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MARK McLAUGHLIN ATII, ATT, TEP of Forbes Dawson warns that the settlements anti-avoidance provisions have longer tentacles than is commonly recognised.
MARK McLAUGHLIN ATII, ATT, TEP of Forbes Dawson warns that the settlements anti-avoidance provisions have longer tentacles than is commonly recognised.
HOW AND TO what extent can an individual's contribution of time and effort to a family business constitute the necessary element of bounty, such that the settlement provisions contained in Part XV of the Taxes Act 1988 are deemed to apply? This question has been raised in the Readers' Forum from time to time in the context of share allocations to wives or children's trusts and this article considers the problem further. All references are to the Taxes Act 1988, unless otherwise stated.
'Settlements', 'arrangements' and 'bounty'
Firstly, it is necessary to consider what 'settlement' means. Section 660G(1) states that a settlement includes 'any disposition, trust, covenant, agreement, arrangement or transfer of assets'. In Commissioners of Inland Revenue v Morton 24 TC 259, Lord Moncrieff interpreted a settlement '… in accordance with a familiar use of the term in common law, as meaning a charging of the property of the settlor with rights constituted in favour of others'. This implies that a benefit must be conferred by one party to another.
The word 'arrangement' is not defined for these purposes, but in the Trusts and Settlements Manual at paragraph 4105, the Revenue indicates that a series of transactions should be considered on a global basis, which '… could ultimately lead to a transfer of income, or of assets upon which income arises, from a settlor, who may or may not be named or identified in the deed or other documents'. On this basis, it would be a mistake to consider transactions in isolation to determine whether an arrangement is present.
There must be an element of bounty in the transaction to make it an arrangement, such that the settlement provisions apply. In Chinn v Collins [1981] STC 1, Lord Roskill described the word 'bounty' as 'a judicial gloss on the statute descriptive of those classes of cases which are caught by the section in contrast to those which are not. The courts must, I think, be extremely careful not to interpret this descriptive word too rigidly'. He pointed out that case law had distinguished between situations '… where the recipient has in return for that benefit which he has received accepted some obligation which he has to perform, either before receiving the benefit or at some time stated thereafter, and those cases where the recipient benefits without any assumption by him of any correlative obligation'. Thus a commercial transaction on an arm's length basis would not be caught by the settlements legislation on the basis that there can be no 'bounty' if full consideration is given.
Commercial transactions
The commerciality principle was introduced in Copeman v Coleman 22 TC 594, where an allotment of shares to the children of the controlling directors was held to involve an arrangement as opposed to a commercial transaction. The case was broadly fought on this commerciality issue, with the High Court overturning an earlier decision of the Commissioners given in the taxpayer's favour, on the basis that the transaction was not a bona fide commercial one.
The additional factor that an element of bounty is necessary for the settlement provisions to apply was established by a decision in the taxpayer's favour in Bulmer v Commissioners of Inland Revenue 47 TC 287. In his judgment, Mr Justice Pennycuick attempted to define this principle in the context of tax planning by saying: 'It may be that a transaction has been framed … in such a way as to procure tax advantages to the appellants, but that circumstance does not of itself prevent it from being a commercial transaction or import any element of bounty'.
It follows that a bona fide commercial transaction for full consideration cannot contain an element of bounty, and hence the settlement provisions cannot apply. However, this requirement has the potential to cause considerable uncertainty in its application, as illustrated in the Example.
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Example Smith Construction Ltd is a newly formed building company. The managing director is Eric Smith. The company's shares are subscribed for at par and are held by Eric and his mother, Florence, both of whom hold 50 shares each. Shortly after the shares are issued, Florence settles her shares on The Florence Smith Accumulation and Maintenance Settlement, for the benefit of Eric's children, Ian (aged 6) and Lisa (aged 9). The company subsequently trades successfully with the help of Eric's expertise in the construction industry. No remuneration is voted to Eric, but dividends are paid to the shareholders. The settlement later distributes income for Eric's children. Repayment claims are submitted to the Inland Revenue on behalf of Ian and Lisa. Unfortunately, during the course of a Revenue enquiry, the Inspector of Taxes notes that shares in Eric's company are held in a trust for his children. The outcome is a contention that there is a settlement by Eric for the benefit of his children. The Revenue argues that the formation of the company and the transfer of shares to the trust together constitute an 'arrangement', and that Eric has provided bounty to his children because he did not receive a salary from the company for his efforts. Accordingly, the children's repayment claims are rejected, and the dividends received by the trust are reallocated to Eric and taxed accordingly under section 660B, as Eric is regarded as the settlor for these purposes. |
The writer has seen actual cases similar to the Example, where the Revenue argued that the settlement provisions apply. The Revenue would need to show that there was a wider arrangement between all the parties, but in a family situation this may not be difficult. Should Eric have been advised to receive a commercial salary from the company? Certainly the payment of a salary would not harm any argument against the presence of an element of bounty. However, a practical difficulty lies in deciding on the appropriate level of salary.
