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Tolley's Practical Tax by Anne Redston MA(Oxon), FCA, CTA (Fellow)

Anne Redston reviews the High Court judgment in Jones v GarnettIn April 2003 the Revenue announced that they were using the settlements legislation contained in ICTA 1988. ss660A-G to attack certain small husband and wife businesses.

Their position is set out in the April 2003 Tax Bulletin article ‘Businesses, Individuals and the Settlements legislation’ and also in
A Guide to the Settlements Legislation for Small Business Advisers

This approach caused a storm of protest among tax advisers and small businesses. Mr and Mrs Jones, husband and wife shareholders in a small company, Arctic Systems Limited, agreed to act as a test case in the hope of defeating the Revenue attack.

Arctic Systems went to the Special Commissioners in 2004 (Jones v Garnett [2004] Spc 432) and to the High Court in 2005 Jones v Garnett [2005] EWHC 849. In April Mr Justice Park found for the Revenue. This article summarises the key points of the High Court decision.

Arctic Systems

Arctic is owned equally by Mr and Mrs Jones, who each subscribed for one share at inception. Mr Jones was the sole director and Mrs Jones the company secretary. The company’s business was the supply of consultancy services, which were performed only by Mr Jones, but Mrs Jones performed company secretarial and administrative services amounting to some four to five hours a week. In the year under consideration, the company paid modest salaries to both husband and wife; the balance was paid as dividends which were split equally between them.

The question which the courts had to consider was whether the dividend income paid to Mrs Jones was income arising under a settlement made by Mr Jones and so treated as his income under the provisions of ICTA 1988 ss 660A-G.

The Special Commissioners

In 2004 the case was heard before two Special Commissioners. One, Ms Judith Powell, found for the taxpayer, while the other, Dr Nuala Brice, found for the Revenue. As Dr Brice was the presiding Commissioner, she had a casting vote, which she exercised for the Revenue.

A subsidiary issue raised in the High Court was whether Dr Brice had exercised her vote correctly. Malcolm Gammie, for the taxpayer, argued that precedent required that, where the commissioners could not agree, the benefit of the doubt should be given to the taxpayer. This was because the Revenue had not succeeded in bringing the taxpayer clearly within the charging provisions. However, Mr Justice Park declined to rule on the issue, as it would make no difference to the case before him – it was accepted by both parties that the case would have been appealed by the Revenue if the taxpayer had in fact won. This interesting technical point therefore remains undecided.

The main issues

The Revenue argued that the corporate structure whereby:

(a) Mr. Jones was responsible for earning all the income of the company;

(b) drew only very small remuneration; and

(c) substantial dividends were expected to be paid of which half would go to Mrs. Jones on her 50% interest in the company was an ‘arrangement’ within ICTA 1988 s 660G(1), and therefore
ranked as a ‘settlement’ for the purposes of ICTA 1988. s 660A. Mr Gammie disputed this.

If the Revenue were right, then it followed that:

• Mr. Jones was the ‘settlor’ of the settlement within the meaning of ss 660G(1) and (2); the dividends paid to Mrs. Jones on her share were ‘income arising under’ the settlement;

• the property from which Mrs. Jones’s income arose (see s 660A(1)) was her one share in the company;

• the dividends on Mrs. Jones’s share were ‘derived property’ in relation to her share: see s 660A(10);

• within the meaning of s 660A(2) derived property is or will or may become payable to or for the benefit of the spouse of Mr. Jones, the settlor;

• Mr. Jones is regarded by s 660A(2) as having an interest in the property from which Mrs. Jones’s dividends arose; and therefore

• Mrs. Jones’s dividends are to be treated as Mr. Jones’s income for tax purposes by virtue of s 660A(1).

Mr Gammie accepted that if the Revenue were right in their contention that there was a settlement, then these points were also correct. However he argued that if Arctic did in fact fall within the definition of a ‘settlement’ in s 660A(1), it was taken out again by the exclusion in s 660A(6). This subsection states that the legislation ‘does not include an outright gift by one spouse to the other of property from which income arises, unless:

(a) the gift does not carry a right to the whole of that income; or

(b) the property given is wholly or substantially a right to income.

There were thus two questions to be answered, firstly, apart from the outright gift exclusion in s 660A(6), was there a settlement? Second, if there was a settlement, was the structure excluded from the legislation by the outright gift exclusion?

Was there a settlement?

The definition of ‘settlement’ given in ICTA 1988 s 660G(1) is very broad. The courts have however held that Parliament did not intend that all transactions potentially within this broad definition should be caught by the legislation. In the leading case of CIR v Plummer [1979] STC 793, Lord Fraser said:

‘If [the settlements legislation] were read literally it would include a large number of business agreements and would produce results so inconvenient and surprising as to lead to a strong presumption that they cannot have been intended.’

In Plummer the judges tried to find a way of narrowing down the written law so that it focused on the mischief Parliament intended should be caught. Lord Fraser said:

‘Some limit must be placed on the width of the words, and the need for some limit was accepted by both parties to this appeal. The limit must be fixed by some rule capable of general application.’

