Shadow Directors -- Benefit Of The Doubt?

What action should be taken by shadow directors in the light of the decision in R v Allen? RICHARD F CLARKE examines this grey area.

IN J B Priestley's An Inspector Calls the calm certainty of the affluent Birling family is eroded and eventually shattered by the visit of the mysterious investigating inspector. Following the House of Lords decisions in R v Allen, some clients may feel that their financial certainty has, albeit in a less dramatic way, also been shattered.

I will discuss two distinct aspects of the House of Lords decision of which tax advisers should be aware. In this, the first article, I will look at shadow directors and their benefits, including what, if any, steps need be taken both for past and future years; and in the second article, I will consider the affect of the judgment on the Hansard procedure as used by Special Compliance Office.

Mr Allen had been convicted in February 1998 on 13 counts of cheating the public revenue and had been sentenced to seven years imprisonment. Five of the counts related to the question of benefits received by him as a shadow director of Jersey registered companies holding substantial property interests.

Mr Allen had set up trusts in Gibraltar holding shares in Jersey companies. The companies were administered by a Mr Dimsey through his company DFM Consultants Ltd in Jersey. Mr Allen was not a named director of the Jersey companies, but he and his family benefited from them in various ways, including their occupation of the family house.

The structure was a simple one:

[Allenstructure.gif]

The House of Lords accepted that Mr Allen, as shadow director, was liable to tax on the benefit of occupation of the house, i.e. that section 145 and section 146 applied (all references are to Taxes Act 1988 unless otherwise stated).

So, although the case was an appeal against criminal conviction, a technical issue was argued which has wide relevance, especially in tax-efficient planning for non-United Kingdom domiciliaries. The structure above has been widely used by such individuals to ensure that the property is excluded for inheritance tax purposes.

Since the Court of Appeal decision in this case on 7 July 1999, there has been speculation as to the impact on an individual not domiciled in the United Kingdom acquiring a house for his occupation through an offshore company underlying an offshore trust. Now the House of Lords judgment will add impetus to the debate.

Accommodation benefit

On appeal it had been accepted on behalf of the defence that Mr Allen was a shadow director of the offshore companies, but it was argued that the benefits legislation at section 154 would only apply to a shadow director if he was actually employed by the companies and in receipt of Schedule E emoluments.

Lord Hutton dismissed this approach:

'It is clear that it was the intention of Parliament that living accommodation and benefits in kind provided by a company for a director should be taxed as emoluments received by him from his office …

'In my opinion it was the intention of Parliament in enacting the concluding part of section 168(8) that accommodation and benefits in kind received by a shadow director should be taxed in the same way as those received by a director, and I consider that the statutory provisions relied upon by the Crown are effective to achieve that purpose.'

Thus the appeals on this point were dismissed, and the convictions stood.

Advisers may wish to remember that while their Lordships' judgment has clarified whether the benefits legislation applies to shadow directors, it has not added to the understanding of what will render an individual a shadow director. This may be a more fundamental point.

What is a shadow director?

Although the expression 'shadow director' is widely used by practitioners and the Revenue alike, it is not found in the tax statutes. Instead at section 168(8) there is the definition of 'director' which 'includes any person in accordance with whose directions or instructions the directors of the company … are accustomed to act'.

There has been a continuing difference of opinion between the profession and the Revenue as to the applicability of this legislation. Readers who want a full historical perspective should refer to Malcolm Gunn's article 'Chasing Shadows' in Taxation, 14 March 1996 at pages 607 to 610.

Briefly, in 1989 the Revenue's then deputy chairman opined that control through direct or indirect share ownership would make an individual a shadow director. An unreported Special Commissioners' decision in 1994 caused the Revenue to retreat from this stance and to state that 'there was no intention to imply that control through shareholding was critical'.

The Revenue's own view was that it was unlikely to succeed in showing that the beneficiary of the offshore trust occupying a house owned by an underlying offshore company was a shadow director. It recognised that it needed to show evidence of a continuing pattern of directions and instructions flowing from the shadow to the named directors, and those instructions being habitually followed. Such evidence was unlikely to arise in any case where the company did no more than passively hold one asset (i.e. the house) as the named directors would not require any continuing directions or instructions.

