Close companies - Associated Or Not? - Robert Argles, barrister, considers the court decisions in Newfields Development Limited.

Close companies - Associated Or Not?

Robert Argles, barrister, considers the court decisions in Newfields Development Limited.

The 'small companies' rate of corporation tax has been with us since 1972. 'Small companies' is a misnomer. The reference is not to the size of the company but to the size of its profits. The draftsman of the Finance Act 1972 was aware of the possibility that, by accident or design, corporate enterprises could be split between two or more companies; each of these could claim the 'small companies' rate in respect of their particular share of what might otherwise be the profits of a common enterprise.

Hence section 13(3), Taxes Act 1988 provides that where a company has one or more associated companies, the prescribed lower relevant maximum amount below which the full benefit of the small companies rates is applicable, and the prescribed upper relevant maximum amount above which the full rate of corporation tax is chargeable, are each to be taken as reduced by a fraction equal to one divided by the number of associated companies.

It is immaterial that the profits of the individual associated companies are very small or even nil so long as the associated company concerned carries on a 'business'. The effect is to limit the profits of the companies which qualify for the small companies rate by the prescribed fraction.

Section 13(4) provides that a company is to be treated as an 'associated company' of another if one has control of the other or both are under the control of the same person or persons. 'Control' is construed in accordance with section 416, Taxes Act 1988. Obvious cases of 'associated companies' are companies in the same group. One does not need to consider the definition of 'control' in this and in other cases where it will be apparent at first blush that the companies are indeed controlled by the same persons or that one controls the other.

Facts of the case

The dispute in Newfields Development Limited [2000] STC 52 centred on that no-man's land in which the meaning of the words is unclear. 'Control' is defined by section 416(2) as meaning primarily voting control but includes also possession or entitlement to acquire the greater part of the share capital of the company (whether carrying voting control or not) or such part of the capital as entitles the holder thereof to the greater part of the distributable income of the company or assets in a winding-up.

In Newfields, Mrs Walker was the beneficiary of a discretionary trust established by her late husband. The trustees of the discretionary trust held all the shares in and accordingly controlled a company called Lawrek Properties Limited. The trustees of Mr Walker's will held all the shares in and accordingly controlled Newfields. Under the will of Mr Walker, Mrs Walker had a life interest. Since it was self-evident that Mrs Walker did not 'control' either Lawrek or Newfields for the purposes of section 416(2), the two companies could not be regarded as 'associated' under section 416(2) taken by itself.

The Revenue's contentions

The Inland Revenue relied on section 416(6),Taxes Act 1988. This provides

'for the purposes of subsections 2) and (3) above, there may also be attributed to any person all the rights and powers... of any associate of his or any two or more associates of his... and such attributions shall be made under this subsection as will result in the company being treated as under the control of five or fewer participators if it can be so treated.' (Emphasis added.)

Mrs Walker was not a 'participator' and did not herself control the companies. But she was an 'associate' of both the discretionary settlement trustees who controlled Lawrek and the will trustees who controlled Newfields (section 417(3)(b) and (c), Taxes Act 1988). The Revenue decided that section 416(6) obliged it to attribute to Mrs Walker the rights and powers of the discretionary trustees in the one case and the will trustees in the other, with the result that Mrs Walker must be deemed to 'control' each of the companies concerned. Accordingly the companies were 'associated' and the small companies rate in the case of Newfields would be correspondingly restricted.

Basis of the case

The proceedings were for judicial review: the basis for this being that the taxpayer claimed that the Inland Revenue had a discretion under section 416(6) to make the 'attributions' to which the section refers. It had not exercised the discretion and accordingly the decision must be quashed. The justification for seeking a judicial review of the Inspector's decision in such a case is found in the decision in R v H M Inspector of Taxes ex parte Lansing Bagnall Limited [1986] STC 453 where the court quashed a notice of the Inspector to apportion that part of a company's income which it had covenanted to pay to a charity in accordance with the close company apportionment provisions.

In the High Court

Before Mr Justice Moses [1999] STC 373 the Revenue succeeded on the basis that:

'When importing the statutory concept of control from section 416 to section 13, Parliament did not alter the nature or character of the power from that which in section 416 is fettered by a statutory purpose into a power unfettered by any statutory purpose at all. True it is that the final words after the semicolon in section 416(6) have no application. But in my judgment it is not to be supposed that the nature of the powers change. Like so many statutory powers it is to be exercised for the statutory purposes for which it was conferred. In the context of section 13 that purpose is to ascertain whether in the instant case, two companies are under the control of the same person pursuant to section 13(4). That is a statutory question. If it is possible to answer that in the affirmative, by exercising the power of attribution, in my judgment, that power must be exercised. Conversely, if that question, namely are the two companies under the control of the same person, can only be answered in the affirmative by refraining from the exercise of the power, then the power should not be exercised.'

The concept that a power or discretion must be exercised in a particular way was one for which Mr Justice Moses as junior counsel had unsuccessfully contended in the Lansing Bagnall case. Here it resurfaced by imposing on the Revenue an obligation to make the attribution so long as the particular statutory purpose (viz the association of the companies concerned) could be fulfilled. Mr Justice Moses would so fetter the power or discretion imported by the use of the word 'may' in section 416(6) as to lose its character as a power or discretion. His interpretation of 'may' is made less convincing by the contrast with the mandatory attribution required by the word 'shall' in the second part of section 416(6) and in section 416(5) (attribution of powers of nominees).

The Court of Appeal

The Court of Appeal unanimously reversed the decision of Mr Justice Moses. But they were not unanimous in their reasons. Lord Justices Peter Gibson and Sedley rejected the view (as argued by counsel for the taxpayer) that the first half of section 416(6) created a power or discretion. They (at page 59d) explained the word 'may' in the first part of section 416(6) by saying that it 'recognises that more than one attribution could be made'. The power was necessary so as to allow for a choice of attribution.

