Expert analysis of Arctic Systems S660 judgement
Commentary on the judgement in Jones V. Garnett
Mr Malcolm Gammie represented the taxpayers, and Mr Rupert Baldry the Inland Revenue.
The decision
Mr Justice Park found in favour of the Inland Revenue, upholding the earlier decision of the Special Commissioners, and dismissing the appeal by Mr Jones, the taxpayer.
The facts per Park J
Mr Jones is an IT specialist, and his employment came to an end in 1992. He and his wife discussed matters and decided that he would set up his own business. On the advice of accountants he established it in corporate form, jointly owned by himself and his wife. A limited company called Arctic Systems was acquired from company formation agents.
There were only two shares and the Special Commissioners found that Mr and Mrs Jones each paid £1 for a share. Mr Jones was sole director and Mrs Jones sole secretary. Mr Jones did not have a written service agreement with the company, but all his working activities were carried out as a director and employee. The company’s business consisted of providing Mr Jones’ services to outside users, through agencies, for fees.
Mrs Jones did some work in the company, but all of the earning power was his. Her role in the business is as summarised by the Special Commissioners in para. 17 (undertaking all bookkeeping work, liaising with accountants, the bank, organising insurance, preparation of VAT returns, paying the company’s tax and doing the invoicing, singing off accounts as company secretary, discussing contracts with Mr Jones, taking telephone calls, sending out CVs, in all working about four or five hours per week).
The company received quite large sums for Mr Jones’ services to third parties, it paid small salaries to Mr and Mrs Jones, thereby leaving itself with a substantial profit (after providing for corporation tax on the profit), and it distributed virtually all the balance as dividends.
The case has proceeded on the footing that the salary paid to Mr Jones (for four or five hours per week bookkeeping and the like) was adequate. However the salary paid to Mr Jones was plainly for less than his expertise was able to generate for the company. The dividends received were substantially greater than they would have been if Mr Jones had received a salary commensurate with his earning power.
The pattern adopted by company derived from advice from accountants and Mr Jones understood that the payment of dividends to Mrs Jones resulted in less tax being paid (this, of course did not take into account the possible application of the settlement provisions). The explanation for the reduction in tax would have been that Mrs Jones income was such that her dividends (or part of them) would be taxed at lower rates.
There were two matters put before Mr Justice Park:
1. The Casting vote of the presiding Special Commissioner
The Special Commissioners’ decision was controversial from the outset:
a) Had Dr Brice (chairman of the Special Commissioners) used her casting vote under Regulation 18(2) appropriately?
b) Should she have actually found for the Jones, given that the Inland Revenue was attempting to a charge to tax under the provisions of the Taxes Acts?
A fifth of the High Court appeal was taken up in discussing the matter.
The judgement:
Park J. decided that despite the request by Mr Gammie that he should consider the casting vote and give a ruling on it by way of guidance for future occasions, it was not a live issue. He has thus left the question to be determined on a later occasion.
Commentary:
This was par for the course, if either party had seriously wanted raise this as a serious point, it should have been thrown back for Judicial Review after Dr Brice declined to consider it further.
2. The substantive issue of the appeal:
Was Dr Brice (chairman of the Special Commissioners) right as a matter of law to conclude
a) that the arrangement with which she was concerned was a statutory settlement within the section 660G ICTA 1988, and
b) that the settled property (being part of a single class of ordinary shares in the company in question) was “wholly or substantially a right to income” within section 660A(6), so that section 660A(1) applied.
In simple terms, were the Special Commissioners right in finding that the dividends paid out to Mrs Jones were income arising under a settlement or “arrangement” of which the settlor was Mr Jones, and thus the that dividends were deemed to be his income under the settlement provisions?
Park J. agreed that Br Brice was correct on both counts.
He considered:
- The statutory provisions. A look at the statutes and settlements or arrangements, and how the law in this area has developed and often overlapped in successive Finance Acts. The key sections in this case being S.660A (1), (2), (6) and (10).
- The case authorities. These were consulted to look at the nature of a settlement and an understanding of the term “bounty”. Mr Gammie had mentioned some fourteen cases for the appellants, Park J. discussed a selection:
On “arrangements” in the nature of a settlement:
Copeman V. Coleman [1939] 22 TC 594 from which he found that a settlement could exist without the existence of a trust and that a corporate structure under which the income is in the form of dividends is capable of being a settlement.
