tax substance and tax substance

The Importance of Tax Substance in a Trust

Recently, we wrote about the Hong Kong Board of Review (Tax Tribunal) Case X66, which case showed how important substance is within corporate tax structures. In the UK First-Tier Tribunal (Tax Chamber) Case Richard Lee and Nigel Bunter v HM Revenue & Customs, [2017] UKFTT 279 (TC), tax substance was also the main focus, however this time in relation to a trust tax structure.

Simplified Facts Timeline 

1996 – 1997

Mr. Lee was employed by Ford and undertook a management buy-out whereby he took over Ford’s mobile telephone business. In order to make sure that this business was held tax efficiently, the following structure was set-up. A Guernsey company (“FB LTD”) was put in place by a corporate nominee shareholder that was also based on Guernsey (“STC”).

FB LTD itself held an interest in a UK company (“COL LTD”), which company bought from Ford its mobile telephone business. In addition, a Guernsey trust (“RA Lee 1997 Settlement”) was set-up of which Mr. Lee was the settlor and beneficiary at the same time, the trustee was STC. The beneficial owner of the shares in FB LTD was the RA Lee 1997 Settlement.


As the mobile phone business was rather profitable, a call-option and put-option arrangement was made between STC and Vodafone. Vodafone paid GPB 5 million for the grant of the call-option, i.e. to have the right to purchase the shares in FB LTD, whereas a corresponding put-option (in case the sale to Vodafone would not be successful) allowed the RA Lee 1997 Settlement to sell the shares in FB LTD for GBP 1 (only).


On 28 March 2002, Mr. Lee appointed a new trustee (“DTOS”) for the RA Lee 1997 Settlement, which was based on Mauritius. STC resigned simultaneously. As a result of this new appointed trustee, STC’s rights and obligations under the option agreement with Vodafone were transferred from STC to DTOS by means of a novation agreement.


Vodafone exercised their call-option agreement on 12 March 2003 and a consideration of GPB 55 million was paid. On 20 March 2003, DTOS resigned as trustee and was replaced by another trustee (“Island/Walbrook”) based in the United Kingdom. Residual rights and obligations under the option agreements with Vodafone were subsequently transferred under a novation agreement from DTOS to Island/Walbrook.

Tax Substance in a Trust Case

The main question is now whether the realised gain of GPB 55 million (minus paid consideration) should be subject to any capital gains tax in the UK?

According to the UK domestic capital gains anti-tax abuse legislation, if at any time during the year Mr. Lee as a settlor has an interest in the RA Lee 1997 Settlement (which condition has been met) and Mr. Lee as a settlor is and the trustees (like Island/Walbrook) are, either resident in the UK during any part of the year or ordinarily resident in the UK during the year, any gains realised by these UK resident trustees for the RA Lee 1997 Settlement will be charged at the level of the settlor, being Mr. Lee, instead of at the level of the settlement itself.

However, does the double taxation treaty between Mauritius and the UK (“DTC”) prevent the UK from taxing the realised gains with capital gains tax and consequently, allocate the levy rights of those gains to Mauritius, resulting in no taxation at all?

According to article 13(4) of the DTC, capital gains from the alienation of shares shall only be taxable in the state of which the alienator is a resident. Therefore, the questions raises whether the RA Lee 1996 Settlement is a resident of Mauritius during the time it sells its interest in FB LTD? Residence within the DTC is further defined within article 4 of the DTC, which looks at, amongst others, the place of management and stipulates that if both Mauritius and the UK claim residency over a person other than an individual, one needs to look at its place of effective management.

Mr. Lee’s Defence Arguments

Mr. Lee, first of all, argued that the residence of DTOS was in Mauritius. However, as a result of an earlier Court of Appeal Case, Smallwood v Revenue and Customs Commissioners, [2010] EWCA Cic 778 (“Smallwood”), it was accepted that the residence of a taxpayer such as DTOS and its tax liability that arises from that cannot be determined by reference only to one moment. In other words, one cannot rely on the so-called snapshot argument.

Secondly, Mr. Lee argued that, as a result of the tie-breaker provision in article 4(3) of the DTC, which focuses on the place of effective management when both Mauritius and the UK would claim residence over the RA Lee 1997 Settlement, the settlement was based on Mauritius. Basically, according to Mr. Lee, it could not be said that DTOS simply did what Mr Lee wanted them to do.

The UK Tax Authorities therein after argued, by referring to Smallwood as well, that the scheme utilised in this case had been devised before DTOS was even appointed and that it was appointed simply to carry the scheme into effect.

The Tribunal’s Decision

The UK First-Tier Tribunal discussed the role of the DTOS. Without going into the details here, despite the (written) evidence provided by DTOS, the Tribunal found that the trustee had a limited grasp of the transaction with Vodafone despite having obtained legal advice upfront. Further, it found that, upon the appointment of DTOS, DTOS was aware of the fact that they would need to resign and make place for a UK trustee as soon as the Vodafone transaction took place.

The Tribunal stated that the essential question, as was in Smallwood, is: ‘Where were the most important decisions relating to the governance, or management, of the settlement taken?’ It found that although at formal level, the decisions to execute the relevant documents took place by DTOS in the UK, ‘DTOS knew what was required of it […] there was a clear understanding […] that they would do what was required of them, at a time determined by Mr. Lee […].  The shots were called in the UK.’

Further, the Tribunal found that that the information provided to DTOS by the UK tax advisor and Mr. Lee was ‘not merely advice but crossed the threshold into instruction […].The decisions of real importance concerning the settlement was taken in the UK and merely implemented in Mauritius, and that the place of effective management of the settlement was therefore also in the UK.

The tiebreaker rule therefore allowed the realised gains to be taxed in the UK with capital gains tax.

Tax Substance Takeaway

Whether enough tax substance in a Trust is present will always depend on the relevant facts of the case. Fact is though that a subsidiary (represented by a director) is always somehow influenced by its parent company and a trust (represented by its trustees) might always be somehow influenced by its settlor and/or its beneficiary.

Therefore, it will be important to find the correct threshold or balance between advice & information at one hand and instruction at the other hand in order to be able to establish proper tax substance for a subsidiary and/or a trust as well a corporation.

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