All Very Unsettling

Are you busy incorporating your clients' small businesses? If so, the Revenue may have a shock in store, warns MALCOLM GUNN FTII, TEP.

WHAT CANNOT BE seen or touched, but can be given to the wife as a present? It costs about £57, but saves money by the shovelful. It cannot be love and affection because that will cost you everything! No, the answer is a newly formed company. Why does it save money? Do not ask me, but apparently the Treasury has decided that small companies equal good news, and self employment equals bad news. So for the moment the incentives to incorporation are very hard to ignore and I bet that just about every small practitioner has been busy on this front, particularly over the last year.

I bet too that plenty of new shares are finding their way into the hands of the spouses of the clients, or even into a children's settlement. In some cases most or even all of the shares may be in the spouse's name. Why not, if it saves tax, as is the duty of any adviser to achieve? Actually I am about to tell you why not! The Revenue does not like it at all and it is on the warpath.

Capital versus income

We are all so well used to swapping quoted shares between husband and wife so that they can be sold out of the right hands in order to minimise capital gains tax liability and maximise the use of the annual allowance, that it is easy to lose sight of the fact that there is a critical policy distinction between capital gains and income.

For some reason, the Revenue is very relaxed about capital gains being shunted between married persons (or for that matter between group companies). The same principle does not apply to income tax. So, for example, the accrued income provisions do not admit the possibility of a stock with accrued income being transferred on a tax-free basis to a spouse, so that the recipient can realise the accrued income. Any gift or transfer is deemed to be a realisation at market value. The same applies with relevant discounted securities and with the offshore income gains provisions; there is no tax-free transfer between married persons.

More importantly, the anti-avoidance legislation relating to settlements is specifically designed to operate not only where funds are put into trust for the spouse but also where one spouse makes a gift to the other and, as a result of the gift, income becomes payable to that other spouse. There are exceptions, as examined below, but that is the broad thrust of the legislation and it operates to tax the income as if it had never been given away in the first place. There are in fact two examples buried in the Revenue's Trusts Settlements and Estates Manual which will be of vital interest to all those incorporating family businesses. They are reproduced as Examples 1 and 2 with this article and. as readers will see, they broadly cover two scenarios.

Example 1

The first scenario is the formation of a service company by a professional partnership with the shares being held by the wives of the two partners. One assumes that the example is dealing with a situation where the wives subscribe for the shares in the first place, but probably it makes no difference if they buy the shares at par value from the partners in the professional practice.

Example 2

The second scenario deals with the incorporation of a one-man business with all the shares in it being given by the businessman to his wife.

The Revenue's manual suggests that both these situations are caught as 'settlements' and the dividends on the shares are therefore taxable on the professionals because they have diverted some of their income through the structure into the hands of their wives.

These two examples may come as some surprise to readers. The most recent case on this theme was Young v Pearce and related appeal 70 TC 331 but that concerned preference shares given to the wives of those conducting a family business. I think most practitioners have worked on the basis that the case fell down because the shares were simply preference shares and not ordinary shares and that conclusion got some encouragement in the judgment. Unfortunately, the Revenue seems to want more encouragement than was given at that time!

Echoes of the past

Prior to that case, there was a case late in 1988 called Butler v Wildin . This has had something of a chequered career in its tax life as I fired a sort of Exocet missile at it many years ago in an article in Taxation . It was a case which was robustly decided in the High Court in favour of the Revenue, but which went on to the Court of Appeal where the hearing collapsed at lunchtime on the first day. In the corridor outside the courtroom, the taxpayers and the Revenue thrashed out a deal and so the proceedings were abandoned. But of course the High court decision remained as apparently good authority for an extreme Revenue point of view.

In those days, tax credits on dividends were recoverable and the whole case was about the repayment claims. The deal with the Revenue simply dealt with that angle and did not impact on the company at all.

