HMRC wins Smallwood trust case in the Court of Appeal

27-Jul-2010

The UK Court of Appeal found, on 8 July 2010, that the UK/Mauritius double tax treaty did not provide protection from a UK capital gains tax (CGT) charge arising on the disposal of shares by an offshore trust which had UK resident trustees for part of the year. The decision was based on the fact that the trust was effectively managed and controlled in the UK.

In Revenue and Customs Commissioners v Smallwood and another, Trevor Smallwood, a UK resident individual, settled shares into a trust. A Mauritian corporate trustee was appointed in December 2000 and the trust sold the shares in January 2001. The Mauritian trustee then resigned in March 2001 and Smallwood and his wife Caroline, who were both UK residents, were appointed as trustees.

HMRC argued that the Smallwood's were liable to UK CGT on the gain under section 86 of the Taxation of Chargeable Gains Act 1992 and issued two closure notices on 31 January 2005 in respect of the taxpayers' tax returns for the year ending 5 April 2001. The Smallwood's appealed, contending that Article 13(4) of the UK/Mauritius treaty prevented the UK from taxing the gain on the shares because it provided that capital gains were only taxable in the contracting state where the person disposing of the asset was resident.

The Special Commissioners decided, on 19 February 2008, that "resident" in Article 4(1) of the treaty meant chargeable to tax. The concession allowing a person to be resident for only part of the year could not be applied when the taxpayer was seeking to avoid a tax liability, so the trustees were therefore resident in both Mauritius and the UK. The residence tie-breaker in Article 4(3) of the treaty was based on the place of effective management (POEM). They found that, although trustee meetings took place in Mauritius, the top level management of the trust was carried out in the UK through its UK tax advisors. The trust was therefore UK resident and Article 13(4) did not provide any protection from UK tax. The Smallwoods appealed.

Upholding their appeal, the High Court held, on 8 April 2009, that a "snapshot" approach should be used when interpreting Article 13(4) of the treaty. On this basis it was only necessary to consider the residence of the trust at the date of the disposal of the shares. Since the trust was clearly resident in Mauritius at the date of disposal, the gain arising on the sale of the shares was only taxable there, and there was no need to consider the treaty tie-breaker test based on the POEM of the trust. HMRC appealed.

The Court of Appeal held that the "snapshot" approach was not the correct way to interpret Article 13(4). The trust was resident in both the UK and Mauritius in the year in question, so it was necessary to look at the residence tie-breaker test in Article 4(3) based on the POEM of the trust. But the three judges failed to agree on how to apply the POEM test.

Patten LJ considered that the POEM test should be based on whether the decision of the Mauritian trustee to implement the tax scheme and sell the shares was taken by the board of directors of the Mauritian trustee company or whether the directors were merely carrying out the instructions of the UK tax advisors. In his view, the function of the board of directors had not been usurped by the UK tax advisors and the Special Commissioners had therefore made an error of law and no UK tax would be payable.

But the remaining two judges, Hughes LJ and Ward LJ, disagreed. They held that the question was not where was the POEM of the individual Mauritian trust company trustee at the time of the disposal but the POEM of the trustees as a continuing body. Based on the facts they concluded that the POEM, and therefore the residence of the trust, was in the UK. Hence the trust was liable to UK tax in respect of the gain on the disposal of the shares.