But here the story diverts. While the Revenue had gone quiet on the shadow director point, the Department of Trade and Industry had not. In Secretary of State for Trade and Industry v Deverell [2000] 2 All ER 365, the definition of shadow director was examined in some depth. For the purposes of this case, shadow director is defined at section 22(5), Company Directors Disqualification Act 1986 as:

 'a person in accordance with whose directions or instructions the directors of the company are accustomed to act (but so that a person is not deemed a shadow director by reason only that the directors act on advice given by him in a professional capacity).'

 This is virtually identical to the definition used for tax purposes. Thus the judgment has application when looking at shadow directors and possible taxable benefits.

In Deverell, the lower court had declined to make disqualification orders against two individuals as it had concluded neither were shadow directors. In the Court of Appeal, Mr Justice Morritt disagreed, saying:

'What is needed is that the board is accustomed to act on the directions or instructions of the shadow director. As I have already indicated, such directions and instructions do not have to extend over all or most of the corporate activities of the company; nor is it necessary to demonstrate a degree of compulsion in excess of that implicit in the fact that the board are accustomed to act in accordance with them …

'[The judge's findings] make it plain that Mr Deverell was concerned at the most senior level and with most aspects of the direction of the company's affairs … the directors were accustomed to submit to his requirements.'

 Mr Justice Morritt noted that 'the directors listened to [Deverell] … his advice [had] the potency of directions … and his suggestions … when given, were adopted … The fact that he did not at the management meetings tell the directors what to do is not sufficient to refute the case for the Secretary of State'.

So this non-tax case has re-opened for the Revenue the possibility of arguing that United Kingdom beneficiaries of offshore trust/company structures who make their wishes known are acting as shadow directors, where those wishes have 'the potency of directions'. The provisions of sections 145 and 146 may then bite. In practical terms, it is the effect of section 146 which gives the cause for concern. It charges to tax the cost to the company of providing the house measured by reference to the official rate of interest for beneficial loans (6.25 per cent in 2000-01). So for a house costing £2 million, the benefit charged by section 146 alone is £120,312. (The cost up to £75,000 falls to be charged under section 145.)

As Special Compliance Office has previously taken the lead for the Revenue in this area, incorporating the argument into a number of investigations, it will be interesting to see how it now reacts.

 The future – and the past

The Deverell and Allen decisions have led to a cautious approach to the problem of tax-efficient property planning. A number of proposals have been made to circumvent the benefits 'trap'. These have included:

• the non-domiciled individual purchasing the house and then gifting it to the company (no section 146 charge);
• using life assurance to cover possible inheritance tax;
• arranging for multiple ownership;
• direct ownership coupled to a substantial mortgage;
• ownership by the trust, possibly using offshore borrowings.

 The most suitable solution, if one is thought necessary, will depend on the particular facts of each case. But two other questions need to be addressed. First, what should an individual with this structure in place for the year to 5 April 2001 put on his tax return? Second, are previous years' tax returns affected?

It is impossible to generalise about the correct method of filing the tax return, just as it is not possible to advocate one solution for future planning. It will depend on the structure used and the degree of involvement of the United Kingdom beneficiary. In instances where the named directors received and acted on clear instructions from the United Kingdom party, the advice may well be that the benefit under sections 145 and 146 needs to be returned. In long-standing arrangements where in the year 2000-01 no instructions or directions were given to the offshore directors, there may be arguments to say that the United Kingdom beneficiary was not a shadow director and thus no benefit arose. Some commentators, however, claim that property occupiers will find it difficult to escape a tax charge. Each case will need careful examination and specialist advice.

When deciding what to return for 2000-01, advisers may turn their clients' minds to the problem of earlier years. Again, the range of possible facts in each case will indicate the correct approach. An extreme example would be a United Kingdom beneficiary who routinely contacted the non-United Kingdom directors and 'advised' them, and whose advice had been routinely followed. There is now a strong case for the Revenue to argue that he had been a shadow director throughout. Although he will have undoubtedly acted on professional advice himself in implementing the structure, his actions will probably have gone way beyond the involvement his advisers envisaged. He will have to consider whether a disclosure is required, and may also need to review the company's residence status.

Richard Clarke was formerly group leader of Special Compliance Office London and now works in the tax investigations team at PricewaterhouseCoopers. He may be contacted on 020 7213 5778 or at richard.f.clarke@uk.pwcglobal.com.

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