There were many fascinating aspects to the case. It was all about a property development company apparently formed by four infant children; one was on fact under one year old at the time and must have subscribed for shares from her pram! The money for the share subscriptions came from the children's own funds, being gifts from grandparents. One of the brothers spotted a disused railway yard and he arranged for the company to obtain a licence to develop the site, granted by British Rail. He prepared the detailed drawings for the development and got the planning permission. After that, a building contract was entered into with a firm of builders and the whole thing got under way to produce some very nice profits for the company.

If all this is sounding like a wonderful tax scheme for those inebriated by television property makeover programmes such as 'Property Ladder', then please do not try it at home. Children lack the legal capacity to subscribe for shares, which is largely why things ground to a halt at the Court of Appeal. Also, the company had in the bank account only the equivalent of children's pocket money, raised from the share subscriptions, so where were the funds coming from to pay the builders? The answer was, in the main, interest-free loans from the two brothers plus guarantees given by them to a bank for an overdraft. So there was a whole range of arguable points in the case, but the central feature was the work carried out by the brothers free of charge for the company; the Revenue thought that was enough on its own to cause there to be a settlement, but tax counsel advised to the contrary.

Hayley Mills

In fact we have to go back to 1974 to find some solid ground on this whole topic. The case of Mills v Commissioners of Inland Revenue [1974] STC 130 concerned a company formed by the actor John Mills who put the shares into trust for his daughter, Hayley. The company then became the vehicle through which Hayley Mills appeared in various films with Hayley's earnings going into the company, and from there out by way of dividend to the trust where the money was accumulated. The case arrived at the House of Lords and the issues were:

(1) Was there an arrangement in the nature of a settlement by the formation of the company and the service agreement with it?

(2) If so, was Hayley Mills the settlor of that arrangement?

(3) If so, did she provide any funds for the settlement?

As readers will all know, the crucial feature of every settlement is 'bounty'. Funds must be provided on generous and uncommercial terms. Once this feature is present, it only remains to establish whether or not the settlor or settlor's spouse has some interest in the vehicle concerned. The vehicle need not be a trust but can be a company or some other structure. Section 660A, Taxes Act 1988 can apply to treat any income arising from the arrangement as being taxable on the settlor. As an aside, there has never been a case where it has been held that this legislation enables the corporate veil to be pierced so that income retained within a company is never caught by section 660A. The income must emerge from the company in the form of dividends.

The House of Lords held that Hayley Mills had diverted her earnings to the company in return for a small salary and so there was 'bounty'; she was a settlor of an arrangement. The income emerged from the company and those dividends were caught by what is now section 660A. She was therefore liable to surtax on them, even though they were accumulated within the trust.

Back to the railway yard

If Hayley Mills lost her case, why then was there any doubt about the case of Butler v Wildin ? The point here is that there was a subtle but important distinction between the two. Hayley Mills effectively assigned her income from contracts with third parties to a company. All the Wildin brothers did was to provide their own services free of charge to a company owned by their children. If this sounds like a difference without a distinction, then the point will perhaps become clearer from the following extract from the judgment in the Mills case:

'[It was] pointed out that a stockbroker might, if the advice he gave to the trustees of a settlement proved well founded, be said to be contributing to the settlement. The difference between those cases, on the one hand, and Crossland v Hawkins and this case, on the other, is that in Crossland v Hawkins and in this case funds which ordinarily would have been received by Mr Hawkins and by Miss Mills for their acting were diverted to companies which were channels for their transmission to trustees. It is not the provision of services but of funds which comes within the section.'

The Mills case was therefore caught because funds were provided to the company in the form of a stream of earned income. The Wildin case should not have been caught because all that was provided were the free services of the brothers to the company - there was no provision by them of any funds. (I am disregarding matters here relating to the interest-free loans and bank guarantee given by the Wildin brothers; these aspects are allegedly caught by the settlements legislation to make them partial settlors in view of the decision in Wachtell v Commissioners of Inland Revenue 46 TC 543, although that is another decision which is controversial and disputed!)