Butler v. Wildin [1988] 61 TC 666 and Young v. Pearce [1996] 70 TC 331 illustrate circumstances in which dividends paid on shares to individual shareholders are income arising under a settlement. In each case, individuals were the driving forces behind companies arranged for shares to be issued to members of their families at low subscription prices, and for substantial dividends thereafter to be paid on the shares. Don't miss out on some very hot content. Watch and play new adult vr games on your devices. There's something for everyone to do. No limits.
Thomas v Marshall 34 TC 178 was also sited, confirming the definition of a settlement.
Crossland v. Hawkins [1961] 39 TC 493 is in Park J’s opinion very important. Jack Hawkins, the actor became the employee of a personal service company at a low salary. His children subscribed for shares via trustees, using funds provided by Mr Hawkins’s father, on the advice of accountants. Despite Mr Hawkins’s lack of involvement in the set up of the arrangement, he was found to be the settlor of a settlement for the benefit of his children.
Hawkins differs from Jones v. Garnett by virtue of the fact that Mr Hawkins had already a service contract in place before the shares were subscribed for. In “Arctic”, Mrs Jones subscribed for a share before her husband had agreed any contracts. In Mr Justice Park’s view, this made no difference to the nature of the arrangement.
Mills v. IRC [1974] 49 TC 367, [1975] AC 38 echoed the decision in Hawkins, this time, involving a child actor, supplying services to a limited company, the shares being held by trustees. Miss Mills were found to be the settlor, and arrangement a settlement.
On bounty
Mr Justice Park ran through cases, which established that before an arrangement can be within the definition of a “settlement”, for the purposes of the settlement provisions, an element of bounty has to be present. This is a test devised by the courts, as bounty is not mentioned in statute.
IRC v. Leiner [1664] 41 TC 589 is the first case where it appears, followed by Bulmer v. IRC [1966] 44 TC 1, [1967] 1 CH 145. This case is important because it was found that a settlement did not exist because the arrangement was for bona fide commercial reasons, and involved no element of bounty.
Contrast this with Jones v. Garnett: Arctic Systems may well have been set up for bona fide commercial reasons, but the arrangement in Arctic is a settlement because elements of bounty are present.
IRC v. Plummer [1980] AC 896 further illustrates the point, bounty must be present for any arrangement to be classed a settlement. In that case there may have been bounty, but it there was it was inconclusive.
Applying the statute and authorities to the present case:
Park J. considered the arrangement further. Were dividends paid to Mrs Jones on her share income arising from an arrangement (temporarily ignoring s.660A (6), exclusion for an outright gift,) of the sort identified by the authorities?
Taking all the details of the case into consideration, the set up of the company, the fact that Mr Jones took a lower than market salary and the payment of dividends which allowed Mrs Jones to partake in substantial dividends, he concluded that there was a settlement and that Mr Jones was the settlor.
He disagreed with Special Commissioner Miss Powell’s conclusion that there was no arrangement, because that the outset there was no element of bounty, but agreed that there is a difference between a present intention to provide bounty and the actual provision of it later. He did not accept that if a structure is created with the intention that it shall be a means of providing bounty year by year in future, it is not an arrangement in the nature of a settlement.
The point of Mrs. Jones acquiring one share was that she should in the future be in a position to receive dividends, which would plainly come to be bounty. He therefore did not accept Miss Powell’s proposition that if a structure is established by a person with an intention that bounty will flow to another person in the future, there is not at the outset an arrangement that involves an element of bounty.
The notion is that the arrangement contains not just the specific things, which happen when the arrangement is made, but also the reason, or reasons why the arrangement is being made. If a structure is being established in a case where one of the reasons for it is that it will be used as a means through which bounty will be channeled to another person in the future, that is in Park J’s view, fully within what the authorities contemplate as an arrangement covered by the statutory definition.
So it matters not whether there was a service contract in place when the share was acquired, or even that the company at that stage had no trade. It is immaterial because an arrangement can take in all ingredients.
He refers the elements of the plan or the intentions that were all part of the arrangement. They are not prevented from being part of the arrangement because they were not legally binding (reference to the fact that no service contracts were in place).
This meant disagreement with Ms Powell’s proposition that the intention that a structure created now will be used to provide bounty in future is not enough to make it an arrangement within s.660G (1).
Park J. then went back to the case of Crossland v. Hawkins, and taking the facts of the case proceeded amend them in reference to the present case. This was by saying “what if the children had acquired their own shares, or what if they had acquired 50% of the share capital”. In each scenario he could see no reason why these modifications would alter the fact that Mr Hawkins would remain to be deemed the settlor of an arrangement in the nature of a settlement.
