries of these trusts were Oxfam and the Red Cross. There was a power to add
beneficiaries, but this had not been exercised. The first instance judge's direction to the jury
on this issue included the following passage:
"... if you were to conclude ... that in practice Mr. Allen used any moneys or assets
belonging to any of the various companies as if they were his own then ... that would
17
[2001] UKHL 45
be an indication that the various trusts do not set out the true position. An owner of
things is the person generally who has the say so about what happens to them. You
are entitled to say whether you keep your motor car or you sell it for instance. Take
one absolutely particular example and if you concluded that Mr. Allen actually did
whatever he liked with any of the assets or moneys of any of these companies that
would be powerful evidence that these documents, lengthy as they are, are ... simply
pieces of paper."
Whilst other aspects of the judge's summing-up were criticised, the Court of Appeal treated
this part with approval – "The plain fact is that if the jury found that Allen was the beneficial
owner of the assets in question, they must inevitably have convicted him … And there was,
in fact, overwhelming evidence that the assets were Allen's to dispose of as he would, that
he treated them as such, and that there was no question of the trustees possessing any real
power or discretion in the matter."18
England and Wales: Petrodel Resources v Prest19
HMRC's hostility to form over substance can be seen from its concerted attack on the rule in
Hastings-Bass, leading to the Supreme Court's decision in Pitt where mention has already
been made of Lord Walker's suggestion than equity's help might be withheld from tax
planning which is not an exercise of good citizenship on grounds of "public policy".
A further instance of this changing attitude is provided by the Supreme Court's decision in
Petrodel Resources v Prest, which arose from enforcement of an award of £17 millon in
favour of the wife. The husband claimed poverty. The wife contended that real estate in
London owned by companies in fact belonged to the husband on the basis of his ownership
or control. She asked the court to order that the properties be transferred to her in
satisfaction of the award. Lord Sumption delivered the leading judgment. He declined to
pierce the corporate veil, because of the Salomon v Salomon principle of separate corporate
personality. Veil piercing, he held, is confined to abuse of that corporate personality. The
trial judge had found that the companies had been formed for tax and estate planning
reasons – rather than abusively.
In order to reconcile the apparently conflicting cases in this area, Lord Sumption
distinguished between the ‘concealment principle’ and the ‘evasion principle’.
The
concealment principle was described in the following terms: “the interposition of a company
or perhaps several companies so as to conceal the identity of the real actors will not deter
the courts from identifying them, assuming that their identity is legally relevant. In these
cases the court is not disregarding the “facade”, but only looking behind it to discover the
facts which the corporate structure is concealing.” The evasion principle applies where a
company is deliberately interposed in order to defeat or evade an existing legal obligation or
liability would otherwise be enforceable against the controller of the company. In these
18
19
[2000] Q.B. 744 page 774
[2013] UKSC 34
limited circumstances in which the evasion principle applies, the court may pierce the
corporate veil in order to deprive a person of the advantage sought to be obtained by the
company’s separate legal personality. The practical effect of the concealment principle is
exactly the same as the evasion principle though the narrow approach in the evasion
principle appears to be contrary to the thesis in this paper. However, importantly, Lord
Sumption found, by drawing inferences not drawn by the trial judge, based on the failure to
disclose the source of funds for the initial purchases, that the properties in question were in
fact held on resulting trust for the husband, and on this basis required the companies to
transfer them to the wife – and in this way substance triumphed over form.
Conclusion
Public attitudes towards offshore trusts are certainly hardening. The stage is set for validity
challenges to be brought. It remains to be seen whether the test for sham will be revised,
though the indications are that judicial attitudes are also hardening against form and in
favour of substance. Trustees should be vigilant, exercise control over trust assets, maintain
proper records of decisions, and be careful with underlying companies that are part of the
trust structure, ensuring that they are controlled by the trustee and that their central
management and control is in fact carried on offshore.