A construction too far?

KEY POINTS

• Most of shares given to wife had no voting rights.
• Young v Pearce claim by HMRC that there was a settlement.
• Judge found that there was a constructive trust.
• Major change of law, which was not argued by counsel.

Credit where it is due: I must thank Tim Good, speaking at the CIOT’s residential conference in Warwick, for drawing my attention to the case of Patmore (TC619) and the – shall we say ‘novel’? – doctrine contained in it.

To give you an indication of its importance, it probably means that virtually every tax return you have completed so far this year for companies owned by husbands and wives is likely to be technically incorrect (assuming the decision stands).

We reported the case briefly last week in Tax Case News; I want to look at it in more depth and explain the implications here.

Facts

The facts are not at all unusual. C Ltd was a company founded by a Mr Henson, who owned 75 of the 100 ordinary shares in issue. His wife owned another eight and his two children owned one each. The remaining 15 shares were owned by another director, Mr Patmore.

Mr Henson wanted to sell up, and Mr Patmore agreed to buy him out. The sale agreement, entered into in January 2000, provided that Mr & Mrs Henson and their two children would sell all their 85 shares, and that Mr & Mrs Patmore would buy them.

Mr Patmore was to get 83 of the shares and Mrs Patmore two. The total consideration was £100,000 on completion in January 2000, and then two further payments of £100,000 each on 1 October 2000 and 1 October 2001. The liability for the consideration was joint and several, but only Mr Patmore gave a guarantee in a separate deed, assigning a life policy as security.

The first payment was met by a mortgage taken out by Mr & Mrs Patmore on their home, and the final two payments were met by dividends paid from the company.

Despite the finding that the liability for the payment was joint and several, the accountant said that Mrs Patmore only received two of the 85 shares in order to protect her from liability on the cost of the remainder.

In order, he said, to pay her a fair share of profit, the existing ordinary shares were renamed as A shares, and a new class of non-voting B shares were created, with ten being issued to Mrs Patmore.

Approximately £20,000 a year was paid in dividends on the B shares, the payment of dividends on the A shares was more erratic.

Settlement provisions

Whatever the reason, this must have looked to HMRC remarkably like the case of Young v Pearce [1996] STC 743. The key difference between this case which the taxpayers lost, and Jones v Garnett [2007] STC 1536 where the taxpayers won, was that Mrs Jones received ordinary shares in Arctic Systems Ltd, carrying full voting rights.

This brought her within the exception to the settlement legislation in what was then TA 1988, s 660A(6). Mrs Pearce, by contrast, was given non-voting shares with no right to participate in the surplus at a winding-up.

The exception in s 660A(6) only takes effect if the gift is not one which is ‘wholly or substantially a right to income’; Mrs Pearce’s shares could give her virtually nothing but income, whereas Mrs Jones’s shares gave her an equal share of the company with Mr Jones.

Barbara Mosedale, the tribunal judge, gave a convenient summary of her conclusions on the intentions of the parties in Patmore in para 35 of her decision:

‘We find that the agreement was that Mrs Patmore, in return for her equal investment with her husband, would get far fewer shares than him and have no control over the company but that she would get a much more equal share of the dividends. Nevertheless these dividends would be at the discretion of Mr Patmore, and in the event I find that they were only paid to Mrs Patmore on the understanding she would pay them to Mr Patmore.’

It is worth noting, however, that there is no indication that Mrs Patmore actually had to perform any significant duties, as opposed to Mr Patmore who ran the company.

Furthermore, although she was equally liable on the purchase agreement (contrary to the expectation of the accountant), Judge Mosedale found that the original intention was that dividends would be paid on the B shares and used to repay the mortgage, since that was Mrs Patmore’s prime concern.

When the company did not do as well as was expected, she agreed to pay the dividends to Mr Patmore so that the stage payments to the Hensons could be made.

However, the intention (as opposed to either the reality or the outcome) of the original agreement appears to be that Mrs Patmore would only be at risk to the extent of the mortgage on the joint property, and then only for five years or so until the dividends could be voted to pay it off.

