’Settlements’ – Cause For Concern?

Lee Sharpe looks at the settlements anti-avoidance legislation and says many need not worry. 

The settlements anti-avoidance legislation is quite complex. This article will try to explain the concepts and why its reach may be shorter than HM Revenue and Customs (HMRC), and even some accountants, might think. 

In the context of trusts, etc., a settlement can take many forms. This article looks at where one party ‘settles income’ in favour of another. 

Very simply, if John refrains from taking income so that Jane can take more, then John is settling his income entitlement on Jane. This is very decent of John. John may not need the money, or he may not want to pay so much tax on the income to which he is entitled so he does not take it.

Two relatively common examples of this are perhaps where:

Note that in these examples, John and Jane are not married. 

In such cases, John is either ‘giving’ his income to Jane, or he is allowing his right to income to be overlooked, to Jane’s advantage. The courts have established that, for there to be a settlement there must be an element of ‘bounty’ – the provision of some kind of value, without something equivalent in return. Hence a commercially driven transaction will not be a settlement, as HMRC recognises in its Trusts and Estates Manual (at TSEM4110).

So far, so good. Why does HMRC care about John’s generosity? Because I neglected to mention that John pays tax at 40%, but Jane pays tax at only 20%. If John took his full entitlement, then HMRC would take more in tax. At this point, HMRC is looking for ways to tax John on the income he never had, so that proportionately more tax can be raised. ‘It’s really John’s income, not Jane’s income, so it should be taxed as John’s income’, says HM Inspector, who is not overly concerned with the fact that John may have avoided paying tax, but only because he avoided having any income in the first place.

The settlements legislation drags on for several pages. It is to be found at ITTOIA 2005, s 619 et seq. One of the thornier issues is that a settlor is deemed to have retained an interest in the thing (income) that has been settled on someone else if he, his spouse, or his minor children have benefited, will benefit, or may benefit. And if John (above) could benefit, either through his spouse or minor children, then HM Inspector can apply the legislation to tax John. 

Spouses and young children are specifically mentioned in the legislation because the logic goes that, if my spouse or children can benefit from the income that I have ‘settled’/given away, then it has come back to me because my household has benefited. And to an extent, I agree with this concept. 

But HMRC argues that the settlements anti-avoidance legislation has a much wider reach (TSEM4200):

‘…the settlor is treated as having an interest in property if ‘that property or any related property is, or will or may become, payable to or applicable for the benefit of the settlor or his spouse or civil partner in any circumstances whatsoever’. It is not necessary for the settlor’s spouse, civil partner or children to be the people to whom the income is transferred. If the settlor or their spouse or civil partner may benefit, regardless of who else benefits, then the legislation can apply…’

It then goes on to give a quite unusual example of a settlement between brothers, where one brother gives his shares to the other, so that the second brother can enjoy a large dividend, but only on the basis that the first brother can have his shares back afterwards – so HMRC can say that the first brother has ‘retained an interest in the property’ – the shares in this case. So, in the example, HMRC can say that the dividend that was physically paid to the second brother, actually belongs to the first brother and is taxable on him.

At this point, it is arguable that things are not looking very good for John. But how likely is it that a settlor will retain an interest in the property, or benefit from the settled income, in most cases?

In fact, HMRC’s own manuals later say this specifically about the settlor having waived a dividend (at TSEM4220):

‘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.)’ (emphasis added). 

So, TSEM4220 admits that there is a practical limitation: HMRC would have to demonstrate that John somehow benefited from his generosity to Jane.

There is support for this in the courts as well. One of the most famous tax cases of recent years, Jones v Garnett [2005] STC 1667 (also referred to as ‘Arctic Systems’) was one of a series of cases wherein the husband had done all the income generation in his consultancy company, then split the dividends equally with his spouse. The taxpayer won when the case went ultimately to the House of Lords, because of special reliefs afforded to spouses. But while the case was being heard at the High Court, Sir Andrew Park QC said that, if Mr Jones’ co-shareholder had been his sister, then the settlements rules could not have applied. 

The implication is that, unless HMRC can demonstrate that there is in fact a mechanism whereby John (or his spouse or minor children) can benefit from John’s generosity to Jane, then HMRC cannot invoke the settlements income tax anti-avoidance legislation, to treat the income transferred to Jane as being John’s, and taxable accordingly. Jane could be John’s sister, or adult daughter, and this would still be OK. 

Having established that most non-spouse/minor child relationships should not be affected by the settlements income tax anti-avoidance legislation, I think this does still rely on being able to prove that the person settling the income cannot benefit from that income, in future. I therefore recommend that the income in question not be paid into a joint account that both parties (settlor and beneficiary – John and Jane respectively) can draw on. 

While care needs to be exercised between spouses, and also where income is settled on minor children, it is much less likely that the settlements legislation can bite for other relationships. I should always recommend, however, that taxpayers check with their advisers for reassurance that this complex legislation is not triggered.