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MUCH HAS BEEN written recently about the implications of the decision in the 'Arctic Systems' case (Jones v Garnett [2005] STC (SCD) 9 (SpC 432)) and how TA 1988, s 660A will apply to family businesses. There can be little doubt that the current situation has created uncertainty for professional advisers and concern among the hundreds of thousands of family businesses which may be adversely affected.
In this article I will examine the issue from a different angle — that of human rights. If I am correct, the conclusion is that the contentious Revenue interpretation of s 660A, as described in its recent Guide to the Settlements Legislation for Small Business Advisers (www.inlandrevenue.gov.uk/practitioners/guide_sba.pdf), needs to be reviewed and fresh consideration given to husband and wife arrangements.
The application of TA 1988, s 660A
Those adversely affected by the Revenue's approach in the guide will be surprised to hear that in many situations s 660A will only apply to husband and wife businesses; unmarried couples and same sex couples will often not be caught because s 660A(1) can only apply if either the settlor of the statutory settlement has an 'interest' in the settlement property or his spouse has such an interest. So, for example, in Arctic Systems the property in the statutory settlement was one ordinary share. The Commissioners held that the dividend income from the share was taxable on the settlor not because the settlor had an interest in the property, but because his spouse had an interest. He could not benefit from the exemption in s 660A(6), both because the gift was not an outright gift and because the property given was substantially a right to income. If the facts in Arctic Systems had involved an unmarried couple, it appears that the Commissioners would have held that the section did not apply, as neither the settlor nor a spouse had an interest in the property; reliance on the exemption would have been unnecessary.
Similarly, in Young v Pearce [1996] STC 743, which involved gifts of preference shares by two husbands to their wives, it seems that s 660A applied only because the spouses of the settlors benefited under the statutory settlement. In the words of Mr Justice Vinelott:
'If the creation and allotment of the preference shares constituted a settlement, the subject matter of which was the preference shares allotted to the wife of each of the taxpayers, it must follow that the allotment of the preference shares taken by each wife was an outright gift from which income (the dividends paid on the preference shares) arose.'
The settlors did not have interests in the preference shares which were outright gifts; however, their spouses did have interests in the settlement property.
The settlement provisions applied because the property given was wholly or substantially a right to income and the exemption in s 660A(6) was not available to the husbands.
Again, had, for example, the shareholders in Young v Pearce been a same sex couple, the settlement provisions would not have applied, as neither the settlors nor spouses of them had interests in the preference shares. A number of examples in the Revenue's guide illustrate situations in which a husband and wife business is caught in circumstances in which unmarried couples and same sex couples would not be, according to the Arctic Systems decision.
The Revenue guidance claims, at paragraph 3.9.1, that
'It is a common misconception that the settlements legislation applies only to arrangements involving a settlor's spouse or minor children.'
This is explained in the following paragraph. The legislation also applies when the settlor retains an interest and, because the person doing the work can always withdraw his labour, this condition is satisfied: he still retains control over his earning capacity, which is the subject matter of the settlement. This was not, however, the way that the case was argued before the Commissioners, and it would seem to come up against the obstacle that s 660A is not a charging section — 'earning capacity' is not taxable, only earnings.
Moreover, there is House of Lords authority that in s 660A:
(1) settled property can only refer to property of the settlor with rights vested in favour of others; and
(2) that s 660A does not authorise use of extrinsic evidence to ascertain the settlor's intention (see Vestey Executors v CIR 31TC1 at pages 88 and 89).
It follows, therefore, that:
(1) 'earning capacity' is not settled property; and
(2) an intention to withdraw labour is not relevant and must be ignored.
The rest of this article therefore considers the guidance in the light of the Commissioners' decision.
The Revenue guide
In its guide, the Revenue says in paragraph 3.9.2:
'The settlements legislation applies not only where there is a benefit to the settlor's spouse, but also where the settlor retains an interest in the settlement whoever the beneficiary may be.'
This is not, in fact, a strictly accurate statement. What is required is that the settlor retains an interest in the property comprised in the settlement (my italics). So it is always crucial to determine what that property consists of in any potential case. In Arctic Systems the property was the ordinary share and it could not become applicable for the benefit of the settlor. For the legislation to apply, the settlor's interest in the settlement needs to be a financial interest in the property comprised in the settlement.
The question which arises is whether s 660(A), as it applies to husbands and wives, breaches the Human Rights Act 1998. Article 14 of the Human Rights Convention guarantees that the rights set out in the convention are to be secured 'without discrimination'. Marriage is prima facie a status falling within Article 14 and tax is within Article 1 of the First Protocol of the Convention which provides for protection of private property.
Secondly, it is clear that in many circumstances different treatment will apply to married couples on the one hand, and unmarried couples and same sex couples on the other. The question then is whether or not this is a breach of the Human Rights Act; the test which needs to be applied to determine this requires two questions to be answered.
1. Is the first group in an 'analogous' situation with the second group?
2. Is the different treatment of the two groups objectively justifiable in the sense that it has a legitimate aim and bears a reasonable relationship of proportionality to that aim? (See Wandsworth London Borough Council v Michalak 2003 1WLR 617 as confirmed in A (FC) and others v Secretary of State for the Home Department (2004) UK HL 56).