A majority of the judges in Plummer decided that the rule to be used in order to determine whether the legislation applied was to see if there was bounty in the arrangement. If there was, then the arrangement was a settlement.

Miss Powell, the Special Commissioner who found for the taxpayer, held that there was no settlement because ‘the arrangement has to be judged at the time the share was acquired by Mrs. Jones and the arrangement at that stage lacked the requisite element of bounty.’

Mr Justice Park summarised her reasoning by saying that:

• When the company was established, Mrs Jones’s share was probably still worth no more than the £1 which she had paid for it;

• Mr. Jones was not contractually bound to draw only low salaries from the company, so there could be no certainty that, even if his services did generate large receipts for the company, the result would be significant profits within the company capable of being distributed as dividend;

• Furthermore, it may have been the case at the original creation of the structure that there was no means of knowing whether the company would succeed in finding outside parties willing to pay substantial fees for Mr. Jones’s services.

In summary, as Ms Powell put it, ‘The Appellant was not worse off at the time that Mrs. Jones acquired her share merely because he intended to provide bounty. An intention to provide bounty is not the same as the provision of bounty.’

Mr Justice Park dismissed this reasoning, saying that the arrangement is within the legislation if it ‘is being established in circumstances where one of the reasons for it is that it will or will be available to be used as a means through which bounty will or may be channelled to another person in future.’ He also held that the absence of a service contract requiring Mr Jones to provide his services for a low level of remuneration was irrelevant. In other words, he found that there was sufficient bounty for there to be a settlement.

Did case law precedent indicate that there was a settlement?

In the course of the case both Malcolm Gammie and the Revenue examined in considerable detail the earlier cases dealing with the legislation. Some of these cases are highlighted in the judgment. But the key precedent, in the view of the judge, was that of Crossland v Hawkins [1961] 39 TC 493, a settlement case which was won by the Revenue. Mr Justice Park said (at para 41):

‘The facts of Crossland v. Hawkins which I have postulated gives me almost the exact equivalent of this case, with the only difference being that in Crossland v. Hawkins as varied the shares in the employer company not owned by Mr. Hawkins himself were assumed to have been owned by his children, whereas in this case the share in Arctic Systems Limited not owned by Mr. Jones was owned by his wife. In my judgment that is, so far as the present case is concerned, a distinction without a difference.’

Was s660A(6) effective?

Mr Justice Park held s 660A(6) was not effective to protect the taxpayer from the settlements legislation. In the first place, the share was not gifted, but subscribed for. However, even had it been gifted, he said that the exemption would still not apply. He said:

‘Subsection (6) does not provide that subsection (1) does not apply to a settlement or arrangement of which one element is an outright gift. It provides that subsection (1) does not apply to a settlement or arrangement which is an outright gift.’

He went on to say:

‘I do not consider that subsection (6) was intended to exclude a case like this from the charging provisions. It was intended for straightforward cases where one spouse gives income-yielding property to the other, and ordinary investment income continues to arise. For example, a husband gives some quoted shares to his wife (a ‘settlement’ on the authority of Thomas v. Marshall 34 TC 178) and she thereafter receives the normal dividends which the quoted shares carry. Or a husband gives a tenanted property to his wife and she thereafter receives the normal rents. Or even a husband and wife have a joint deposit account; the husband pays his income into the joint account so that the wife now owns half of the income so paid in and she will receive half the bank interest on that money. The present case is in my opinion not realistically comparable with those straightforward examples, but it is only for cases like them that in my view subsection (6) is intended.’

What happens next?

The case is currently being listed at the Court of Appeal, but in the mean-time Mr Justice Park’s judgment is likely to be subject to considerable technical analysis in the professional press. Key issues include:

• Whether the judge is correct to equate the Jones’s case with that of Crossland v Hawkins;

• Whether his analysis of the application of s660A(6) is correct;

• Whether parliament intended the legislation be applied to companies like Arctic Systems.

Consequences for practitioners

Mr Justice Park tried to reassure practitioners, saying that:

‘In my view apprehensions that almost every case of a husband and wife company is going to be affected by this case are greatly exaggerated. 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 judgment in this case that the husband is going to be taxed on the wife’s dividends.’

However, Mr and Mrs Jones did set up a joint company and run it together – but Mrs Jones’s contribution was deemed insufficient for them to escape the application of the legislation. Any married couple in business together where one spouse does less work than the other may (or may not) be within these rules, although Mr Justice Park did say that:

‘It would be far harder for the Revenue to establish that there is a settlement or arrangement of which a husband is a ‘settlor’ if he is paid the going rate for employees carrying out the sort of work which he does.’

The professional bodies are currently considering revised guidance on self-assessment which will take into account this decision. In the meantime practitioners should consider their current client base to see what action they may need to take in respect of existing husband and wife businesses.

July 2005

ANNE REDSTON MA(Oxon), FCA, CTA (Fellow).

Anne is a member of the Council of the Chartered Institute of Taxation and Chair of its Personal Taxes Subcommittee. The views expressed in this article are her own and do not necessarily reflect those of the Institute.

This article first appeared in ‘Tolley’s Practical Tax’ on 1 July 2005, and is reproduced with the kind permission on Lexis Nexis Butterworths