The distinction in practice

Identifying which free services offered to a company are caught as a settlement and which are not may seem a little confusing at first sight. Both Miss Mills and Mr Wildin offered their time free of payment, or for minimal payment, to their respective companies and the view taken here is that one was caught and one was not. To clarify this a little, if the brother in the Wildin case who had drawn up the plans had offered his services to others, through the medium of the company, to draw up plans for them as customers of the company, once again he taking no payment from the company for this work, that would be the provision of funds to the company in the form of the fees charged to the customers. There would thus be a settlement. There is no settlement without the provision of funds.

Having identified something within the scope of the term 'settlement', it is then necessary for income to arise and for that income to be caught by either section 660A (settlor or spouse) or 660B (certain children of the settlor), Taxes Act 1988. Remember that the 'income' for this purpose is not the company's profits; those belong to the company and nobody else. Income will be anything which comes out of the company whether by way of remuneration or dividend. In the circumstances under consideration here, one will be looking for that income to be paid to the spouse of the company director or to any of his or her children who are unmarried and under the age of 18.

The Revenue's examples

How then do the two examples in the Revenue's manual shape up to this analysis?

Others may have alternative views, but Example 1 seems to me to fall within the parameters of the Mills case and the settlement provisions may indeed apply.

However, I do have some reservations about Example 2 . In this case, the consultant draws over half of the company's profits as remuneration leaving less than half to be paid out as dividend to his wife. There is only a settlement if there is an element of 'bounty', and no doubt a dividend of £30,000 on a few £1 shares looks very generous indeed. But who is to say that the remuneration drawn by the consultant is, or is not, a market rate? Example 2 is fairly clinical, and one imagines that the consultant has already established his practice and his fee rate which the market can sustain, and the company enables some of this to be diverted to his wife.

In real life, however, the situation is likely to be far more complex. The wife may well be performing some duties for the company: bookkeeping, organising, deputising. She may fulfil some of the engagements when her husband is too busy, or off sick. Also, the husband's remuneration of £40,000 may be no more than what the company could have paid to a third party to carry out the consultancy work as substitute for the director, so is that not a full commercial rate? As a self-employed individual, the director has personal liability which justifies the higher rate charged, but through the medium of a limited company that risk may be greatly reduced.

All these variations make it very difficult to decide whether there is any settlement at all in Example 2 and, if there is, how much of the 'income arising' is caught and how much is not. Every case will be different, and more than likely, every year in every individual case will be different from every other year. This whole business is a minefield for both the Revenue and the taxpayer. I doubt whether the Revenue has the resources to apply the legislation in the hundreds of thousands of cases which there must be, especially given the depth of enquiry which would be required. It will be akin to a transfer pricing enquiry where the negotiations can go on for years and at least in those circumstances the taxpayer is supposed to start with some proper supporting paperwork.

Furthermore, how is the self-assessing taxpayer to complete his or her tax returns, even if the Revenue view is accepted? Where are the guidelines to be followed? How does one work out the fraction of income caught as a settlement, so that the tax return is complete and accurate, and how is the fraction going to be checked by the Revenue?

Worse still there will be many people who may be about to find that they have a problem going back into past years. The Revenue has responsibility in an area affecting so many small businesses and individuals to keep taxpayers aware of its view and to announce any changes of view from an effective date. It is not satisfactory to leave it to a professional grapevine to do the job instead.

Recent focus

I have heard that the Revenue has shown special interest recently in cases where the wife has subscribed for shares in the family company at the outset with the business then being transferred to the newly formed company and the parties then taking a return from the business out largely by way of dividend. This seems to be particularly pernicious since it is not a point covered even in the dusty recesses of the Revenue's Settlements Manual , and I doubt anyway whether that manual is a best seller amongst high street business people. It also means that the Revenue is operating in open conflict with Gordon Brown's repeated theme of promoting enterprise and initiative. Perhaps we must leave those two sides to sort that out privately.