To some extent, the two questions overlap in that if there is a justification for different treatments their situations are more likely to be analogous. A rigidly formulaic approach is to be avoided (see Ghaidan v Godin-Mendoza (2004) UKHL 30 at para 134).
The Holland case
These questions were in fact raised in a recent Special Commissioners' hearing (Holland v CIR [2003] STC (SCD) 43 (SpC 350)).
The issue in this case was whether the survivor of an unmarried couple could claim the inter-spouse inheritance tax exemption on the death of his partner.
In answer to the first question above, the Commissioners felt that they were bound by two European Court of Justice decisions which had held that married persons were not in an analogous situation to persons who lived together as husband and wife, but without being legally married. It should be noted however that in both decisions it was unmarried persons who were seeking benefits which by statute were only available to married persons. The benefits claimed were suitable to married couples in a way which meant that unmarried couples were not in an analogous situation.
In answer to the second question above, the Special Commissioners held that discrimination was objectively justified. It was permissible for Parliament to legislate so that different tax provisions applied to married persons, as this reflected the fact that married persons had mutual rights and obligations relating to maintenance during their lives and after their death (for example, specific rules relating to intestacy).
The Special Commissioners concluded that:
'These interlocking property rights and obligations are a justification for a different tax treatment.'
Secondly, they concluded that the steps taken by Parliament on the IHT exemption to implement its policy of recognising the mutual obligations of married persons in the tax laws was both reasonable and proportionate and was logical in forwarding that policy.
Can discrimination be justified here?
The Revenue may argue that discriminatory treatment can be justified, as it was in Holland v CIR; however, it is very difficult to point to a rational policy which justifies the taxation of family businesses owned by spouses more harshly than those owned by unmarried couples, especially under a complex tax avoidance section which makes no direct reference to family businesses whatsoever.
It should be noted that the Commissioners had no UK legal authorities to guide them in their decision and it should be open to the taxpayer in Arctic Systems to raise the issue on appeal. Moreover, the point appears to have been recognised in part by the Government, which announced in the Pre-Budget Report in November 2004 that the Finance Bill 2005 would include provisions whereby same sex couples who register under the Civil Partnership Act 2004 will be treated as married couples for tax purposes. But that will leave unmarried couples and unregistered same sex couples with a generally more favourable treatment under s 660A.
It follows from this that s 660A may be discriminatory under Article 14. What is to be done about it? The Human Rights Act 1998, s 6 states that it is unlawful for a public authority (which includes the Inland Revenue) to act in a way which is incompatible with a Convention right. However, s 6(2) provides a public authority with a defence if it could not have acted differently. Similarly, if Parliament has granted the authority a statutory power which, regardless of how it is exercised, will inevitably result in a breach, then it can operate the statute in a discriminatory manner.
The application to the Revenue statutory power in TMA 1970, s 1 was considered in the recent case of Wilkinson v IRC (2003) STC 1113. Here, a widower claimed widow's bereavement allowance on the grounds of sex discrimination. The Court of Appeal examined whether or not the Revenue had the power to grant him the allowance under its 'care and management' power and concluded that it did not.
It was not within its ambit to grant a tax allowance that had been clearly given to a widow and not to a widower; that was a matter for Parliament; the Revenue could not have acted differently. However, the Court of Appeal also concluded that the Revenue's argument that s 6(2) gave it a discretion whether or not to exercise its power to avoid discrimination was wrong. In most cases failing to exercise its power would not involve incompatibility with the Human Rights Convention. However, the Court decided that:
'If circumstances arise under which it is necessary to exercise the power in order to avoid a breach of Convention rights, we can see no basis upon which the Commissioners can rely upon s 6(2) to justify a refusal to exercise the power.'
Could the Revenue act differently?
If s 660A is discriminatory and there is no clear mandate in the section requiring the Revenue to apply the provision in a discriminatory way, a decision not to discriminate against married couples would appear to be a proper application of the Revenue's statutory power and would in fact be a statutory duty. It would not be synonymous with the grant of a tax allowance to a new class of persons; rather, it would be an executive decision to avoid discrimination in circumstances where there was no clear indication that Parliament had intended the discrimination to exist.
There is a further point. The Revenue has said that the application of s 660A to family businesses will affect around 30,000 cases; professional bodies estimate that the number runs to more than 500,000. The Revenue has also indicated that it does not intend to apply additional resources to the collection of tax by the application of the section. No doubt the large number of businesses affected will make it impractical for it to do so. This opens up the possibility that tax on settlor-interested businesses will be charged on an arbitrary basis depending on which ones are selected for challenge by their Inspector.
The Revenue's powers under TMA 1970, s 1 were the issue in CIR v National Federation of Self Employed and Small Businesses [1981] STC 260. Here, it was made clear that the power was to enable it to set about the task of collecting tax in a pragmatic fashion having regard to principles of good management. Anomalies and injustices could be avoided through the use of extra statutory concessions and their use in collecting taxes more efficiently was a proper use of the power. It seems that the application of this principle to s 660A is both sensible and pragmatic. If, having done this, the Revenue was to open a debate on whether or not targeted legislation is needed to counter unacceptable tax avoidance by family businesses run by couples (whether or not married) it would then be open to Parliament to legislate.
John Wosner is tax partner at PKF, accountants and business advisers.
