Arctic Systems and the settlement provisions

The family company tax case of Jones v. Garnett was heard in very quick time by the Law Lords last week, and we expect to hear the outcome within the next five weeks (but twelve if their Lordships go on summer holiday first). In this article I am looking at the settlements legislation, the case, probable outcomes and consider some future planning points.

The settlements legislation
The purpose of the legislation is to ensure that someone who has taxable income of their own cannot escape tax by saying it belongs to someone else, and then still benefiting from it. Such a person is called a settlor, and if you hear the phrase “settlor interested”, it means that they have set up something (normally in the form of a trust) where they too are a beneficiary. The law evolved a long time ago and there have been a number of tax cases before the courts which have helped to define the term “settlement”.

The term “settlement” is extremely broad, it can cover any arrangement which shifts income or assets. As this would include just about any transaction you care to name the courts have agreed over the years that certain characteristic must be present for “an arrangement” to be termed “a settlement”. The major one of these is that it must contain some form of gift, so that someone essentially gets something for nothing. The gift is termed as “bounty” by the courts, and in most commercial transactions there is no bounty, and so these are not settlements.

The interesting thing about these rules are that they are specially designed to catch out parents who try and divert their income or assets to their minor children, and there are also ones to catch out settlors, or their wives, if they divert income or assets for their mutual or exclusive benefit. However, there is a specific exclusion if one spouse (and this term for the purpose of this article includes civil partner, within the meaning of the 2005 Civil Partnership Act) makes an outright gift of property to their spouse.

Outright gift exemption
For a gift to be outright, it must not have any conditions attaching, it must not be payable to or for the benefit of the giver, and it must carry with it the right to both income and capital (if must not be wholly or substantially a right to income). It is very important to get this right; for example, if I give my husband the meagre contents of my bank account, he will receive interest that accrues on the account, and he will also get capital in the form of the cash in the bank at the time of the gift. If though, he pays the interest into my bank account or a joint account, I as giver get the benefit of the interest too. The gift fails, and I am taxed on the interest, instead of my husband. In theory if my husband brought a house with the interest and I lived there, this would fail the benefit test too. HMRC have not taken things to this extreme, but it remains a possibility if they win Jones v. Garnett.

The outright gift exemption has also failed in a couple of tax cases where husbands allowed their wives to buy preference shares at a nominal cost. The shares, unlike ordinary shares allowed the wives to receive dividends from the husbands’ company, but did not entitle them to vote at company meetings or share in assets if the company was wound up. The cases were called Young v Pearce and Young v Scrutton and the important points of these were that the company was up and running and profitable before the husbands re-jigged the share capital, this meant that the shares which the wives purchased possibly has a higher value than the £1 each paid, this meant that bounty was present. The husband’s actions amounted to a gift, but the exemption did not apply as the shares were substantially a right to income.

Jones v Garnett – also known as Arctic Systems
The facts are pretty well known; Geoff Jones, an IT contractor and his wife Diana, a business woman, purchased a company off-the-shelf (Arctic Systems Limited). Each paid £1 for an ordinary share, he was director and she secretary. He then obtained and performed IT contracts, and she did the administration. Some years they took minimal salaries and the balance of profits as dividends, as recommended by their accountant, and some years they did not as they thought that they were caught by IR35. The questions which the courts have had to resolve were did setting up the company constitute a settlement, and if so, did the outright gift exemption apply?

HMRC’s argument was that there was a settlement, as there was bounty as Geoff did not pay a market salary so that he could divert income to his wife. They suggested that you look at an arrangement in the round and review the situation year on year (they did suggest this was pretty flexible, which is possibly the most ludicrous aspect of the whole case – taxpayers being expected to self-assess annually to discover whether or not they had fallen foul of the rules). They also argued that as Diana paid for her share, there was no property and so gift.

Geoff’s legal team argued that there was not a settlement, it was a basic family company and it was stretching things too far to claim that this was anything else. There was no bounty as Geoff would never have paid himself a market rate (what ever that is) salary anyway – why bother to pay National Insurance when you could avoid it by paying dividends? If there was found to be a settlement then the outright gift exemption applied in any case, as there had to be property gifted - the ordinary share, and this carried more than a right to dividend income.

What has complicated the case is that various courts have taken different approaches to the idea that you look at events “in the round”, the gift, and whether it mattered that Diana was not a director. Most commentators now agree that HMRC’s approach is wrong and they are applying the rules too broadly.

Avoiding a settlement
Before I go on to discuss spouses in business, I just want to consider children and the settlement rules. The following was found to be a settlement in the case of Butler v Wildin:
Brothers formed a company and then their infant children, with the help of grand parents subscribed to the share capital. The brothers worked for the company for free and it earned huge profits which were paid to the shareholding children. The court looked at the arrangement and agreed it was a settlement, irrespective of the fact that the grandparents had turned the wheels to ensure that the children held shares. I do not think it matters who forms this sort of company, the fact was that the parents diverted their income to the children. If there grandparents had worked for nothing there would not have been a settlement. S 629 of ITTOIA 2005 is the section that contains these rules for parents, incidentally, children can receive up to £100 of income p.a. without the provisions biting.

Spouses in business; If the Law Lords find in HMRC’s favour then the obvious thing is for one spouse to set up a company and then when it is up and running gift shares to the other, thus utilising the gift exemption in what is now s 626 ITTOIA 2005. HMRC have tried to argue that ordinary shares in IT service companies are “substantially a right to income”, avoid this by building up the company’s reserves so that there is cash in the company’s bank and put every last bit of equipment into the balance sheet. Avoid paying dividends into joint accounts at all costs. If the Law Lords find in the Jones’ favour, then set up your company in the normal way but still avoid banking dividends in joint bank accounts.

I hope that the Lords will find in favour of the Jones. Many people have said that HMRC will just change the rules but it is more complicated than that. Mr Brown has already put up tax rates, and even though 99.6% of businesses in the UK are small his meddling is highly damaging. Fairness in tax is a touchy subject for politicians especially when the newspapers are full of reports that the managers in the private equity industry pay tax at only 10%. It is anyone’s guess what lies in store for small business.

Nichola Ross Martin FCA is Tax Editor of Accountingweb and director of Ross Martin Tax Consultancy Limited


14th June 2007

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