However, as a matter of pure theory, it does seem hard to resist the suggestion that the position is any different if the shares are initially subscribed for. The hallmarks of a problem are an arrangement involving bounty from which income arises and on this basis the actual mechanism by which the arrangement is set up is not of key importance.

In Butler v Wildin , the High Court thought that the existence of a section 660A or 660B arrangement must be tested when the structure is first set up. It cannot arise at a later time in an existing framework. This seems another doubtful aspect of the decision, but if correct it offers a small possible loophole.

A let-out

Subsection (6) of section 660A does, however, contain a very important exclusion from the settlement provisions. This relates to an outright gift by one spouse to the other, so long as the gift carries a right to the whole of the income arising from it and what is given is not wholly or substantially a right to income. The subsection also states that a gift is not outright if it is subject to conditions or if the gift itself or anything derived from it (which includes the income arising) may become in any circumstances whatsoever payable or applicable for the benefit of the donor.

So a suggested solution to all the foregoing problems would be for the husband to form the company, subscribing for the shares himself, and then to give those shares to his wife as an outright gift. Dividends on the shares must be mandated or paid into an account solely in the wife's name and there must be no understanding that the value of the shares themselves or the income arising will be used for the benefit of the donor spouse.

The majority view on this - and perhaps I should say it is a view of the overwhelming majority - is that this structure falls safely within the exclusion so that all the problems melt away. Unfortunately, the Revenue is of the minority view which is that it does not work! The Revenue's argument is that unless the company has sufficient fixed assets, the property given is wholly or mainly a right to income, even though they are ordinary shares. I must say that I have mentioned this Revenue viewpoint to a number of people, including tax counsel, and some the responses cannot be repeated in polite company, but suffice it to say that they were all unanimously against the Revenue view.

The idea that ordinary shares in a company can be substantially a right to income is entirely novel, given all the rights which are wrapped up in the shares, and of course the director may decline to declare any dividends, in which event the alleged 'right' to income entirely evaporates. Furthermore, the company must have some goodwill if it takes over a business as a going concern, even if some of it is personal to the director. In the case of an accountancy or tax practice, the practice should be saleable for a sum equal to one year's gross recurring fees and in other businesses, client lists are no doubt equally saleable.

The position can be further tested by considering what would happen if the husband and wife separate. One can soon imagine that the dividends would cease immediately and the wife would then want to wind up the company and extract whatever she could in the winding up. To prevent this the husband might have to make a compelling offer to buy the shares. This hardly makes the ordinary shares look like a right to income.

Minimising the risk of attack

I understand that the Revenue has not to date been convinced by the argument that the existence of goodwill or a saleable client list in the company means that the ordinary shares in the company cannot be wholly or substantially a right to income. There will perhaps have to be a test case on the matter before too long, but if readers wish to avoid their clients being the test case they will need to take further steps to protect them.

Peter Vaines of Haarmann Hemmelrath suggests joint ownership of shares in the names of husband and wife with documentation to give the non-working spouse a 2 per cent beneficial interest. Only the 2 per cent could be caught as a settlement (if at all) and the normal section 282A, Taxes Act 1988 rule would otherwise apply.

Another answer seems to be to make absolutely sure that the ordinary shares are not wholly or substantially a right to income. Substantially in tax legislation is generally interpreted by the Revenue as 75 per cent or more; see the retirement relief test for 'full-time working director', and the same test in the benefits in kind legislation; likewise see also the 'substantially reduced test' in the purchase of own shares provision at section 221, Taxes Act 1988.

A possible solution therefore should be to purchase sufficient investments or to ensure that there are other assets in the company, so that more than 25 per cent of the rights in the shares represent fixed capital in the company which would be available for distribution on a winding up. To achieve this, it might be necessary to increase share capital, or to capitalise sufficient profits.

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