It was a bright and calm day when Mr. Smallwood, a U.K. resident, decided to suggest that a Jersey Trust of which he was the settlor, and in which he maintained an interest, should dispose of certain shares. Mr. Smallwood obtained advice from accountants in Bristol that if the trust sold the shares the gain would be attributed to him because of a provision in the taxing statute that would apply "if the trustees were not resident in the United Kingdom during any part of the year". The Bristol advisors then informed Mr. Smallwood that there was an off-the-peg "Round the World" tax scheme that was intended to eliminate the tax. At this point, the storm clouds began to gather.
The RTW scheme
In implementing the RTW scheme, the Jersey trustee was replaced on December 19, 2000 with a Mauritius trustee, and the Mauritius trustee was in turn replaced by Mr. and Mrs. Smallwood as trustees on March 2, 2001, prior to the April 5 tax year-end of the trust under U.K. tax law. The intention was that when the shares were sold during January of 2001 the trust's capital gain would be protected from U.K. tax by virtue of the provisions of the U.K.-Mauritius Tax Treaty. Further, as Mr. and Mrs. Smallwood, being U.K. residents, would be trustees "for part of the year" the attribution rule quoted in the preceding paragraph would not apply and no tax would be payable on the gain in the U.K.
Issues on appeal
The primary question was whether the Treaty applied to exempt the trust's gain from U.K. tax. The threshold issue was whether the matter of residence fell to be determined at the date of the disposal or more generally within the year of the disposition. Clearly the trust was, at least, resident in the U.K. from March 2 until April 5.
On July 8, 2010, the Court of Appeal held in HMRC v. Smallwood & Anor,  EWCA Civ 778, that the issue of whether the taxpayer should be resident in a particular state at the time of disposal or at some other point in time is an issue for each state to decide as part of its own taxation regime. The Treaty must be assumed to have been drafted in a way that contemplates any tax treatment of capital gains based on residence or similar criteria. "Resident of a contracting state" means chargeable to tax in that state on account of residence and, for this purpose, one has to take into account the tax treatment of the gain under the domestic legislation of both contracting states regardless of the period of residence which gives rise to the liability. The Treaty accommodates legislation under which a gain is made taxable in the U.K. by virtue of residence in a period after the gain has occurred.
Place of effective management / central management and control
The Court concluded that the trust was resident in both Mauritius and the U.K. under each jurisdiction's domestic legislation. The issue then fell to be determined under the tie-breaker rule in the Treaty based on the place of effective management ("POEM"). The judges referred to comments of Chadwick L.J. in Wood v. Holden,  EWCA Civ 26, indicating that it was difficult to draw any distinction between the concepts of POEM and central management and control ("CMC"), the later being the terminology generally used to describe the test in cases dealing with the residence of corporations.
The Court referred to the OECD commentary on Article 4(3) of the Model Convention, which provides that "the POEM is the place where key management and commercial decisions that are necessary for the conduct of the entity's business are in substance made. An entity may have more than one place of management, but it can only have one place of effective management at any one time." What has to be identified is the place where the real top-level management of the trustee occurred rather than day-to-day administration of the trust.
It was found as a fact by the Special Commissioners that the appropriate meetings took place in Mauritius and the necessary resolutions were passed in Mauritius by the Mauritius trustee. The books and records were properly maintained. While there was a "confident expectation" that the Mauritius trustee would choose to sell the shares, there was no agreement that the trustee would behave in a certain way or would make certain decisions. Its duties as a trustee were laid down in the legislation. If it had not been in the interest of the beneficiaries, the trustee would not have sold the shares. For example, if the share price dropped dramatically, and if the fund manager had advised against the sale, then the trustee would have decided not to sell.
However, the facts surrounding the appointment of the Mauritius trustee led the Court to conclude that the real top level management, or the realistic, positive management of the trust, remained in the United Kingdom. The sale of the shares was motivated by U.K. tax planning reasons. The details relating to the actual sales were found to be low level management decisions, as there was no doubt the shares would be sold; the real top level management decisions or the realistic, positive management decisions of the trust, to dispose of all the shares in a tax efficient way, had already been, and continued to be, taken in the United Kingdom. Mr. Smallwood had the power to appoint new trustees.
