The powers that be

  • Author : Emily Yiolitis
  • Date : December 2012
ABOUT THE AUTHOR: Emily Yiolitis TEP is Managing Partner of Harneys, Aristodemou Loizides Yiolitis LLC and Chair of STEP Cyprus

Ask any trustee what the most difficult part of their job is and they will tell you that it is informing a hesitant prospective settlor that to establish a trust, they must relinquish legal ownership and control of hard-earned assets and businesses. For many settlors, settling a trust, which will often comprise valuables earned over generations of labour, in an unknown jurisdiction under the control of trustees they have never met and who have little, if any, business know-how of the industry in which the settlor is engaged, requires an inordinate amount of trust. Settlors essentially want to set up a trust for tax, asset protection, succession or other reasons, but at the same time to continue to manage their assets as they have done for years, unfettered by interfering trustees.

The traditional methods of retaining settlor control include the appointment of a protector and drafting and delivering to the trustees a letter of wishes (which is legally unenforceable). Nowadays, for a settlor to retain effective control, they will usually either set up a private trust company, be appointed to the board of the underlying company of the trust, or specifically reserve powers under the trust deed. This article will focus on the latter method, using settlor-reserved powers, a new feature in the Cyprus trust legislation.

Cyprus International Trust Law

Section 4A of the recently amended Cyprus International Trust Law permits a settlor to reserve powers, to retain a beneficial interest in the trust property and to act as protector or enforcer of the trust. The list of powers that may be reserved is extensive and includes the powers to revoke, vary or amend the terms of a trust; to advance income or capital of the trust property or to give directions for the making of such advancement; to give binding directions as to the appointment or removal of a director of any company wholly or partly owned by the trust; to appoint or remove any trustee, enforcer, protector or beneficiary; and to restrict the exercise of any powers or discretions of a trustee by requiring that they shall be exercisable only with the consent of the settlor.

There is also an explicit provision that where a power listed above has been reserved by or granted to the settlor, a trustee who acts in accordance with the exercise of the power is not acting in breach of trust. Furthermore, the reservation of any powers shall not be construed as an ‘intent to defraud’ the settlor’s creditors, and that intent will therefore have to be independently proven.

Reserved powers in other legislation

Settlor pacifiers in the form of reserved powers are not exclusive to Cyprus and have been around for years, as is evident in the legislation of other trust jurisdictions. The British Virgin Islands enshrine these powers in s86 of the British Virgin Islands Trustee Act. Section 15 of the Trusts (Guernsey) Law 2007 and s47 of the Nevis International Exempt Trust Ordinance make similar provisions. Jersey relies on s9A of the Trusts (Jersey) Law of 1984 as amended in 2006. The Cayman Islands have Part III of the Trusts Law (2001 Revision), which was introduced as early as 1998 by the Trusts (Amendment) (Immediate Effect and Reserved Powers) Law 1998. Sections 3 and 81 (2) of the Bahamas Trustee Act 1998 also provide for the reservation of such powers.

“Settlor power to replace trustees may alone trigger a sham risk”

What is the attraction of settlor-reserved powers that has seen them entrenched in legislation in so many jurisdictions, most recently in Cyprus? They are introduced specifically to address the concerns of settlors, particularly from civil-law jurisdictions, who are accustomed to exerting full control over their assets and for whom the creation of a trust involves a considerable leap of faith. Entrenching these powers in legislation means that a trust cannot, at least in accordance with the laws of the governing jurisdiction enabling these powers, be formally declared a sham. Interestingly, there is international protection, of sorts, too, in Article 2 of the Hague Trusts Convention, which provides that ‘the reservation by the settlor of certain rights and powers is not necessarily inconsistent with the existence of a trust’. However, despite the widespread legislation and the nod to the practice by the Hague Convention, there is little guidance on which ‘certain rights and powers’ it is acceptable for a settlor to reserve and at which point the reservation becomes tantamount to a settlor not relinquishing a proprietary interest to the trustees at all.

