Say Hello, Waive Goodbye

By | 4 August 2008

They think it’s all over … it is now!

This will be a familiar quotation to football loving readers of Taxation (or the more senior ones, anyway), being the famous words from Kenneth Wolstenholme’s BBC TV commentary in the closing moments of the 1966 World Cup, in which England beat West Germany 4-2 after extra time to win the final.

When I hear that quotation these days, it is tempting to draw an analogy in tax terms to the Arctic Systems case (Jones v Garnett [2007] STC 1536), regarding the income tax anti-avoidance provisions on settlements (ITTOIA 2005, Part 5, Chapter 5).

After all, both events were a long time in the making, contained twists and turns along the way, and were decided in a dramatic, sudden death manner.

One could be forgiven for thinking that the settlements provisions were largely ‘all over’ for husband and wife companies following the House of Lords’ decision in the taxpayer’s favour in Arctic Systems. However, the rules are widely drawn, and HMRC still appear to be looking for situations in which to apply them.

The income shifting rules, which are to be introduced in FA 2009, are not intended as a substitute for the settlements provisions, but for circumstances not considered to be caught by them. So the taxpayer’s upper hand could turn out to be as short lived as England’s domination of Germany in international football.

This article considers the settlements rules in the context of dividend waivers between spouses (or civil partners) who are shareholders in family companies. All statutory references are to ITTOIA 2005, unless otherwise stated. References to spouses in this article apply equally to civil partners.

What the law states

It may be useful to recap the settlements legislation which is relevant to what follows regarding HMRC’s potential treatment of dividend waivers. Section 620(1) defines a ‘settlement’ widely to include ‘… any disposition, trust, covenant, agreement, arrangement or transfer of assets…’.

The important word here is ‘arrangement’, but unfortunately that term is not defined in the legislation.

Section 624(1) deals with the income tax treatment of settlement income where the settlor retains an interest. It states:

‘Income which arises under a settlement is treated for income tax purposes as the income of the settlor and of the settlor alone if it arises:

‘(a) during the life of the settlor: and
‘(b) from property in which the settlor has an interest.’

The ‘settlor’, i.e. the shareholder waiving the dividend, is treated as retaining an interest in the settlement for the above purposes if there are any circumstances in which the property or any related property is payable to, or is applicable for the benefit of, the settlor or spouse (or civil partner), or will or may become so in the future (s 625(1)).

The exception from the settlements rules in s 626 for outright gifts between spouses does not apply to dividend waivers, as the gifted property is wholly or substantially a right to income.

No part of the settlements code refers directly to dividend waivers, and there is, so far, no specific case law on the subject, so the application of the anti-avoidance rules is, unfortunately, largely a matter of interpretation.

HMRC’s view

The guidance on dividend waivers in HMRC’s Trusts, Settlements and Estates Manual (paragraphs 4220 and 4225) indicates that there may be an arrangement for which the settlements legislation could apply if a shareholder waives a dividend in circumstances where another shareholder may benefit.

This is on the basis that the ‘arrangement’ or ‘settlement’ involves the shareholder giving up an entitlement to money.

To the extent that an enhanced dividend is received by the other shareholder, that act is regarded as being ‘bounteous’ (incidentally, ‘bounteous’ was described as ‘patronising and inaccurate’ by Baroness Hale in the Arctic Systems case). If the other shareholder is a spouse, in HMRC’s view s 624 applies.

While acknowledging that not all dividend waivers can be challenged, HMRC list a number of factors which they consider indicate that the settlements legislation is likely to apply.

These factors are broadly concerned with:

  • the level of the company’s retained profits, i.e. could the company sustain the rates of dividends paid in the absence of waivers?; 
  • whether a waiver influenced the level of dividends paid;
  • the intentions of the waiving shareholder, i.e. did he wish to benefit a non-waiving shareholder?; and
  • the non-waiving shareholder’s tax position, i.e. would he would pay less tax on the dividend than the waiving shareholder?

The Example, taken from TSEM 4225, shows when HMRC consider that the settlements provisions would apply in respect of a dividend waiver.

Example

‘Mrs H owns 80 ordinary shares in H Limited. Mr H owns 20 shares. In 2000, the company made a profit of £25,000. Mrs H waived her right to any dividend. The company then declared a dividend of £1,000 per share, and Mr H, who had no other income, received a dividend of £20,000.

No property has been transferred so the settlement is one of income. As such, the exemption for outright gifts to spouses is not in point and we would apply the Settlements legislation in these circumstances. Clearly a dividend of this amount could not have been paid from the company’s profits on all the shares, so the waiver arrangement enhanced the dividend paid to Mr H. £16,000 of the dividend paid to Mr H is attributed to Mrs H under section 624 because the waiver was a bounteous arrangement.’

The arrangement

HMRC’s example illustrates what is a probably not uncommon scenario in small family companies. TSEM 4225 encourages HMRC officers to report such cases to their trusts head office for advice.

On the face of it, HMRC appear to have a sound argument that the settlement rules apply. However, before conceding that the settlements rules catch husband and wife clients where the facts seem to match, it is worth making one or two observations about HMRC’s example of Mr and Mrs H.

