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And the rest ...

13 October 2005 / Mike Truman
Issue: 4029 / Categories: Comment & Analysis , Arctic Systems , Jones v. Garnett
MIKE TRUMAN looks at how the decision on Jones v Garnett affects the other areas where HMRC believe the settlement provisions apply.

YES I KNOW. 'Not another article on Arctic Systems'. Well, sort of. There has been a lot of discussion about the implications for cases that are more or less on all fours with the judgment, but I have not seen much about the ones that are not. Yet the Revenue's original assertion in Tax Bulletin 64 was that there were many situations covered by the legislation. So has the case given the Revenue comfort, or can taxpayers take some heart?
The guidance in Tax Bulletin 64 was eventually combined with other material into A Guide to the Settlements Legislation for Small Business Advisers, and it is to that version that this article relates. This included, in Annex A, a list of 'Examples where the settlements legislation does apply' and of 'Examples where the settlements legislation does not apply'. Not, note, where it is believed to apply or where the Revenue consider it applies — just 'where the settlements legislation does/does not apply' …
Each of the examples is based on the analysis given earlier in the guidance note of particular areas of dispute about the settlement legislation. In the rest of this article I want to consider several of the examples, see what principles earlier in the note underpin the assertion that the legislation does or does not apply, and then to see whether the case sheds any light on this assertion. Although the legislation has now been included in ITTOIA 2005, the references to TA 1988 are used here, as they are in the guidance.

Settlors

Example 1 reads as follows:

'Mr X is the director and owns all the 150 issued ordinary £1 shares of X Ltd. X Ltd issues 100 new ordinary £1 shares which are acquired for £100 by the X Family Trust. The trust has been established for the benefit of Mr X's family by his father, Mr X Senior, who created the trust by settling cash of £100. Shortly after the issue of the new shares, a dividend of £100 per share is declared and paid and the trust receives dividends of £10,000. Mr X controlled the arrangement for the issue of the shares at par followed by the dividend. Mr X is therefore the true settlor of the settlement …'

The basis of this example is the case of Crossland v Hawkins [1961] 39 TC 493) which is mentioned, although not highlighted, in the guidance. This case appears to have formed the basis of Park J's reasoning in Jones v Garnett — he even considers how to get from the former to the latter case one step at a time. Unless the case is won by the taxpayer at the Court of Appeal, or a significantly different reason is given for upholding it, it seems that the Hawkins case is likely to be the most important precedent for these types of arrangements. Unfortunately it is a case that took a very broad view of the legislation, perhaps unusually for its time, and which offers very little comfort for the taxpayer. 
Example 2 looks at reciprocal arrangements — where a gift from X to the child of Y is matched by a gift by Y to the child of X. Again the analysis of Crossland v Hawkins would support the view that the Revenue is right that the settlors here are the parents for their own children. These arrangements used to commonly be found lurking in the affairs of taxpayers who got advice from 'a friend down the pub' back in the days of tax deductible covenants.

Example 10

Many of the following examples are uncontentious, until we get to Example 10, which reads as follows.

'Mr C is the sole director and owns all the 1000 ordinary £1 shares in C Limited. His aunt, Mrs D, has always been very kind to him and he wants to thank her for this. He subscribes, at par, for 100 B shares, with no voting rights and restricted rights to capital of £10 per share in the event of winding up. He gifts the shares to Mrs D. Mr C then declares a dividend of £100 per share with Mrs D receiving dividends of £10,000.'

The Revenue conclude that this is a settlement and that the income remains Mr C's. The guidance deals with this in two different ways.
The first is that the whole arrangement must be considered:

'It is essential to look at the whole arrangement when considering whether the settlements legislation applies. This could include a series of transactions, some of which may be commercial or involve outright gifts between spouses. If the overall effect of the whole arrangement is to transfer income from one individual (the settlor) to, say, the settlor's spouse or unmarried minor children, the settlements legislation is likely to apply.'