They took the view that section 416(6) is a single provision. The first part is concerned with the ways in which attribution could be made. The second, which hung together with the first, obliges one to make the attributions in a way which resulted in the company being controlled by five or fewer participators if it could be so treated. Since section 416(6) cannot be sensibly divided into independent parts, it cannot be applied for the purposes of associated companies under section 13(4) unless the attribution itself leads to their control by five or fewer participators.

Since Mrs Walker was not a 'participator' in either of the two companies the necessary process of attribution to give her 'control' could not be made under section 416(6).

Analysis of the decisions

Both Lord Justice Gibson and with somewhat greater force Lord Justice Sedley, pointed out the difficulties in giving to the word 'may' in section 416(6) the status of 'power' or discretion. Who was to exercise it: the Inspector of the Board, or even the taxpayer? What criteria would be used in determining whether or not the discretion should in fact be exercised? None of these considerations sufficed to deter Mr Justice Gibson, as he then was, and the Court of Appeal in Lansing Bagnall from importing in the shortfall apportionment provisions as they applied to covenanted donations to a charity by a close company a power or discretion on the part of the Inspector of Taxes. In my view, the assumed obstacles to interpreting the first part of section 416(6) as conferring a power or discretion simply do not exist. The only person who can sensibly exercise that power is the Inspector or the Board (which normally delegates its functions to the Inspector). Interpreting the word 'may' as conferring a power or discretion will itself import a requirement to exercise that power or discretion 'reasonably' with in turn a requirement to consider various criteria (see below).

Section 417(3) in defining 'associate' begins by defining it as a word in relation to a participator and ends 'and has a corresponding meaning in relation to a person other than a participator'. If the attribution process in section 416(6) is limited to the attribution of powers and rights to persons who are participators, these closing words are largely redundant. This interpretation of section 416(6) would open the door to those who devise schemes to limit their tax liability, by the vesting of shares carrying control of companies originally under common control in separate 'associates' of the common controller.

Sir Christopher Staughton preferred the interpretation that, save in cases where it was necessary to make such attributions to ensure that a company was controlled by five or fewer participators, the section imported a power or discretion for the Revenue to make such attributions. Since it was plain that the Revenue had not exercised this power or discretion (indeed its argument was that it had effectively no power or discretion) the decision of the Revenue in this case must be quashed and the appeal allowed. In my view Sir Christopher was plainly right.

If the first part of section 416(6) is interpreted as giving to the Revenue a power or discretion to make the attributions there referred to, there must necessarily be imported a requirement on them to consider the purpose for which such attributions should be made, and in turn a power to act reasonably. Certain of the criteria to which regard could be had in determining whether to apportion the covenanted donations made by a charity between the participators and the company were referred to in Lansing Bagnall. It should not be impossible to lay down criteria of a different kind to be taken into account in determining whether to make the attributions of associates of a person to him or her.

Take, for example, an example of companies with no common history and no possible economic connection with each other: Company A, the shares in which are held by the London based partner (P) of a large firm of chartered accountants and Company B, the shares in which are held by the Hong Kong based partner (Q) of the same partnership. Neither P nor Q necessarily knows of the other's shareholdings in their respective companies. Both P and Q as partners are 'associates' within the meaning of section 417(3)(a). If Mr Justice Moses and the Revenue are right, there will be no option other than to treat A and B as associated companies and A (assuming that to be a United Kingdom resident company subject to corporation tax) would have its 'small companies' rate cut down accordingly. Of course, the chances are that P and Q would be in ignorance of each other's respective control over their companies and the Revenue would be unlikely ever to discover the same.

But the rights and obligations of the Inland Revenue and the taxpayer should not be made to depend upon the chance discovery of facts which might otherwise affect liability. If the majority in the Court of Appeal's reasoning was upheld, there would be no right or power for the Revenue to treat A and B as associated companies. They could not be associated companies and A's limited entitlement to the small companies rate would not be cut down.

If Sir Christopher Staughton was correct in his reasoning, the Revenue would have a power, but it would be a power which could not reasonably be exercised by attributing the rights of P to his partner Q or vice versa. The draftsman of section 13(4) in importing the 'control' definition in section 416 cannot have intended to treat as 'associated' companies which have no common history or economic connection. In the instant case neither A nor B in the example have any connection other than the coincidental one that individual partners control each company.

Contrast the position with that in Newfields. Had the Revenue chosen to exercise the power of discretion which Sir Christopher Staughton found it had in Newfields, it could validly have made the process of attribution which it is permitted to do (section 416(6)) because it is clear that each of the two companies Lawrek and Newfields were controlled originally by the same person.

Conclusions

The Revenue has long recognised that the definition of 'associated company' as importing the control test required by section 416 is far too wide. Extra-statutory Concession C9 contains no less than four concessions, three of which disapply the control test where control is exercised by fixed rate preference share, loan creditors or trustee companies. In addition they interpret the reference to 'relative' for the purposes of the definition of 'associate' as being limited to the husband or wife of a person or his child who is a minor. The rights and powers of other 'relatives' are not to be attributed to a person under section 416(6) whether or not he is in fact a participator in the company.

An interpretation of the first part of section 416(6), which would confer a mere power or discretion on the Revenue which would be exercised only for the purpose of making attributions of the rights and powers of associates (whether or not they are also participators) in cases where the companies were originally under common control (as in Newfields) or have some common commercial or economic history, could sensibly give effect to these provisions without the need to make concessions of the kind which the Revenue so obviously considers to be needed.

Robert Argles is a member of tax chambers at 24 Old Buildings, Lincoln's Inn, London WC2.

 

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