Mr H had no other income. However, did he earn any income from H Ltd? Let us suppose that Mr H did perform some work for the company, e.g. director’s duties.

What would be the effect on the company’s profits if Mr H had received a commercial rate of remuneration for that work? The payment would reduce the company’s distributable profits. So by not receiving this remuneration, Mr H is providing bounty to the other shareholder.

HMRC may argue that it is unnecessary to look beyond the dividend waiver to find the arrangement caught by the settlements provisions, and that the rate of remuneration is therefore irrelevant.

However, there are numerous cases where the courts have held that two or more transactions constitute an arrangement.

For example, in Crossland v Hawkins 39 TC 493, it was held that the formation of a company, a service agreement and a deed of settlement together constituted the arrangement.

Indeed, in his judgment Donovan LJ indicated that it was not necessary for the whole of the arrangement to be in contemplation from the outset.

He added:

‘The company is formed, the service agreement executed and the deed of settlement made, all in this one year. But even were it otherwise, I think there is sufficient unity about the whole matter to justify it being called an “arrangement” for this purpose.’

Even HMRC’s own guidance concedes that an arrangement can include a single transaction or a series of associated transactions, and states:

‘It follows that it is necessary to consider any series of transactions globally’ (TSEM 4105).

On that basis, it would at least seem arguable that the ‘enhanced’ dividend received by Mr H should be reduced by the remuneration not taken, calculated at a commercial rate.

What’s the point?

It is worth remembering that the general thrust of the settlements rules as they affect spouses is to prevent the diversion of income from one spouse to the other, where the overall tax burden would otherwise be reduced.

As HMRC explain:

‘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’.

In other words, there is no point in HMRC applying the settlements rules if there is no loss of tax for them to recover.

Let us take HMRC’s example a stage further. Suppose that Mr H did receive a salary from H Ltd (say £20,000 a year), whereas a commercial rate of remuneration would be £40,000. At that higher level, Mr H’s basic rate band is all but fully used.

Once again, HMRC may argue that the level of remuneration is not material to the settlements provisions.

However, reference to the extended meaning of arrangements in case law and HMRC’s own guidance may help to persuade them otherwise.

Substituting a commercial level of remuneration would mean that the anti-avoidance rules only bite to the extent that there is still an overall tax saving.

In HMRC’s example, it is not explicitly stated that Mrs H is a higher rate taxpayer, although in practice this will invariably be the case.

If Mr H were also liable to higher rate tax on the dividends resulting from the waiver, there would seem little point in HMRC considering the application of the settlements provisions.

Unfortunately, practical experience of HMRC’s approach to dividend waivers has been inconsistent. In my first settlements case on the subject approximately 15 years ago, HMRC’s technical specialist readily accepted that the arrangement included the non-waiving spouse’s salary, and was prepared to substitute a commercial rate of remuneration for the amount actually paid, in calculating the amount of dividends income subject to the settlement rules.

Unfortunately, the same approach was not accepted in a more recent case I have seen.

Settlements and income shifting

It is a pity that HMRC do not even follow the approach indicated in the consultation document issued in December 2007 on the proposed income shifting rules. This seemingly recognised that an individual’s level of income from a company (or partnership) should reflect their contribution to the business.

The consultation document states:

‘The legislation is not intended to apply to genuine commercial arrangements, broadly where the share of overall income received by each individual is a fair and reasonable reflection of what they would be entitled to in a normal commercial arrangement, or where there is no overall tax advantage as a result of income shifting.’ [Emphasis added.]

It is also worth noting the following example from the consultation document, which HMRC considers to be ‘a reasonable basis for quantifying shifted income’:

Scenario 1: individual 1 and individual 2 form a company, each owning 50 £1 ordinary shares. The business of the company is to provide the personal services of individual 1. Individual 2 spends around five hours a week on back office duties for the business. In the first year they each receive a salary of £5,000 and dividends of £30,000. The salary received by individual 2 is considered to be the market rate given the nature of the work done and time spent doing it. The company has no significant assets or liabilities other than the personal goodwill of individual 1.

‘If individual 2 has no capital in the business and bears no risk, the whole of the £30,000 would be treated as shifted income because individual 2 is already receiving a market rate for the work done, has no capital in the business and bears no risk.

Scenario 2: as above, except this time the market rate for the work done by individual 2 is considered to be £15,000. The shifted income would be £20,000 (i.e. £35,000 – £15,000 salary).’

If we ignore the faults and impracticalities of the income shifting proposals in this article and instead concentrate on applying the above approach to dividend waivers and the settlements rules, it is surely more logical to view arrangements such as described in Scenario 2 in the round for the purposes of establishing the level of dividends potentially caught by s 624. But then tax and logic never got on particularly well.

Heading for a rematch?

It is likely that eventually another case will follow Arctic Systems to the courts on the settlements legislation, this time on the application of those provisions to dividend waivers. So unlike England’s extra time victory, the settlements match between taxpayer and HMRC seems far from over.

The above article was published in ‘Taxation’ on 31 July 2008.