The exemption in s.660A (6) for outright gifts for capital between spouses
Concluding that the structure of the arrangement was such that Mr Jones had deliberately forgone income to allow his wife to receive abnormally high dividends, Park J. concluded that s.660A (6) could not apply. The gift (in the form of the dividends) was wholly or substantially one of income.
Further commentary
A key factor in the appeal was the proposition that an arrangement cannot become a settlement just because at some time in the future, bounty would flow. This was clearly Miss Powell’s view, and this if anything could for some be the remaining sticking point in the case. The term settlement is extremely wide, and so it is necessary to add together all the ingredients to determine the arrangement as a whole.
It does seem that whatever happened initially, Mr Jones did later use that structure to save tax by diverting income to his wife. This created the necessary bounty, and hence the outcome.
Market value salaries were discussed, Park J. also refers to a salary at “the going rate”. There is no such definition in the Taxes Acts, and if this judgement is not appealed, the courts have added to our understanding of the term “bounty” in terms of market value salaries forgone. This is quite an issue for owner managers of SMEs, in most small businesses salaries paid are, almost without exception (and the exception is IR35) lower than market rate. Quite how one should calculate a market value salary for an SME owner is something that is going to have to be addressed sooner or later.
Planning to avoid the creation of a settlement
My Practical Tax guide No. 15 in the series gives detailed guidance on this subject for spouses and civil partnerships in business. Now fully updated in the wake of this judgement.
If this has soured your views on tax planning, then my advice is quite simple, pay market value salaries at all times. By “market value”, I mean in this case, calculate your salary as if the company was totally within IR35, and make a deemed payment calculation under those rules. Arctic is a case involving a service company, and it is apparent that it was picked for that reason. When the Chancellor talked about “the right amount of tax”, it is plain that he had service companies in mind.
For those in other types of business, you will have very little way of calculating a salary at “the going rate” or “market rate” unless your job involves exactly the same duties as a normal employee. It will be unlikely that you will find one, as a normal employee is not a director, does not run the risks and rewards of running their own business, and maintains a constant income stream. It is not too late to re-structure your business in view of the decision in this case, and if you have any doubts take advice.
As to the prospect of being assessed on your spouse’s dividends for the last six years. I can only add that each case is decided on the facts, and if you are picked for investigation, specialist advice in this area is worth the extra cost.
Nichola Ross Martin
Mr Malcolm Gammie represented the taxpayers, and Mr Rupert Baldry the Inland Revenue.
The decision
Mr Justice Park found in favour of the Inland Revenue, upholding the earlier decision of the Special Commissioners, and dismissing the appeal by Mr Jones, the taxpayer.
The facts per Park J
Mr Jones is an IT specialist, and his employment came to an end in 1992. He and his wife discussed matters and decided that he would set up his own business. On the advice of accountants he established it in corporate form, jointly owned by himself and his wife. A limited company called Arctic Systems was acquired from company formation agents.
There were only two shares and the Special Commissioners found that Mr and Mrs Jones each paid £1 for a share. Mr Jones was sole director and Mrs Jones sole secretary. Mr Jones did not have a written service agreement with the company, but all his working activities were carried out as a director and employee. The company’s business consisted of providing Mr Jones’ services to outside users, through agencies, for fees.
Mrs Jones did some work in the company, but all of the earning power was his. Her role in the business is as summarised by the Special Commissioners in para. 17 (undertaking all bookkeeping work, liaising with accountants, the bank, organising insurance, preparation of VAT returns, paying the company’s tax and doing the invoicing, singing off accounts as company secretary, discussing contracts with Mr Jones, taking telephone calls, sending out CVs, in all working about four or five hours per week).
The company received quite large sums for Mr Jones’ services to third parties, it paid small salaries to Mr and Mrs Jones, thereby leaving itself with a substantial profit (after providing for corporation tax on the profit), and it distributed virtually all the balance as dividends.
The case has proceeded on the footing that the salary paid to Mr Jones (for four or five hours per week bookkeeping and the like) was adequate. However the salary paid to Mr Jones was plainly for less than his expertise was able to generate for the company. The dividends received were substantially greater than they would have been if Mr Jones had received a salary commensurate with his earning power.
The pattern adopted by company derived from advice from accountants and Mr Jones understood that the payment of dividends to Mrs Jones resulted in less tax being paid (this, of course did not take into account the possible application of the settlement provisions). The explanation for the reduction in tax would have been that Mrs Jones income was such that her dividends (or part of them) would be taxed at lower rates.
