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KEY POINTS:
- Tax Bulletin 64 was much wider than husband and wife companies.
- Why did the Revenue not consult on changing the law in 2006?
- Was there a deliberate attempt to create uncertainty?
- The line between unacceptable avoidance and legitimate planning.
The answer to the question at the top of the page may seem obvious; what HMRC know now is that the House of Lords has found in favour of Mr Jones. As a result of that finding, they now feel that they need to change the law in order to prevent income splitting.
But consider a couple of statements from the dim and distant past — Tax Bulletin 64 (TB64), the guidance originally given by the then Inland Revenue when the issue of applying the settlement legislation to husband and wife companies first arose.
'It is a common misconception that the settlements legislation applies only to arrangements involving a settlor's spouse or minor children. However, section 660A(2) makes it clear the settlor is treated as having an interest in property if “that property or any derived property is, or will or may become, payable to or applicable for the benefit of the settlor or his spouse in any circumstances whatsoever”. It is not necessary for the settlor's spouse or children to be the people to whom the income is transferred. If the settlor or their spouse retains an interest in the property then the legislation can apply.
'It is necessary to look at the arrangement as a whole. If there is a bounteous arrangement which effectively transfers income earned by one person to another resulting in a reduction in overall tax liability, the arrangement may be liable to challenge under the settlements legislation.'
Husband and wife
The Arctic Systems case was taken on the basis that the income had been transferred to Mrs Jones by Mr Jones. It therefore fell squarely within the words of s 660A(2) provided it was a settlement at all, because it was income that arose for the benefit of the settlor's spouse. Indeed, the House of Lords held that it did fall within this section, but then held that it was exempted under s 660A(6).
Throughout the case, the applicability of subsection 2 was never in doubt if the arrangements constituted a settlement, because Mr and Mrs Jones were married. So how did the Revenue in TB64 conclude that the section could apply to those who were unmarried? Here is the example that they reference:
Example 2 — Gifted shares with restricted rights
'Mr C is the sole director and owns all the 1,000 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.
'This is a bounteous arrangement and we would apply the settlements legislation to the dividends. The property giving rise to the dividends cannot be looked at too narrowly as the shares alone. The wider arrangement must be considered. 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.'
Some elements of this argument were present in the initial decision of the presiding Special Commissioner, Dr Nuala Brice, who laid significant store on what she saw as the controlling position of Mr Jones as the sole director. However, Mr Justice Park, in finding conclusively for the Revenue in the High Court, made it clear that if Mr and Mrs Jones had not been married there would have been no liability under s 660A.
Arguably at that point, and certainly by the time they lost in the Court of Appeal at the end of 2005, the Revenue could not have been under any illusions that they were going to get a judgment which was wide-reaching enough to encompass unmarried partners. Apart from anything else, in order to have any chance of achieving it they would have to have run the argument that the settlement should be considered on a year by year basis, deciding each year whether Mr Jones was effectively giving up some of his income to Mrs Jones. Although the argument was raised in the House of Lords, Lord Hoffmann said that it was not pursued with any vigour.
Ministerial statement
Now look at the ministerial statement made the day after the judgment:
'Some individuals use non-commercial arrangements (arrangements that they would not reasonably enter into with an arm's length third party) to divert income (which would, in the absence of those arrangements have flowed to them) to others. That minimises their tax liability, and results in an unfair outcome, increasing the tax burden on other taxpayers and putting businesses that compete with these individuals at a competitive disadvantage.
'It is the Government's view that individuals involved in these arrangements should pay tax on what is, in substance, their own income and that the legislation should clearly provide for this.'
Note that there is no mention here of husbands and wives, it simply refers to 'individuals'. There is no reference to not receiving market rate salaries, or to the method of splitting the income. But it does bear a remarkable similarity to the passage quoted above from TB64, particularly when you also consider another sentence from TB64 which read:
'A good test of whether or not the legislation could apply is to consider would the same payments be made to a person who acquired shares in a company or a share of a partnership at arm's length.'
That turned out to be an entirely inaccurate summary of what the settlement provisions, as interpreted by the House of Lords, actually said. It appears, however, that it is still an entirely accurate summary of what HMRC think the law SHOULD say. We will no doubt return to that in later issues of the magazine as the consultation process begins, but TB64 includes gifts of shares by those who run the business to unmarried partners and relatives, patnerships where some partners get more than would be commercially expected for the work they contribute, and 'dividend waivers' effected by means of separate A and B shares.
When to consult
What I wanted to concentrate on in this article is the way that the issue has been dealt with by HMRC during the course of the Arctic Systems case. Because, if it was obvious to them by the start of 2006 (as it surely must have been) that legislation would be needed to correct the 'unfairness' which they still consider the transactions covered by TB64 to constitute, why didn't they announce it then? They were clearly going to have to change horses, because case-law was not going to win it for them. At some point they were going to have to switch to legislation, so why not announce it earlier?
As Francesca Lagerberg commented in her recent article 'Arctic chill' (see Related Links above) there was a forum for discussing the issue of small business taxation set up in 2004, which raised hopes of a thorough review of the subject, but it seems to have fallen by the wayside.
