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Tolley's Practical Tax by Roger Jones

Roger Jones considers apparently opposing views from HM Revenue & CustomsWhilst I was pondering the Court of Appeal judgment in Arctic Systems, something suddenly struck me. What if HMRC were to offer the opportunity of reducing tax liabilities by making a transfer of income?

Geoff and Diana Jones must be congratulated for their perseverance. Many are heralding the Court of Appeal decision as a victory for commercial common sense over the might of HMRC who wish to employ some rather arcane legislation in a manner which many felt was never intended.

Like a number of more notable commentators on the tax scene, I had to eat humble pie when the judgment was delivered. I had thought that Andrew Park’s attitude had considerable merit.
Whatever the commercial justification, arrangements of this type do have the advantage of income distribution.

That may not be the end of it. HMRC has since sought leave to pursue the Arctic Systems case to the House of Lords. Although HMRC have always said that they never viewed it as a test case, has the tax profession relied rather too much on it and missed the bigger picture?

Tax Bulletin Examples

In Tax Bulletin 64, HMRC (Inland Revenue as it then was) sought to demonstrate the possible application of the settlements legislation to businesses and individuals. Example 3 looks awfully like the facts of Mr & Mrs Jones in Arctic Systems. Indeed, with the benefit of hindsight and the glare of publicity surrounding the case, was this the company on which the example was based?

But it does not stop there; Example 4 concerns subscription for shares followed by a gift – a route which the Jones could so easily have taken. HMRC comments have since been revised with more examples in Tax Bulletin 69 and, more recently, a consolidated guidance note. Likewise, the professional bodies have made their counter opinions known.

I think it is unfair of the professional bodies to say ‘we did not know’. Long before all of this came out into the open, I had warned company proprietors of the risk of an attack under the settlements legislation. I alluded to it in the first edition of my book ‘Incorporating a Business’, the manuscript of which was, coincidentally, delivered to the publisher in the week that Tax Bulletin 64 was issued. My advice was based on the view expressed in HMRC Trusts, Settlements and Estates Manual para 4210 which, to this day, remains unchanged.

Settlements legislation

The underlying theme is that the settlements legislation can be used to counter arrangements which permit the redistribution of income to gain a tax advantage. Throughout the passing of Arctic Systems through the judicial process, I have tried to demonstrate its implications to many of my colleagues and their diverse clients. I usually refer to a ‘spectrum of risk’. There are the personal services type of companies which, in effect, act as a conduit for the external income of one individual and can provide a means of redistributing that income with tax advantages (oops! – did I really say that?)

Although it was not their prime purpose, apparently Geoff and Diana Jones were told it was one of the advantages of the arrangement they went into). At the other extreme there are businesses with a substantial capital structure, other employees, assets etc which seem accepted to be outside the scope of the settlements legislation. Examples 11 & 12 in the original Tax Bulletin article state as much. What troubled me was, not so much that there could be such things as ‘bad’ companies and ‘good’ companies, given that one could have almost any permutation in the middle, where in the spectrum did the boundary of risk lie?

Arctic Systems has not demonstrated this and, until more general guidance is forthcoming, I would not like to lay my hand on my heart and say that all small private companies are now free from the risk of a challenge under the settlements legislation.

Rental Income

But, what was it that set me thinking? I have been mulling over a different issue, apparently rather more mundane, for a long while. Let me demonstrate. Mr & Mrs Smith have run a successful business for many years. They have two daughters and, as they grew up, they joined the business too. None of which has anything to do with the settlements legislation. Mr Smith though has always had an innate distrust of pensions. In recent years, he has followed the line of many other business proprietors with excess profits to invest. He, and his family, have gone into the ‘buy to let’ market. As a result they now have a fairly large portfolio of let properties, all owned equally between the four of them as tenants in common. The letting business does not amount to a partnership and none of the properties are furnished holiday lettings.

The net rental income has been divided equally between the four of them (Mr & Mrs Smith and the two daughters). The shares so apportioned have been shown on their respective tax returns and income tax paid accordingly. Then one day, Mr Smith asked whether he could ‘vote’ all of the income to his two daughters as he and his wife had no real need of it.

There is actually very little written about the treatment of joint property, except where the beneficial owners are spouses (in which case ICTA 1988 s 282 treats the income as belonging to them equally, with the option to elect under s 282B for the income to follow the underlying beneficial ownership). Otherwise, under a joint tenancy, all the joint owners have equal interests in the property. This must extend to the income arising which belongs to them all in equal shares. It should not be possible to elect for income sharing which contradicts the legal ownership.