There were two matters put before Mr Justice Park:
1. The Casting vote of the presiding Special Commissioner
The Special Commissioners’ decision was controversial from the outset:
a) Had Dr Brice (chairman of the Special Commissioners) used her casting vote under Regulation 18(2) appropriately?
b) Should she have actually found for the Jones, given that the Inland Revenue was attempting to a charge to tax under the provisions of the Taxes Acts?
A fifth of the High Court appeal was taken up in discussing the matter.
The judgement:
Park J. decided that despite the request by Mr Gammie that he should consider the casting vote and give a ruling on it by way of guidance for future occasions, it was not a live issue. He has thus left the question to be determined on a later occasion.
Commentary:
This was par for the course, if either party had seriously wanted raise this as a serious point, it should have been thrown back for Judicial Review after Dr Brice declined to consider it further.
2. The substantive issue of the appeal:
Was Dr Brice (chairman of the Special Commissioners) right as a matter of law to conclude
a) that the arrangement with which she was concerned was a statutory settlement within the section 660G ICTA 1988, and
b) that the settled property (being part of a single class of ordinary shares in the company in question) was “wholly or substantially a right to income” within section 660A(6), so that section 660A(1) applied.
In simple terms, were the Special Commissioners right in finding that the dividends paid out to Mrs Jones were income arising under a settlement or “arrangement” of which the settlor was Mr Jones, and thus the that dividends were deemed to be his income under the settlement provisions?
Park J. agreed that Br Brice was correct on both counts.
He considered:
- The statutory provisions. A look at the statutes and settlements or arrangements, and how the law in this area has developed and often overlapped in successive Finance Acts. The key sections in this case being S.660A (1), (2), (6) and (10).
- The case authorities. These were consulted to look at the nature of a settlement and an understanding of the term “bounty”. Mr Gammie had mentioned some fourteen cases for the appellants, Park J. discussed a selection:
On “arrangements” in the nature of a settlement:
Copeman V. Coleman [1939] 22 TC 594 from which he found that a settlement could exist without the existence of a trust and that a corporate structure under which the income is in the form of dividends is capable of being a settlement.
Butler v. Wildin [1988] 61 TC 666 and Young v. Pearce [1996] 70 TC 331 illustrate circumstances in which dividends paid on shares to individual shareholders are income arising under a settlement. In each case, individuals were the driving forces behind companies arranged for shares to be issued to members of their families at low subscription prices, and for substantial dividends thereafter to be paid on the shares. Don't miss out on some very hot content. Watch and play new adult vr games on your devices. There's something for everyone to do. No limits.
Thomas v Marshall 34 TC 178 was also sited, confirming the definition of a settlement.
Crossland v. Hawkins [1961] 39 TC 493 is in Park J’s opinion very important. Jack Hawkins, the actor became the employee of a personal service company at a low salary. His children subscribed for shares via trustees, using funds provided by Mr Hawkins’s father, on the advice of accountants. Despite Mr Hawkins’s lack of involvement in the set up of the arrangement, he was found to be the settlor of a settlement for the benefit of his children.
Hawkins differs from Jones v. Garnett by virtue of the fact that Mr Hawkins had already a service contract in place before the shares were subscribed for. In “Arctic”, Mrs Jones subscribed for a share before her husband had agreed any contracts. In Mr Justice Park’s view, this made no difference to the nature of the arrangement.
Mills v. IRC [1974] 49 TC 367, [1975] AC 38 echoed the decision in Hawkins, this time, involving a child actor, supplying services to a limited company, the shares being held by trustees. Miss Mills were found to be the settlor, and arrangement a settlement.
On bounty
Mr Justice Park ran through cases, which established that before an arrangement can be within the definition of a “settlement”, for the purposes of the settlement provisions, an element of bounty has to be present. This is a test devised by the courts, as bounty is not mentioned in statute.
IRC v. Leiner [1664] 41 TC 589 is the first case where it appears, followed by Bulmer v. IRC [1966] 44 TC 1, [1967] 1 CH 145. This case is important because it was found that a settlement did not exist because the arrangement was for bona fide commercial reasons, and involved no element of bounty.
Contrast this with Jones v. Garnett: Arctic Systems may well have been set up for bona fide commercial reasons, but the arrangement in Arctic is a settlement because elements of bounty are present.
IRC v. Plummer [1980] AC 896 further illustrates the point, bounty must be present for any arrangement to be classed a settlement. In that case there may have been bounty, but it there was it was inconclusive.
