Retained Powers in Offshore Trusts: Planning Benefit Versus Sham Trust Risk

The Settlor's Dilemma

The settlor who creates an offshore trust faces a fundamental tension. On one hand, the settlor wants the trust to be effective — to provide asset protection, tax benefits, and succession planning. This requires the settlor to relinquish control: the assets must genuinely belong to the trust, managed by an independent trustee.

On the other hand, the settlor has spent a lifetime accumulating those assets and is reluctant to hand them over to a stranger — no matter how reputable the trust company. The settlor wants to retain influence over investment decisions, distribution timing, and the ultimate disposition of the wealth.

The law accommodates this tension, to a point. A settlor can reserve certain powers in the trust deed — and modern offshore trust legislation expressly validates many reserved powers. But if the settlor retains too much control, the trust may be characterised as a sham: a legal fiction that does not reflect the true arrangement between the parties.

What Is a Sham Trust?

A sham trust is a trust that exists in form but not in substance. The trust deed says the trustee has discretion, but in reality the settlor directs every decision. The trust deed says the assets belong to the trustee, but in practice the settlor treats them as their own.

The classic formulation comes from Snook v London and West Riding Investments Ltd [1967] 2 QB 786: "a sham 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 intend to create."

In the trust context, this means: if the settlor and the trustee both intend that the trustee will follow the settlor's instructions without exercising independent judgment, the trust is a sham — regardless of what the trust deed says.

The Leading Cases

Pugachev (2017)

JSC Mezhdunarodniy Promyshlenniy Bank v Pugachev [2017] EWHC 2426 (Ch) is the most significant modern sham trust case. The English High Court found that five trusts established by the Russian oligarch Sergei Pugachev in New Zealand were shams. The key findings:

• Pugachev treated the trust assets as his own, directing the trustee to make payments for his personal expenses
• The trustee had no independent authority and followed Pugachev's instructions without question
• The trust deeds gave Pugachev extensive reserved powers, including the power to add and remove beneficiaries, veto distributions, and direct investments
• The court found that "the trusts were in reality set up to enable Mr Pugachev to keep the ultimate beneficial ownership and control of his assets whilst creating a veneer of trust ownership"

Rahman v Chase Bank (1991)

In Abdel Rahman v Chase Bank (CI) Trust Co Ltd [1991] JLR 103, the Jersey Royal Court considered the sham doctrine in the context of a Jersey trust. The court held that the settlor's conduct — directing the trustee to make specific investments and distributions — was inconsistent with the terms of the trust deed, but stopped short of finding the trust was a sham because the trustee had exercised some independent judgment on other occasions.

Minwalla v Minwalla (2004)

In Minwalla v Minwalla [2004] EWHC 2823 (Fam), the English Family Division found that a Jersey trust was a sham in divorce proceedings because the husband (the settlor) had complete control over the trust assets and the trustee acted purely on his instructions.

Esteem Settlement (2003)

In In the matter of the Esteem Settlement [2003] JRC 092, the Jersey Royal Court conducted a thorough analysis of the sham trust doctrine. The court held that the trust was not a sham, because the trustee had exercised independent judgment on key matters — even though the settlor had considerable influence over the trust's administration.

Statutory Validation of Reserved Powers

Recognising that settlors legitimately wish to retain some influence, offshore trust legislation expressly validates certain reserved powers:

Jersey

Article 9A of the Trusts (Jersey) Law 1984 provides that a trust is not invalid, nor is the trustee liable, merely because the settlor reserves powers to:

• Revoke, vary, or amend the trust
• Advance, appoint, pay, or apply income or capital
• Act as or appoint a director of a company owned by the trust
• Give binding directions to the trustee on investment or distribution
• Appoint or remove trustees, protectors, or beneficiaries
• Change the governing law
• Restrict the exercise of any trustee power

BVI

Section 86A of the Trustee Act provides similar protections, expressly stating that a trust is not a sham, is not invalid, and is not to be treated as a bare trust merely because the settlor retains powers including the power to revoke, to direct investments, to appoint and remove trustees, and to act as a director of a trust company.

Cayman Islands

Section 90 of the Trusts Law (2021 Revision) provides that a trust is not invalidated or rendered revocable by reason of the settlor reserving a power of investment, a power to revoke or amend, a power to appoint or remove trustees, or a beneficial interest.

Guernsey

Section 15 of the Trusts (Guernsey) Law 2007 provides a comprehensive list of reserved powers that do not invalidate the trust.

The Boundary: Form vs Substance

The statutory validations protect the form of the trust, but they do not protect against a finding of sham based on the substance of the arrangement. The distinction is:

• Reserved powers properly exercised: The settlor reserves the power to direct investments (as permitted by statute). The settlor provides investment directions. The trustee considers the directions, reviews them against its fiduciary duties, and implements them. The trust is valid.
• Reserved powers as a facade: The settlor reserves the power to direct investments. The trustee never exercises any judgment — it rubber-stamps every instruction. The settlor treats the trust account as a personal bank account. The trust is a sham, regardless of the statutory validation.

Factors That Increase Sham Risk

Courts will examine the totality of the relationship between the settlor and the trustee. The following factors increase the risk of a sham finding:

• The trustee never refuses or questions the settlor's instructions
• The trustee does not maintain separate files, minutes, or records of its decision-making process
• The settlor has direct access to trust bank accounts (signatory authority, debit cards)
• The settlor uses trust assets for personal expenses without formal loan or distribution documentation
• The trustee does not hold independent board meetings to consider trust matters
• The settlor dictates all investment decisions without the trustee conducting its own analysis
• The beneficiaries are unaware of the trust's existence
• The same lawyers act for both the settlor and the trustee

Factors That Reduce Sham Risk

• The trustee has refused or modified the settlor's instructions on at least some occasions
• The trustee maintains detailed minutes of its consideration of the settlor's wishes
• Distributions are made through formal resolutions with documented reasons
• The trustee conducts independent due diligence on investment proposals
• The trustee provides periodic reports to the protector (if any)
• The trust has been administered consistently with the trust deed over a sustained period
• Independent legal advice was taken at the time of establishment

Tax Authority Perspectives

Tax authorities take a different (and often more aggressive) approach than the courts:

UK — HMRC

HMRC does not need to prove sham to tax the settlor. The settlements legislation (ITTOIA 2005) and transfer of assets abroad provisions (ITA 2007) can attribute income to the settlor even if the trust is valid, provided the settlor retains the power to enjoy the trust property or the power to control the trust's income. HMRC's view is that reserved powers — even those validated by offshore statute — may be sufficient to trigger these provisions.

US — IRS

The IRS uses the grantor trust rules (IRC sections 671-679), which attribute income to the settlor if the settlor retains certain powers — including the power to revoke (section 676), the power to control beneficial enjoyment (section 674), or the power to substitute assets (section 675). The IRS does not need to argue sham — the grantor trust rules achieve the same result through statutory attribution.

Key Takeaways

• Offshore trust legislation expressly validates many reserved powers — including the power to revoke, direct investments, and appoint trustees
• Statutory validation protects the form but not the substance: if the trustee acts as a rubber stamp, the trust can still be found to be a sham
• The leading case of Pugachev demonstrates that extensive reserved powers combined with a compliant trustee will result in a sham finding
• The trustee must exercise genuine independent judgment — and must document that judgment — even when the settlor provides directions
• Tax authorities do not need to prove sham to attribute trust income to the settlor — domestic anti-avoidance rules achieve the same result through different mechanisms
• The optimal balance retains meaningful influence for the settlor (through a protector, letter of wishes, and limited reserved powers) while ensuring the trustee maintains genuine independence