In essence, the same result should apply where the property is held as tenants in common. The income follows their respective beneficial interests. So, if Mr & Mrs Smith and their daughters owned the properties as to 25% each then they get the income in the same ratio. I do not think it is possible to elect for income sharing which contradicts the legal ownership.

A Settlement?

Even if it were possible, I am inclined to think that the result must be a settlement. Whilst the examples given in HMRC Tax Bulletin 64 do not include property letting, it must be remembered that the profits of a property business are effectively computed as if it were trading income, see ITTOIA 2005 s 272. I was therefore inclined to the view that, if Mr & Mrs Smith’s shares of the income were somehow transferred to the daughters, it would still be taxable in the hands of the parents.

At this point, I became somewhat embarrassed. Mr Smith is a well informed man and he drew my attention to paragraph 24 of IR 150 ‘Taxation of rents: a guide to property income’. This is under the general heading of ‘Jointly owned property’ and concerns the situation where there is no partnership. It begins: ‘Where you are not in partnership, your share of any profit or loss arising
from jointly owned property will normally be the same as the share you own of the property being let. But joint owners can agree a different division of profits and losses and so occasionally your share of the profits or losses will be different from your share in the property. Your share for tax purposes must be the same as the share actually agreed. However, where the joint owners are husband and wife …’

IR150 is now defunct but the same words can be found in HMRC Property Income Manual para 1030. The first sentence states what I thought I had demonstrated. The fourth concerns husband and wife whose special situation is mentioned above. But, the second and third sentences seem to suggest that (non-husband and wife) property owners can choose whatever income split they like.

Kings v King

How can this be possible? For a long time, it had me stumped. Determined to get to the bottom of it, I started asking other tax professionals. All of them agreed with my conclusion. My attention was drawn to the decision in Kings v King [2004] STC (SSCD) 186, especially the very odd comment by the Special Commissioner that Mrs Kings (being the joint owner of property with her husband) had surrendered her entitlement to the rents arising as her husband was named as the sole landlord and the rent was paid into his account. Clearly with husband and wife the matter is determined by s 282A. In my situation, what about the balance as between parents and children?

Eventually, I asked Robert Maas and I am grateful to him for permission to quote part of his response to me. He sees the decision in Kings v King as a bit odd. The Commissioner seems to have based his determination on ITTOIA s 271 ie ‘that the person liable for any tax charged under this Chapter is the person receiving or entitled to the profits’. However, this does not necessarily mean that the ‘profits’ form part of the total income of the person receiving them. All it was intended to do was to say that HMRC can collect the tax from a person receiving the profits, albeit that it is not that person’s income. That is a common provision, in relation to sources of income other than trades, but it does not seem to make a lot of sense in the context of property income which is deemed to arise from a trade.

The Revenue view expressed in IR 150 and PIM 1030 may stem from the principle enunciated in Leigh v CIR 11 TC 590, namely that ‘receivability without receipt for the purpose of income tax is nothing at all’. Accordingly, if a person passes his right to income to someone else, that income ceases to be his income and becomes income of the other person. This is the principle that applies in relation to dividend waivers. It would have applied to property income prior to 1995/96
but, surely, can no longer do so now that property income has to be computed as if it were from a trade.

What happens where the property owners agree to divide the rent differently from their capital interests? The starting point seems to be that a person’s interest in a property under the Law of Property Act 1925 is his rights as a beneficiary of the statutory trust for sale, to receive both the capital and the income from his share of the property. If he passes his right to income to someone else that has to be a part disposal of his right as a beneficiary with capital gains tax (and inheritance tax) consequences. Furthermore, for income tax purposes an arrangement under which a person passes to his children the right to income from a property, but keeps that property, is a settlement within ITTOIA 2005 s 624 with the result that the settlor is taxable on the income attributable to his share of the property.

Which is where I came in and it leaves me with a question. HMRC has gone to great lengths to demonstrate that the redistribution of earned income by using a company is ‘offensive’ and must be stopped. At the same time, there is an open offer to permit redistribution of rental income amongst joint owners. Why the difference?

February 2006

Roger Jones

Roger Jones is Senior Tax Manager at Larking Gowen in Norwich but the views expressed are personal and do not necessarily represent the opinion of the firm. The 2nd edition of “Incorporating a Business” is published by Tottel Publishing and available direct from Marston Book Services 01235 465500, price £59.95.

This article was originally published in Tolley’s Practical Tax, LexisNexis Butterworths leading information service for small to medium sized tax and accountancy practices. It provides the day-to-day information needed to deal with all tax compliance issues and general client problems. For more information or to order this title please visit www.lexisnexis.co.uk/taxationweb