Dividends And Settlements: Where Are We?

Ken Moody highlights some circumstances in which the ‘settlements’ anti-avoidance rules could bite in the context of dividend payments.

Recent experience suggests that the application of the settlements legislation to dividends is not fully understood even by some professional advisers. Without intending to ‘reinvent the wheel’ this article is an update on the circumstances where payment of dividends could be caught by the settlements legislation. 

I recently advised one of my client firms on a company sale, which involved payment of a pre-sale dividend and a dividend waiver. The company was a family company owned by two siblings, the brother being UK resident and the sister being Hong Kong resident. A pre-sale dividend was to be paid, to which the brother would waive his entitlement. One of the professional advisers involved raised the question of whether the dividend waiver might amount to a ‘settlement’, which was a fair point to which my answer was, in a nutshell, ‘yes but no’.

My understanding was that there was no intention on the part of the brother to benefit the sister, though in my view it would not have made any difference at the end of the day if there had been. 

It is established in case law that a settlement requires an element of ‘bounty’, i.e. a desire of one party to an arrangement (the ‘settlor’) to benefit the other. This concept was first articulated in IRC v Leiner (1964) 41 TC 589, and approved in subsequent decisions including the famous case of Jones v Garnett [2007] UKHL 35 (http://www.bailii.org/uk/cases/UKHL/2007/35.html) to which I refer shortly. It follows though that a purely commercial arrangement cannot be a settlement. 

Put simply: if the dividend waiver amounted to a settlement and if the settlements legislation applied, part of the dividend could be treated as income of the brother. As we are talking about a six-figure sum that would have been somewhat unwelcome!

The settlements legislation is of course anti-avoidance legislation and as such is intentionally very widely drawn and may apply to ‘any disposition, trust, covenant, agreement, arrangement or transfer of assets’ (ITTOIA 2005, s 620). A dividend waiver is clearly within the definition.

As mentioned, there may have been no element of bounty in the case in point, but what is perhaps not clearly understood is that where bounty is present in an arrangement, which is therefore a settlement, it does not necessarily follow that the anti-avoidance provisions apply to it. 

Other than where the settlement benefits the minor children of the settlor, the income of a settlement is only taxable on the settlor if the settlor retains an interest in the settled property (ITTOIA 2005, s 624). However, the settlor is deemed by s 625(1) to retain an interest if there are any circumstances in which the property or the income from the property is payable to or applicable for the benefit of the settlor or the settlor’s spouse or civil partner. 

As regards dividend waivers, the views of HM Revenue and Customs (HMRC) are reasonably well known and are set out in the Trusts, Settlements and Estates manual (at TSEM4225). Broadly, a dividend waiver may be regarded as a settlement where the company does not have sufficient reserves to pay the same rate of dividend on all the shares, where an intention to benefit may be inferred and less income tax is payable as a result.

The query in the case in point referred to Example 12 at TSEM4225:

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. 

Example 13 concerns a similar situation, except that there are two share classes which rank equally and a dividend is paid on one class where the same rate could not have been paid on all the shares. In both situations, HMRC may consider this to be a settlement.

However, these examples concern husband and wife (or civil partners), which is the crucial distinction. The legislation (at ITTOIA 2005, s 626) makes an exception from the provisions of s 624 (see above) where the settlement consists of an outright gift between spouses, which: (a) carries the whole of the income; and (b) does not consist ‘wholly or substantially’ of a right to income. 

In Examples 12 and 13, since the settlement would be a settlement of income, the exception would not apply, and in that sense spouses and civil partners are in a worse situation than other persons because they are deemed to retain an interest by s 625.

Examples 12 and 13, however, have no application to settlements where persons other than husband and wife are involved, and at TSEM4220 HMRC acknowledge that:

Where the person benefiting under the arrangement is not a spouse, civil partner or minor child the settlements legislation will not apply unless there are arrangements under which the money will be paid, or used to benefit the settlor (or spouse etc).

The peculiar situation of spouses and civil partners was considered in the case of Jones v Garnett mentioned earlier, which is sometimes referred to as the Arctic Systems case. The facts are fairly well known, but, briefly, Arctic was a ‘personal service company’ which provided Mr Jones’ services as an IT consultant, and whose turnover consisted entirely of charges for those services. Mrs Jones was company secretary and performed minor administrative duties. The shares in Arctic were held 50:50, and as a result Mrs Jones received dividends that far exceeded a commercial return on her investment in the company or in relation to her services to the company. 

Had it not been for them being spouses, Mr Jones would obviously not have entered into such an arrangement, which was clearly bounteous and therefore a settlement. The question that arose was whether the exception at s 626 applied. HMRC argued otherwise on the basis that the arrangement was ‘wholly or substantially’ a right to income. They therefore assessed Mr Jones on the dividends received by his wife. 

The courts, however, took the view that the settlement property, being ordinary shares in the company, with voting rights and rights to capital on a winding up, could not be wholly or substantially a right to income and that the exception did apply. This decision may be contrasted with an earlier decision (in Young v Pearce [1996] STC 743), which involved the issue of preference shares to the wives of the controlling directors and sole shareholders. The shares carried a right to a dividend but no right to capital in a winding up and no votes. The Court held that the preference shares were substantially a right to income and that the exception at (now) s 626 did not apply. It followed that the preference dividends were assessable on the husbands as settlors. 

Finally, a decision worth mentioning in the context of dividend waivers is Buck v HMRC [2008] Sp C 716 (www.bailii.org/cgi-bin/markup.cgi?doc=/uk/cases/UKSPC/2008/SPC00716.html, where the controlling shareholder-director held 9,999 of the 10,000 issued shares, and his wife (who was not a director) owned the remaining share. Mr Buck waived his dividend entitlement so that his wife received an enhanced dividend of the whole of the distributable reserves. It was fatal to Mr Buck’s arguments that the commissioner decided that the dividend waiver was not an ‘outright gift’, but merely the renunciation of a right by a one-off waiver. It followed that the exception at s 626 did not apply.

As illustrated by Buck v HMRC (and Example 12 at TSEM4225), dividend waivers affecting husband and wife should be avoided: a Jones v Garnett type argument will not wash. 

Where two separate share classes are held by husband and wife the settlement provisions may still apply according to Example 13 at TSEM4225, but that only concerns husband and wife. Otherwise the guidance at TSEM4220 (see above) should apply. However, where the shares rank equally there may be other implications in paying a dividend on one class of shares to the exclusion of the other, unless the company’s articles of association authorise the directors to do so.