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KEY POINTS:
- Questions for decision in Arctic Systems.
- Was there a settlement, and when is bounty to be considered?
- Can the shares be the property of the settlement?
- What constitutes an outright gift?
I will be strangely sad to see the end of the Arctic Systems case, or Jones v Garnett as it is correctly reported. The history of the case spans my time so far as editor of Taxation — it was heard by the Special Commissioners in June 2004, shortly before I took over, and it has been a constant fixture ever since. The case is being heard from 5 to 7 June, and Taxation hopes to have full reports of the arguments each day on our website.
However, it is now nearly eighteen months since the Court of Appeal decision, and whilst most people will undoubtedly remember the basic principles at stake, it may be helpful to run through some of the arguments, and some of the decisions taken on key issues, from the earlier cases. In doing so, we can identify some of the questions which the House of Lords has to determine and what the implications of their determination will be for taxpayers.
Facts
Mr Jones had always worked in IT, his wife had previously worked in management. Mr Jones was made redundant one Friday. Over the weekend, they had determined that he was going to work freelance, that to do so he needed to operate through a company since any client would require him to do so, that whilst he had saleable skills in IT he was lacking the management skills to run a company, but that his wife had them and could handle that side of the business.
Using a company formation agent, they set up Arctic Systems Ltd, with Mr Jones as the sole director, and each owning a share. Mr Jones worked full time for clients, operating through the company, Mrs Jones worked a few hours a week running the company. They both received fairly low salaries (except for a period when they thought IR35 would apply when Mr Jones received a much larger salary) and they distributed significant further profits in the form of dividends.
Revenue arguments
The Inland Revenue's argument was that the dividends received by Mrs Jones were settlement income under TA 1988, s 660A. Subsection 1 says that income from a settlement is treated as income of the settlor unless it arises from 'property in which the settlor has no interest'.
Subsection 2 says that the settlor is regarded as having such an interest if the property, or any derived property, may be payable to 'the settlor or his spouse in any circumstances whatsoever'. Subsection 6 excludes from subsection 1 an 'outright gift' from one spouse to another of the property, unless either the gift does not carry the right to the whole of the income, or the gift is wholly or substantially a right to income.
The Inland Revenue's wider argument in such cases, which had been the subject of published guidance, was not only that Mr and Mrs Jones were married, so bringing the references to income of a spouse into play, but also that the people 'earning the money' in such cases had not fully divested themselves of the asset, because at any time they could stop working for the company and retain the earnings from their work themselves.
This argument has yet to make any significant appearance in the case as it has been heard through the tribunal and the courts. It does seem to me that if HMRC intend to apply it if they win Arctic Systems then they need to raise it as an argument in the House of Lords case, so that we get some judicial pronouncement from their lordships on it. Although HMRC have studiously avoided giving Arctic Systems the status of a test case, it would be ludicrous if we had to start this all over again when considering the position of unmarried donors and donees.
Key questions
The key questions in the case were set out by the Special Commissioners. I have not entirely followed their outline below; some of the questions seem to me to be inextricably linked, whereas others need to be split. I have, however, tried to see what the six individuals who have given decisions in this case concluded on the key issues involved.
Was there a settlement?
Settlement is defined widely for the purposes of the Act as including (amongst other things) an 'arrangement'. For the Special Commissioners, Dr Nuala Brice concluded that the whole of what had been done, from forming the company through to paying the dividends, was an arrangement. It was relevant, she said, that as the sole director Mr Jones had the sole right to declare dividends. The element of bounty was the declaration of dividends which went to Mrs Jones when she had already been fully remunerated for her work by her salary.
By contrast, although Judith Powell (the other Special Commissioner) held that there was an expectation that dividends would be paid, there was no obligation for Mr Jones to work for below market rate when the share was acquired, and therefore that there was no bounty at that time (although there was later). Since there was no bounty at the time of the arrangement, it was not a settlement within the section.
Mr Justice Park seems to follow Dr Brice's reasoning almost entirely on this issue; he sees the totality of what happened as the arrangement, and sees bounty as being present, although for him it is more in the allocation of the shares with the intention of paying dividends rather than the actual payment of them — an attempt perhaps to deal with Judith Powell's line of reasoning.