With reference to Wood and DeBeers Consolidated Mines Ltd. v. Howe,  AC 455, the Court adopted a two-prong test in deciding where POEM or CMC resides. The first question is whether (i) CMC is exercised through the constitutional organs of the vehicle in question, or (ii) the functions of those constitutional organs are usurped, as in Unit Construction v. Bullock,  AC 351. If the functions have not been usurped, the test requires that a second question be asked, namely whether there is an "outsider" that (iii) proposes, advises and influences the decisions which the constitutional organs take in fulfilling their functions, or (iv) dictates the decisions which are to be taken. If either (ii) or (iv) occurs, POEM or CMC will generally reside where the usurper or outsider makes its decisions.
In Smallwood, the POEM test inevitably led to the question of whether the effective decision by the Mauritius trustees to sell the shares was taken by the Board of Directors of the trustee (albeit on the advice of, and at the request of, the U.K. advisors), or whether the Mauritius trustee effectively ceded any discretion in the matter to the U.K. advisors by agreeing to act in accordance with their instructions. With "suitable hesitation" the majority of the Court agreed that the POEM of the Mauritius trustee and of the trust was in the U.K. There was a scheme of management of this trust which went above and beyond the day-to-day management exercised by the trustee for the time being, and the control of it was located in the United Kingdom.
The battle in Smallwood has been close. HMRC won before the Special Commissioners, lost on appeal to the High Court, and won by a 2-to-1 margin in the Court of Appeal with two goals "for" in the 89th minute of play. The only true basis for distinguishing the case from Wood might appear to be a change in judicial tolerance for schemes that have no purpose other than tax avoidance.
Earlier jurisprudence in this area
The facts in Wood were strikingly similar. A scheme was devised and implemented by tax advisors to avoid U.K. tax. As part of this scheme, a special purpose Dutch corporation had a limited role of signing documents to authorize an agreement that appeared to have been reached in the U.K. The primary issue was whether the POEM of the Dutch company was in the Netherlands or the U.K. The Special Commissioners were not satisfied that CMC was not in London, concluding that:
...the only acts of management and control of the Dutch company were the making of the board resolutions and the signing and execution of documents in accordance with those resolutions. We do not consider that the mere physical acts of signing resolutions or documents suffice for actual management. Nor does the mental process which precedes the physical act. What is needed is an effective decision as to whether or not the resolution should be passed and the document signed or executed. Such decisions require some minimal level of information. The decisions must to some extent be informed decisions. Merely going through the motions of passing or making resolutions and signing documents does not suffice. Where the geographical location of the physical acts of signing and executing documents is different from the place where the actual effective decision that the documents be signed and executed is taken, we consider that the latter place is where CMC actually abides.
However, the High Court, with the subsequent approval of the Court of Appeal, overturned the decision of the Special Commissioners on the basis that the holding company did what it needed to do in its jurisdiction of purported residence and there was nothing improper about the U.K. parent ensuring that the board of the Dutch company knew what its parent desired its decisions to be. The fact that special purpose vehicles have little to do does not mean that they are agents or nominees, provided they do the little that is required of them in a proper fashion.
In Laerstate v. HMRC,  UKFTT 209 (TC), the issue
also was whether the POEM of a taxpayer was in the Netherlands or
in the U.K. The Tribunal stated that the "whole picture must
be considered in each case" and the director in the
Netherlands did not possess the minimum information necessary for
anyone to be able to decide whether to follow the instructions of
the guiding hand. Those decisions were taken in the U.K. and the
CMC and the POEM of the taxpayer was therefore in the U.K.
For a Canadian judge who wishes to do so, Smallwood can easily be distinguished on either the facts or the specific U.K. legislation dealing with trusts. However, it might signal, together with Laerstate, a growing lack of judicial tolerance for schemes that appear to be designed for no purpose other than to avoid tax.
In Garron Family Trust v. The Queen, 2009 TCC 450,
Madam Justice Woods found that the residence of a trust depended on
where its CMC was located. It should be noted that
Smallwood decided where the POEM or CMC of a trust was
located, but did not address the particular issue of whether POEM
had to be taken into account in determining where a trust was
resident for the purposes of domestic law. The taxpayer's
appeal in Garron is scheduled to be heard by the Federal
Court of Appeal on September 30, 2010.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.