Would it make any difference in the example if Eric received a nominal salary? The likely answer, in the writer's opinion, is that it would not help his cause, as it is only necessary for 'an element' of bounty to be present. In Commissioners of Inland Revenue v Plummer 54 TC 1, the House of Lords held (albeit with dissenting views) that only transactions containing an element of bounty could be settlements, thereby implying that in the Example a full commercial salary would be required.
A case apart?
In Butler v Wildin [1989] STC 22, a company was formed by two brothers who acted as unpaid directors. Shares in the company were initially held by their infant children, which were paid out of gifts from their grandparents. The company acquired a development site using a bank loan, which was guaranteed by the brothers. The company subsequently became profitable, and dividends were subsequently paid to the infant shareholders. The High Court held that the children's investment of 'trifling sums' in the shares and the parent's provision of services to the company constituted an arrangement. An element of bounty was given by the parents in the free provision of their skill and services, and by adopting any financial risk in the company's venture. Dividends paid to those children born before the arrangements were made (but not dividends in respect of shares transferred to children born afterwards, as there was no apparent arrangement to benefit future children) were taxable on the parents, under what is now section 660B.
Not surprisingly, the Revenue appears to regard Butler v Wildin as an important precedent in situations involving the potential application of the settlement provisions such as in the Example. In fact the case was settled by a compromise between the taxpayer and the Revenue, and its importance as a precedent is not clear. For a start, the acquisition of shares by the young children themselves was out of order as they lacked the necessary legal capacity. In addition it is argued that if parents cannot offer their free services for the financial benefit of their own children without creating a tax problem, there is no end to the everyday circumstances which might be caught. Would not any assistance given in relation to the children's own money be similarly caught? Yet that is surely an important role of good parenthood.
Other factors
Every case should be viewed 'in the round', to establish whether a settlement is created by a series of transactions forming an 'arrangement', and also to ascertain the identity of the settlor for the purposes of the settlement provisions. A 'settlor' can be any person who has provided funds directly or indirectly for the purposes of the settlement.
In Crossland v Hawkins 39 TC 493, the formation of a company by the taxpayer, a deed of settlement made by his father-in-law for the taxpayer's minor children (the trustees of which acquired shares in the company) and a service agreement between the taxpayer and the company for a relatively modest salary were held to be an 'arrangement', and hence a settlement. In effect the taxpayer had diverted his professional income to the company and from there to the settlement. The taxpayer was deemed to be the settlor through the provision of his services, and the settlement provisions (of what is now section 660B) were applied to dividend income received by his father-in-law's settlement, despite the fact that the taxpayer had no direct involvement in it.
The Hayley Mills case
Having established that arrangements are present sufficient to create a settlement, and having identified the settlor in those arrangements, it is then necessary to consider which arm of the settlements legislation applies in the particular circumstances. In Mills v Commissioners of Inland Revenue 49 TC 367, a fourteen year old actress (Hayley Mills) entered into a service agreement with a company formed by her father, who settled the company's shares on trust for her. Miss Mills subsequently entered into a service agreement with the company for an annual salary. The company's profits from film making were substantially in excess of her salary, and were mainly paid as dividends to the settlement trustees. It was held that the formation of the company, the settlement of the shares and the execution of the service agreement constituted an arrangement, and therefore a settlement. Miss Mills was considered to be the settlor, who had retained an interest in the funds indirectly provided by the trust. The undistributed trust income was therefore attributed to her, by virtue of what is now section 660A, notwithstanding that she was a minor when the arrangements were made.
Where does it all end?
Caution should be exercised if an individual works in a family business and the spouse and/or minor children are capable of participating in the profits, where it could be argued that an element of bounty is inherent in the arrangements. This begs the important question: how far could the principle of bounty be stretched in its application? The transactions forming an arrangement must be scrutinised carefully for any components lacking in commerciality. As things presently stand, this may mean the payment of a full commercial salary by the company. Unfortunately, if clarification is not provided by the Revenue, or if litigation does not establish clearer boundaries in the future, we can only live in hope that common sense prevails on this point.
Mark McLaughlin is a tax consultant, author and newly-appointed Associate with Forbes Dawson, which provides tax consultancy and technical support to professional firms. Mark can be contacted on 0161 245 1090. The views expressed by the author are not necessarily those of the firm.