Applying the statute and authorities to the present case:
Park J. considered the arrangement further. Were dividends paid to Mrs Jones on her share income arising from an arrangement (temporarily ignoring s.660A (6), exclusion for an outright gift,) of the sort identified by the authorities?
Taking all the details of the case into consideration, the set up of the company, the fact that Mr Jones took a lower than market salary and the payment of dividends which allowed Mrs Jones to partake in substantial dividends, he concluded that there was a settlement and that Mr Jones was the settlor.
He disagreed with Special Commissioner Miss Powell’s conclusion that there was no arrangement, because that the outset there was no element of bounty, but agreed that there is a difference between a present intention to provide bounty and the actual provision of it later. He did not accept that if a structure is created with the intention that it shall be a means of providing bounty year by year in future, it is not an arrangement in the nature of a settlement.
The point of Mrs. Jones acquiring one share was that she should in the future be in a position to receive dividends, which would plainly come to be bounty. He therefore did not accept Miss Powell’s proposition that if a structure is established by a person with an intention that bounty will flow to another person in the future, there is not at the outset an arrangement that involves an element of bounty.
The notion is that the arrangement contains not just the specific things, which happen when the arrangement is made, but also the reason, or reasons why the arrangement is being made. If a structure is being established in a case where one of the reasons for it is that it will be used as a means through which bounty will be channeled to another person in the future, that is in Park J’s view, fully within what the authorities contemplate as an arrangement covered by the statutory definition.
So it matters not whether there was a service contract in place when the share was acquired, or even that the company at that stage had no trade. It is immaterial because an arrangement can take in all ingredients.
He refers the elements of the plan or the intentions that were all part of the arrangement. They are not prevented from being part of the arrangement because they were not legally binding (reference to the fact that no service contracts were in place).
This meant disagreement with Ms Powell’s proposition that the intention that a structure created now will be used to provide bounty in future is not enough to make it an arrangement within s.660G (1).
Park J. then went back to the case of Crossland v. Hawkins, and taking the facts of the case proceeded amend them in reference to the present case. This was by saying “what if the children had acquired their own shares, or what if they had acquired 50% of the share capital”. In each scenario he could see no reason why these modifications would alter the fact that Mr Hawkins would remain to be deemed the settlor of an arrangement in the nature of a settlement.
The exemption in s.660A (6) for outright gifts for capital between spouses
Concluding that the structure of the arrangement was such that Mr Jones had deliberately forgone income to allow his wife to receive abnormally high dividends, Park J. concluded that s.660A (6) could not apply. The gift (in the form of the dividends) was wholly or substantially one of income.
Further commentary
A key factor in the appeal was the proposition that an arrangement cannot become a settlement just because at some time in the future, bounty would flow. This was clearly Miss Powell’s view, and this if anything could for some be the remaining sticking point in the case. The term settlement is extremely wide, and so it is necessary to add together all the ingredients to determine the arrangement as a whole.
It does seem that whatever happened initially, Mr Jones did later use that structure to save tax by diverting income to his wife. This created the necessary bounty, and hence the outcome.
Market value salaries were discussed, Park J. also refers to a salary at “the going rate”. There is no such definition in the Taxes Acts, and if this judgement is not appealed, the courts have added to our understanding of the term “bounty” in terms of market value salaries forgone. This is quite an issue for owner managers of SMEs, in most small businesses salaries paid are, almost without exception (and the exception is IR35) lower than market rate. Quite how one should calculate a market value salary for an SME owner is something that is going to have to be addressed sooner or later.
Planning to avoid the creation of a settlement
My Practical Tax guide No. 15 in the series gives detailed guidance on this subject for spouses and civil partnerships in business. Now fully updated in the wake of this judgement.
If this has soured your views on tax planning, then my advice is quite simple, pay market value salaries at all times. By “market value”, I mean in this case, calculate your salary as if the company was totally within IR35, and make a deemed payment calculation under those rules. Arctic is a case involving a service company, and it is apparent that it was picked for that reason. When the Chancellor talked about “the right amount of tax”, it is plain that he had service companies in mind.
For those in other types of business, you will have very little way of calculating a salary at “the going rate” or “market rate” unless your job involves exactly the same duties as a normal employee. It will be unlikely that you will find one, as a normal employee is not a director, does not run the risks and rewards of running their own business, and maintains a constant income stream. It is not too late to re-structure your business in view of the decision in this case, and if you have any doubts take advice.
As to the prospect of being assessed on your spouse’s dividends for the last six years. I can only add that each case is decided on the facts, and if you are picked for investigation, specialist advice in this area is worth the extra cost.
Nichola Ross Martin
26th May 2005
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