Commercial transaction

HMRC’s claim was that either the B shares were settled on Mrs Patmore by Mr Patmore, or that the payment of a dividend on the B shares without a matching payment on the A shares constituted a settlement each time it occurred.

In both cases, HMRC contended, the exemption in s 660A(6) did not apply, because in the first the B shares had no significant capital rights, and in the second the settlement was one of pure income.

The taxpayer’s defence to both was that this was an entirely commercial arrangement with no gift element (no ‘bounty’; a term disapproved of in Jones v Garnett, but for which there seems to be no acceptable substitute); indeed that this was the reason for creating the B shares in the first place – an external shareholder would have required a separate class of shares with a separate income stream.

This was quickly disposed of by Judge Mosedale – an external shareholder would also have demanded a guarantee of priority dividends.

However, Judge Mosedale equally did not agree with HMRC that there was ‘an element of gratuity’. HMRC founded this on the fact that she held 11% of the share capital (most of that non-voting) and yet received more than 40% in total of the dividends paid over the four tax years under consideration. By contrast, Judge Mosedale’s view was that:

‘I struggle to see any element of bounty by Mr Patmore. Mrs Patmore was jointly liable with Mr Patmore on the mortgage and Henson debt.  She contributed equally to him in the purchase of the 85 shares. In return, she was given a mere two shares and was later allotted ten B shares with no rights to a dividend.’

There must be a question as to whether she was intended to contribute equally; the judge seems to have equated joint and several liability with equal contribution. In practice, it seems to have been the intention that the purchase price would be met entirely by funds derived from the company, so her contribution was limited to taking some risk that it would all go wrong.

Nevertheless, it is a fair point that, at the time the dividends were paid, she was bearing an equal capital risk to that of her husband. Had the decision simply been that the element of bounty was therefore not present, the case would have been interesting but not unusual.

Constructive trust

What marks it out is the step Judge Mosedale then took. On her own initiative, and apparently without the benefit of detailed argument from counsel for HMRC (the Patmores were represented by their accountant), she decided that the purchase of the company was a joint enterprise, and that there was therefore a constructive trust in Mrs Patmore’s favour over 40.5 of the original ordinary shares, giving her an equal shareholding with her husband.

As such, the dividends should have been reported in equal shares on their tax returns.

Now constructive trusts are a topic of some considerable judicial authority, both in the UK and in other common-law jurisdictions. In some of those jurisdictions, the concept of a ‘remedial constructive trust’ has been developed as a general doctrine, but the UK appears to have generally rejected this approach, although Lord Denning (who else?) did start to head down this route in the 1970s.

Instead, according to Halsbury’s Laws of England, English law only recognises certain categories of constructive trust, such as mutual wills or the common intention to share ownership of land. The common intention to buy shares does not appear to be one of them.

The importance of this is that, if this ‘Mosedale doctrine’ is correct, the totality of the funding for the acquisition of shares or capitalisation of a company needs to be considered where it is set up as part of the financial arrangements of a husband and wife.

The percentages in which the shares are held by the two of them will be irrelevant, it will be the relative contributions they have made which have to be followed.

Where now?

Needless to say, this would make the taxation of such dividends almost impossible to handle. It would also be, so far as I can see, a novel extension of the accepted categories of constructive trust. It is therefore highly surprising that a First-tier Tribunal judge was prepared to make such a far-reaching decision.

The question is whether it will go to appeal. HMRC have lost the case, but they might well lose on appeal anyway, if it is decided that the contribution of Mrs Patmore is enough to negate the element of bounty.

But if it is not appealed, we are left with a major change to the taxation of family companies resting on a decision of a First-tier Tribunal judge who was not aided by the reasoned argument of properly prepared counsel. At the very least, we need an explanation from HMRC of how they intend to view this case.

Can I suggest that they say it ‘appears to be a case decided very much on its own facts’?

Issue: 4274 / Categories: Comment & Analysis , Arctic Systems , Jones v Garnett , Young v Pearce , Income Tax