The risk of sham

A prerequisite for the creation of a trust is transfer of legal ownership to the trustee. If it can be shown from either the nature or the amount of powers reserved to the settlor that the transfer cannot be said to have occurred because the intention of the parties was for the settlor to remain effective legal owner, to do as they please with the assets, the trust will be held void ab initio as a sham. The problem lies in identifying the point at which the settlor has retained so much control that it can hardly be said that they have relinquished any proprietary interest to the trustees. It is not only the number but also the nature of the powers, cumulatively, that may imply a sham trust. So settlor power to replace trustees may alone trigger a sham risk,1 whereas retaining the power to add to the class of beneficiaries and change the governing law may, together, be permissible.2

The Bermudan case of Re the AQ Revocable Trust demonstrates clearly that while a settlor can validly reserve certain powers, there comes a point where the extent of the powers can subsume the irreducible core needed for the existence of a valid trust. In this case, the settlor, who was also sole trustee, was given a power to remove and appoint trustees and to provide written approval for any transaction that would be ‘a complete release of the trustee (including the settlor) of any liability or responsibility of the trustee to any person in respect of this transaction’. The Court held that the concatenation of powers in the settlor, in conjunction with the fact that he was the sole trustee, rendered the trusts he purported to create illusory during his lifetime.

Court-compelled actions of a power-enabled settlor

A court, particularly an onshore court in a country that has personal jurisdiction over a settlor, may rely on settlor-reserved powers entrenched in a trust deed to compel the settlor’s use of them in favour of an onshore claimant, defeating any purpose, particularly with respect to asset protection, for which the trust is created. This consideration is becoming particularly relevant, not only for creditors and disgruntled beneficiaries, but for divorcing spouses, too.3

In the US case of Re Stephen J Lawrence, the settlor, who had reserved powers, claimed it was impossible to comply with a court order to return assets from an offshore trust, and failed to comply. The settlor was held in contempt of court and was therefore jailed. On appeal, it was held that the bankruptcy court did not err in holding that the settlor failed to establish his defence of impossibility because, as a settlor and a prospective beneficiary, he retained de facto control over the offshore trust through his ability to appoint trustees who could reinstate the settlor as a beneficiary under the trust and assign the entire proceeds to him. The defence was invalid because the asserted impossibility was created by the settlor himself.

Tax migration

Settlors who set up in tax-friendly trust jurisdictions with an aim to accumulate assets tax free, but who retain extensive powers over such assets risk being taxed in their jurisdiction of residence. With an increasing number of courts around the world finding de facto directors and taxing accordingly,4 similarly, for trusts, it is feasible that a settlor who has reserved wide-ranging powers to her or himself may find their actions taxable in their jurisdiction of residence.5

In Ingle v McGowan the court found that the settlor’s power of disposition, which allowed him to amend the trust instrument, gave him a control very close to that of complete owner. The court found that a settlor who can control the spending of the trust fund in every respect except spending it for himself is sufficiently the ‘owner’ of the trust fund to make its income attributable and taxable to him.

Trustee liability

Regardless of powers being reserved to settlors, it is imperative to keep in mind that the overriding common-law fiduciary duty lies with the trustees to act in the best interests of the beneficiaries. So while the legislation, as in Cyprus, may permit settlors to give binding directions to the trustees in connection with the trust property, trustees must ensure that they apply their mind independently to the usefulness of such directions and to the wider benefit of the beneficiaries. They must not just sit back and watch calamity befall the trust assets by acting as mere nominees.

Conclusion

While I welcome the new additions as attractive complements to the Cyprus legislation, I advocate a conservative approach to avoid defeating the purpose for which a trust is set up in the first place: to relinquish control and separate the trust assets from the settlor’s own. Great care must be taken to ensure that the use of settlor-reserved powers does not jeopardise the tax, succession or asset-protection features of a Cyprus international trust. When viewed cumulatively, the reserved powers should not, in nature or number, overwhelmingly support a finding that there is in fact no trust. Settlors should be made aware of the risk of reserving too many powers from the outset. So to answer the perennial question of to reserve or not reserve, the most apt reply would be: reserve conservatively and defer to the proverbial impossibility of both having your cake and eating it.

Re the AQ Revocable Trust (2010) 13 ITELR 260
Re Shinorvic Trust [2012] JRC 081
Re Stephen J Lawrence, 279 F.3d 1294 (11th Cir 2002)
Laerstate BV v HMRC [2009] UKFTT 209 (TC)
Ingle v McGowan, Collector of Internal Revenue 189 F.2d 785 (1951)

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