A quick guide to S660A Settlements Legislation

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(December 2005 – post Arctic Systems appeal in Court of Appeal)

Shortly after our May 2005 guidance was published, an appeal was announced against the High Court decision. 

The Court of Appeal published its judgement on 15 December 2005, and overturned the previous decisions at the Special Commissioners and High Court. 

This currently puts the law back to how the accountancy and tax profession had understood it to be for the last century or so – up to 2003 – which was that issuing / gifting ordinary shares in a company, by itself, did not represent a settlement. 

 The most common example of this – and the one effected by the Arctic Systems facts – is shares in a family company being owned jointly by husband and wife, even if one of their contributions to the business are unequal.

 So, for now, spousal shareholdings are allowed again, with their attendant tax savings (in this context spouse includes common law and civil partnership arrangements). 

 The Court of Appeals judgement is through and unambiguous, but HMRC/Government have the possibility of appealing to the House of Lords or enacting legislation in the next finance act.  In his opinion, Lord Justice Carnwath, one of the judges said, “… If the legislature wishes such an arrangement to be brought within a special regime for tax purposes, clearer language is necessary to achieve it.”

 Practical strategies:

 - On HMRCs original, now overruled interpretations, see the guidance below, only a minority of companies were effected – the key criteria being (i) shares being distributed in a manner disproportionate to involvement and (ii) the company not having substantial assets.  Leg (ii) means many, indeed most, family companies would not have been effected (contrary to press reports at the time).  The prime candidate for being effected by the legislation would have been so called “personal service companies” (PSCs) – companies which largely exist to sell the services of one person.

 - for now its sensible for all PSCs to revert / initiate spousal shareholdings.

 - there may be further developments during 2006 dependant on any further court action and/or legislation.

MAY 2005
post Arctic Systems Appeal

S660A ICTA 1988, known as the settlements legislation, is intended to counter perceived tax benefits from giving away income streams to others.

The section has been on the statute book since the early 1900s, but to date has been very rarely invoked by H M Revenue & Customs. In early 2003 this changed – although the change was initially unpublished – as rumours started to circulate in early 2003 of the clause being invoked and large back tax bills being levied.

A test case (Arctic Systems) went before the Special Commissioners (a tax equivalent of a Magistrates Court), and then on to appeal. Both the Special Commissioners hearing and the subsequent appeal were won by H M Revenue & Customs.

Who is affected? Potentially any situation of a family company (including common law relationships and relatives other than spouses) where shares have been distributed in a manner disproportionate to involvement in the company.

Some practical examples are given later in this document.

The details. H M Revenue & Customes state that the settlements legislation is “intended to prevent an individual from gaining a tax advantage by making arrangements which divert his or her income to another person who is liable at a lower rate of tax or is not liable to income tax” (IR Tax Bulletin 64- April 2003)

It therefore is only applicable where income is diverted. As a matter of law – and the Inland Revenue and the Tax Profession agree on this – where an asset is given away on a genuine basis then the income stream arises from the asset and not from a diversionary tactic, and the settlements legislation cannot apply.

What has brought this issue to prominence recently is that the Inland Revenue’s view on what constitutes a genuine gift of an asset (OK) and what is a diversionary tactic (not OK) has changed. Or at least seemingly has changed, as there was initially no public announcement, no new case law and no new statutes. After the issue started bubbling in Spring 2003 some guidance was published in the IR Tax Bulletin 64 (http://www.inlandrevenue.gov.uk/bulletins/tb64.htm) but this does not mention any change in the H M Revenue & Costoms policy – without exception this has been condemned as devious by the Tax Profession – no change in legislation, no new case law, no new guidance until pushed – just a decision to enforce the rules differently!

The analysis by the Inland Revenue in Tax Bulletin 64 is disputed by the Tax Profession, including leading Tax Counsel. Sadly the Courts have upheld H M Revenue and Customs interpretation.

Practicalities of who is effected In practical terms those effected are situations where a company’s revenue is largely derived from the intellectual capital of one of its shareholders, but other shareholders benefit. A partnership situation can also be caught. The other shareholders will normally be related, eg husband and wife (including common law), or other family connections.

The Arctic systems test case concerned a situation, which many reading this will recognise, of a Husband and Wife with a personal service company. Husband is an IT consultant and brought in all the company’s revenue, and his wife carried out administration and bookkeeping for the company. They each drew low salaries and the remainder of the company profits as joint dividends. HM Revenue & Customs alleged that this was a settlement by husband on wife (a form of trust), and as such the income (dividends) were taxable on him. The Court agreed.