This received strong backing in the case. Park J was dismissive of arguments that the arrangement was to be construed in any narrow way, in particular emphasising that all the elements of the arrangement did not need to be set in stone from the start in order to create it.
However, the more contentious issue is the person for whom the settlement was created. The example has Mr C creating a settlement for his aunt, Mrs D. Creating a settlement for your aunt does not bring you within the settlement provisions, but the Revenue's view is that Mr C has retained an interest in the property. In the analysis of the example, this is explained as follows:

'Because he is in effective control of the company Mr C retains an interest in the underlying property as he could simply pay all future income arising to himself as director's salary or as dividends on the ordinary shares.'

This argument is fundamental to HMRC's attempts to extend the settlement legislation further than husbands and wives. It does not appear to have been raised in the case, but it is implicitly rejected by Park J, although it is not clear whether this is a deliberate comment on the Revenue's known views. It comes to light in his comment on the inclusion of the words 'or his spouse' in the legislation, which he appears to feel are anachronistic in the days of independent taxation, even though he believes that he has to deal with them as they stand.

'Second, in my view the modern principle that a husband and a wife are taxed separately from each other may mean that it would be more appropriate for the words “or his spouse” not to be included in section 660A(2). After all, if Mr Jones's co-shareholder was not his wife, but (say) his sister, he could not be taxed on her dividends.'

Similarly if she was his aunt he therefore could not be taxed on her dividends. More importantly, if she was his unmarried partner he could not be taxed on her dividends. HMRC might want to claim that the point had not been argued before the court, and it is certainly true that the comment is clearly obiter, but it does suggest that they may not be on very strong ground when trying to argue from the basis of the settlor retaining a right rather than the income going to the spouse.


Dividend waivers

Example 13 is on dividend waivers:

'Mrs H owns 80 ordinary shares in H Limited. Mr H owns 20 shares. In 2000 the company made a profit of £25,000. Mrs H waived her right to any dividend. The company then declared a dividend of £1,000 per share, and Mr H, who had no other income, received a dividend of £20,000.'

The analysis is that this is a settlement because the company could not have paid the dividend of £1,000 per share if the rights of Mrs H had not been waived. I have never understood why this is important. Mr and Mrs H are entitled to split the profits 20/80. Any waiver by Mrs H which is not matched by Mr H will mean that Mr H gets 'more than he should', and there is therefore bounty. If the dividend was £100 a share, so the total dividend would have been £10,000 (and therefore within the available reserves), and if Mrs H had waived her rights, Mr H would have received £2,000 unmatched by any payment to Mrs H. In the future, any subsequent dividend would start from a position of 20/80 (although the Revenue would not allow the reserves created by this waiver to justify another one). So Mr H has received £2,000 of 'bounteous' income through an arrangement of which his wife is the settlor, and therefore s 660A should apply.
The case does not look specifically at this point, but the way that Park J modifies the steps of Crossland v Hawkins seems to offer similar possibilities here. Suppose it was reasonable, on the basis of the work put in, that Mr Jones should have 75% of the shares and Mrs Jones 25%. Suppose in the first year they make £100,000 profit after tax, Mr Jones waives his dividend, and Mrs Jones receives £25,000. The next year they make a net £35,000 loss after tax. There is no waiver this time, but the remaining reserves are voted out as dividend, £30,000  to Mr Jones and £10,000 to Mrs Jones. In total, Mrs Jones has received more than half the dividends paid out, when she is only entitled to 25%. Does it matter, Park J might ask, whether this has arisen from giving her an uncommercial shareholding or from giving her a commercial shareholding but from waiving dividends? He might well conclude that it does not, and that the settlement legislation therefore applies.