Why did HMRC not announce in 2006 that, in view of the conflicting decisions and arguments already raised in the case, they intended ultimately to legislate in order to create clear liabilities, and that the discussion about what the legislation should say would take place at the same time as the appeal process, so that legislation could be introduced as soon as possible after it finished? At the same time, they could then have admitted that Arctic Systems was indeed a test case, something they signally failed to do through to the House of Lords decision, but which is implicit in the guidance subsequently given about how outstanding cases will be settled.
Accidental or deliberate?
The question it raises in my mind is whether it was accidental or deliberate. I can imagine that HMRC might have thought that to start making proposals about how the legislation should be changed before the case was final would be to invite accusations of prejudging it, but it is hard to see how such an argument would have held water. It is common for judgments in cases on avoidance to start their review of the legislation with the comment that the law has subsequently been changed, and no-one finds that surprising.
The biggest complaint from the profession during the course of Arctic Systems was that practitioners were having to make long-term decisions about the way that their clients' affairs should be organised without knowing what the tax position would be. It was generally accepted that there would be a change in the law if the Jones's won, and although it would have been too much to hope that announcing consultation and intended change back in 2006 would have been welcomed with open arms, it would probably at least have been met with resigned acceptance and a feeling that at least we were moving towards certainty.
The other, rather more unpalatable, option is that uncertainty actually suited HMRC. The tone of the ministerial statement makes it clear that they consider this sort of arrangement to be unfair tax avoidance. At the time of the Court of Appeal case, Dave Hartnett had announced that he intended to make tax avoidance 'not worthwhile' by 2008. If companies splitting income was considered to be tax avoidance, perhaps the best incentive that advisers could be given not to stray from the commercial path was to leave complete uncertainty about how any change was to be effected, thus forcing them to be conservative in the recommendations they made to clients?
Avoidance attack
If the attack on tax avoidance was at the root of this decision (and I would be interested to publish any response that HMRC want to give on that subject), then it is worth looking at the causes of that attack. Looking back at some of the evidence Dave Hartnett has given on the subject, particularly to parliamentary committees, it seems his views on the subject were crystallised during that long game of cat and mouse over the payment of bonuses in ever more esoteric forms after the removal of the NI threshold for employer contributions.
First there was payment in gilts, then unit trusts. After that, gold became the most popular commodity, and then platinum sponge. He has commented before about the increasing artificiality of these transactions, and that if all those who were given the right to acquire platinum sponge had actually taken delivery of it, there would not have been any left to put into the catalytic converters of cars, which is what it was meant for.
In fact, no-one ever did take delivery; they simply sold it back through the arrangements made by the scheme provider. Most of the people whose bonuses were paid this way probably could not tell you what platinum sponge looked like; even though I have confidently written about it in a tax context, I certainly couldn't.
Artificial ethics
I was in practice during that time, both as a tax adviser and an IFA. In the early days, I put through some purchases and transfers of cash unit trusts when that was still seen as effective. I would have justified it at the time on the basis that no-one was obliged to pay more tax or National Insurance than the law provided, that the view at the time (unchallenged by the Contributions Agency) was that Furniss v Dawson did not apply to NIC, and that it was up to Government to get the legislation right.
I am not sure I feel the same way now about completely artificial schemes such as this. The D'Arcy case showed that approaching them by blocking off each loophole as it arises may be ultimately impossible, because each set of anti-avoidance provisions creates more interactions which themselves may give rise to further loopholes. I do now think there is an ethical dimension to tax avoidance (as opposed to evasion) and that the profession needs to be talking to HMRC on that basis — although HMRC need to understand (as I have said before) that the greatest pressure for tax avoidance comes from clients.
In such artificial cases, I have no problem with HMRC acting in a way which, without abusing their powers, makes life difficult for the scheme providers. Those who rely on a step-by-step interpretation of the law should not be surprised, for example, when the mechanics of their schemes are taken apart and examined step-by-step to see whether every nut and bolt was firmly screwed together.
Planning and avoidance
But Arctic Systems was not such a case. It was a decision about how a business should operate which had lasting commercial implications, Mr and Mrs Jones and their accountant undertook the perfectly proper process of looking at the choices on offer and choosing the one which gave the lowest tax liability. We all make choices, as households, about who will make the charitable donations, the pension contributions, who will own the income producing assets, and so on. That is not artificial tax avoidance; that is organising our affairs, in a real rather than an artificial way, to make the best and proper use of the opportunities available to us.
If it is the case that HMRC's attitude to Arctic Systems (and the legislation that was going to be needed after it) was based on treating it as artificial avoidance and therefore to extend the uncertainty, then it seems to me to have been an own goal. There are going to be many views about where the line should be drawn between artificial, unacceptable, avoidance and legitimate tax planning, but to call this case avoidance is to deny that such a line exists at all. Unless HMRC are prepared to see the distinction, it is hard to see how any consensus with the profession can be reached.