The Court also went on to say that not all husband and wife businesses are caught in this way, the judge specifically stating “If a husband and wife set up a joint company and run it together, for example the company opens a shop and the couple run and staff it, it does not follow from my judgement in this case that the husband is going to be taxed on the wife's dividend."

So, what situations are caught and what are potentially acceptable. The following extract from HMRC Tax Bulletin 69 (February 2004) is probably a clear example of how HMRC see the rules working:

Example 5 - Partnerships Mr F and Mr G are in partnership as second hand car dealers. They do not have any premises but buy and sell cars through auctions and the classified adverts of local papers. The partnership's only assets are some office equipment worth less than £1,000 and they usually have a couple of cars in stock at any one time. They are successful and the profits of £80,000 a year are split equally between them. They decide to admit their wives to the partnership and amend the partnership agreement in order to split profits equally four ways. Mrs F and Mrs G do no work in the partnership and the partnership has no employees. This is a bounteous arrangement transferring income from one spouse to the other. The settlements legislation will apply and Mr F and Mr G continue to be taxable on half the profits each.

But compare to:

Example 22 Mr Alpha and Mr Beta are in partnership as second hand car dealers. They own the freehold premises through which the partnership trades (valued at £200,000) and routinely carry a stock of 50 used cars. The business is successful and has established goodwill in the locality as a reliable trader. It employs a number of salesmen and office staff. Profits of £100,000 a year are split equally between the partners. They decide to admit their wives to the partnership and amend the partnership agreement in order to split profits and capital equally four ways. Mrs Alpha and Mrs Beta do no work in the partnership. Although this is a bounteous transaction it is an outright gift that is not substantially a right to income and is excluded from the definition of settlement by section 660A(6).

Put simply if any of the following traits are present, then its unlikely that the settlements legislation will apply:

If the following traits are present, then it is likely the settlements legislation will apply:

Commercial remuneration – During the Arctic Systems appeal the Judge also made reference to the 'market salary'. He said: "It is also an important feature of this case that Mr Jones provided funds directly or indirectly for the purpose of the 'settlement' by working for Arctic Systems in return for a salary below his true earning power.”. He went on to say “It will be far harder for the Revenue to establish that there is a 'settlement' or 'arrangement' of which the husband is the 'settler' if he is paid the going rate for employees carrying out the sort of work which he does."

The immediate response to this is increase the main shareholders salary to a so called “commercial” level. Alas its not so simple as this – meet, Reg, Jane and Frank…

Reg is an IT consultant, operating via a PSC. He is married to Jane who does his books and administers his business. Reg is currently on contract at Mega Bank, and sits next to Frank who does the same type of work as Reg but as permanent staff (ignore the fact this is disastrous for Reg’s IR35 status). Frank is on a salary of £60,000 pa, whereas Reg invoices £2,000 per week before vat.

Currently Reg and Jane have taken their accountants advice, and pay themselves a small salary and draw the rest of the company profits as dividend on a 50:50 split.

They decide post the Arctic Systems judgement that Reg should take a commercial salary, and seek their accountants advice. Their accountant scratches her head and says, “Well, depends on what you mean as ‘commercial’...”. Why the uncertainty – isn’t Frank a good comparator as a commercial salary level? Well, maybe, but there are a number of options for commercial salary:

The point is Reg and Frank may do a similar type of work, but their circumstances are different. Frank has security of employment, Reg doesn’t. Reg has his own company any the ability to offset expenses, take on other work, has to provide his own training, equipment and insurance, Frank doesn’t.

So, in fact, its very unclear exactly what the “commercial salary” would be for Reg.

Lets put some figures on things:

So, in summary, the best option for Reg is to ignore the temptation to pay a “commercial salary” and simply take his wife off as a shareholder. Even if HMRC accept his assertions about “commercial salary”, he is best off keeping salaries low and forgoing spousal dividends, and if they don’t accept his assertions then he is even worse off.

Drop the dividends and keep the spouse salary? – In all probability this is a safe option. In many parts of the country £10 per hour isn’t an unreasonable hourly rate for a bookkeeper / secretary / PA, and if the spouse salary is set to Personal Allowance level of £4,800 pa then this equates to 10 hours a week/48 weeks a year – a bit high for doing the books/raising an invoice/answering the phone/trawling jobserve, but probably not so far off for HMRC to challenge it.

The comments and advice in this briefing are general comments for Garbetts clients only, and personalised advice should be sought on any area of doubt.

Garbetts Chartered Certified Accountants

E-mail: office@garbetts.com

Arnold House, 2-6 New Road, Brading, Isle of Wight, PO36 0DT.
Telephone: 01983 400350. Facsimile: 01983 404016.