Going rate

Examples 18 and 19 are also worth looking at. The situation outlined is unnecessarily complicated, but the crux of it is that initially Mrs V is the sole director and shareholder of V Ltd, which pays her £25,000 as a director's salary (assumed in the examples to be the market rate) and has profits available for distribution of £24,000, of which £20,000 are actually distributed to her as dividends. Both examples deal with what happens in the following year when her husband becomes an equal shareholder and starts to do some part-time work for which he is paid £5,000.
In Example 18, her salary is cut to £10,000, and there is £40,000 available for distribution as dividends, £20,000 to each taxpayer. The Revenue argues that this is a settlement, because Mrs V's earning power has effectively been diverted to Mr V. The £20,000 should therefore be reported as Mrs V's settlement income.
However, Example 19 leaves her salary at the commercial rate of £25,000. For some reason the amount available for distribution is now £20,000 (it should surely be £25,000?), and again they each get half. In the Revenue's view, this has changed nothing. Some of Mrs V's earnings have been paid to Mr V, and therefore there is a settlement. The explanation goes on to say that 'Two of the key elements in the arrangement are that the expertise and earning capacity of Mrs V have been provided to the company at undervalue and Mr V is paid a market rate for his work'.
Whilst this sounds like the comment Park J made about market value salaries, it is in fact crucially different. In the Revenue's original view, provided the donee was being paid a market rate for the work, the settlement legislation could apply. In the judge's view, if the DONOR is being paid a market rate for the work, the settlement legislation CANNOT apply.


 
Partnerships

Mr Justice Park's reworking of the facts could also be  applied to Example 21, which is similar to the 'non-working spouse' cases, except that here there is no company; instead it is a 50/50 partnership. Does it matter that a partnership is used instead of a company?
There is, of course, a reasonable argument that partners are not in the same position as limited company shareholders. They take on unlimited liability, for example. However, 50/50 split partnerships do seem to have problems if the decision in Arctic Systems is upheld — it is fair to argue that the 'non-working' partner is taking on responsibilities anyway, but they cannot be rewarded at the same rate as the working partner without generating bounty, since the working partner has the same responsibilities but also does the work that generates the income.

Companies with capital

Unfortunately, there are equally problems with some of the situations where the Revenue has said that the settlement provisions do not apply:


'Example 24 — Company with subscribed shares
Mr M is the sole director and owns all the 100 ordinary shares in M Limited, a small manufacturing company. The company employs 10 people and owns a small factory, a high street shop, tools fixtures and fittings and 3 delivery vehicles. Mr M draws a salary of £30,000 each year and receives dividends of £20,000. Mr M then gifts 50 shares to his wife who plays no part in the business. Mr and Mrs M then each receive dividends of £10,000.
We would not seek to apply the settlements legislation to the dividends received by Mrs M. This is because the outright gift of the shares cannot be regarded as wholly or substantially a right to income. The shares have capital rights and the company has substantial assets so on the winding up or sale of the business the shares would have more than an insubstantial value.'

This does not appear to agree with the analysis of what was s 660A(6) in the case. Park J does not rely on the right being wholly or substantially one of income, although he does accept this as a secondary ground for upholding the Commissioners' decision. His main ground, however, is that the arrangement is more than an outright gift.
The question is whether Example 24 contains an arrangement that is more than an outright gift, and we are not given enough information to know. We need to know whether Mr M's remuneration of £30,000 and remaining dividends of £10,000 are 'the going rate' for the work that he is doing. If they are not, then it seems highly arguable that the arrangement is still the agreement of Mr M to work for less than the going rate combined with the gift of the shares and the payment of dividends. In that case, the capital value of the company is irrelevant, the test of 'outright gift' has been failed, and s 660A(6) cannot apply.
This is particularly important for those who sought to avoid the provisions by introducing significant capital assets into the company. Again, if the creation of dividends for the 'donee spouse' is by means of the 'donor spouse' working for less than the market rate, the whole arrangement is more than an outright gift, and the settlement legislation should apply. The same is true of Example 31, which is a two-man second-hand car dealing partnership with significant capital assets into which the non-working spouses are admitted as equal partners. Since the profits are £100,000, and the partnership employs 'a number of salesmen and office staff', it is unlikely that £25,000 per working partner is the 'going rate'.

Keep quiet

Why have I gone through all of this — in particular why have I highlighted the areas where the Revenue might be able to tax even more businesses under the settlement legislation? Partly, yet again, to illustrate how wrong Park J's statement was that this 'is a simple application of well-established principles', since it is clear that the Revenue did not understand them either. But also to point out that, if this case is not overturned, the only reason that companies with significant assets will escape charge under the settlements legislation will be because the Revenue chooses not to apply it. And we've been there before.

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