In the Court of Appeal, Sir Andrew Morritt does not even accept that the later elements form part of the arrangement at all. The only arrangement, in his view, is the formation of the company with Mr Jones as the sole director and the issue of the shares. That is not sufficient to create a settlement under s 660G, and there is no bounty. Keene LJ also comments on the issue of the settlement, saying that he initially found the Inland Revenue's argument persuasive, but eventually concluded that it was including within the scope of the arrangement matters which were too uncertain, and that it was difficult to regard such a 'protean' state of affairs as constituting an arrangement and therefore a settlement.
Carnwarth LJ says that this is a transaction in which each partner made a significant commercial contribution (albeit not necessarily an equal one), and for the Inland Revenue to seek to extend the concept of bounty into such an area was a step too far.
It would seem, then that the first question the House of Lords should decide is the degree of certainty necessary for activities to be part of an arrangement at all; and then whether there is an automatic inclusion in 'bounty' of anything that happens within that arrangement, or whether the element of bounty needs to be measured at the time the main elements of the arrangement are put in place.
What property was settled?
The next key question, the fourth as formulated by the Special Commissioners, is what the property of the settlement comprised. Dr Brice says that the share owned by Mrs Jones is the property of the settlement. Although Judith Powell does not consider that there is a settlement, it is clear that she thinks the share would be the property of it if there was. Mr Justice Park seems to think that the question of what forms the property of the settlement is not disputed — it is the share. Sir Andrew Morritt appears to agree with Judith Powell in this area, and the other two judges say very little about it.
Unfortunately all of the judges so far seem to have ignored an argument which Malcolm Gammie has plugged away at for the taxpayers, and which to me is the killer punch. Assume, following Dr Brice's view, that there is an arrangement which constitutes a settlement. The shares in that case are surely part of the mechanics of the arrangement — they are the method by which some of the income gets transferred to Mrs Jones.
In that case, how can they be the property of the settlement? Given that s 660A(1) is not a charging section (a view with which Park J agrees), it must be the income producing asset which is the property of the settlement. But this seems to be no more than the capacity of Mr Jones to earn income, and mere capacity to earn income cannot be charged to tax, otherwise Mr Justice Park would arguably be taxable on the no doubt far larger amount he could have been earning as a QC than he was earning as a judge …
Were there conditions?
If there was a settlement, was the arrangement an outright gift? This brings us to subsection 6, which can usefully be split into two parts, of which the first is a consideration of whether there were conditions attaching which meant that the income could be paid for the benefit of the donor. For Dr Brice, the problem here is that Mr Jones had the right to declare the dividends as a sole director. If that was found to be the ultimate basis for deciding against the Jones's then clearly it would be easy to arrange other companies so as not to fall foul of this case.
Judith Powell, on the other hand, distinguishes this as a matter which may reduce the value of the gift, but which does not affect the outright nature of the gift itself.
Park J sidesteps this issue and says instead that the settlement is the whole arrangement, and that this is not an outright gift. Indeed, there is no one element in the transaction which can be seen as an outright gift, because Mr Jones never owned both of the shares. It is possible that cases where the 'working' spouse owned both shares and then transferred one to the 'non-working' spouse would be in a better position under this analysis.
Sir Andrew Morritt says that, if he had needed to consider this issue, he would have agreed with Park J. Carnwarth LJ treats the problems in understanding what an outright gift is as a justification for being slow to extend the meaning of the provisions.
Substantially a right to income
The final issue to be considered is whether the property given was wholly or substantially a right to income, since it cannot then fall under the exemption in s 660A. For Dr Brice it was substantially a right to income, because (paradoxically) Mrs Jones was only entitled to a dividend if Mr Jones declared one. For Judith Powell, the fact that the shares were ordinary shares that had all their rights meant that they were not simply a right to income. Park J agrees with Dr Brice, although he would base his disapplication of s 660A(6) on the issue of an outright gift instead. Sir Andrew Morritt agrees with Judith Powell, and neither of the other judges at the Court of Appeal takes the point.
Worst of all worlds
Finally, it is worth highlighting what would be the nightmare scenario for Mr and Mrs Jones. It might be held that the whole of what happened does constitute the arrangement and that there is enough bounty to create a settlement. However, it might also be held that the ordinary shares are more than simply a right to income.
The case would then turn on whether there was an 'outright gift', and might come down to what for Park J was simply an a fortiori argument — that there was not even a separate element within the total transaction which constituted an outright gift. The conclusion might therefore be that the cases in which the share had been given to the non-working spouse were safe, but those such as the Jones's where the company was set up that way from the start were not. This only goes to emphasise the issue of costs, and the shoestring on which this case's finances have dangled. I hope that we will not have to worry about that; but if we do, I hope that the response of the profession will be generous.
