Chris Thorpe looks at where we are with the ‘settlements’ legislation 13 years after the ‘Arctic Systems’ case.
It has been nearly 13 years since Jones v Garnett [2007] UKHL 35 (commonly known as the ‘Arctic Systems’ case) emerged from the House of Lords with defeat for HMRC.
However, the ‘settlements’ legislation is very much alive and well, and defeat will not stop HMRC seeking to enforce it.
Background
The settlements provisions are not new. It first arrived in Finance Act 1922. The definition of a settlement appeared in Finance Act 1936, section 21(9)(b) (“any disposition, trust, covenant, agreement, arrangement or transfer of assets”), which is virtually identical to the modern definition in ITTOIA 2005, s 620.
Essentially, the legislation is designed to prevent income being artificially diverted to someone else paying a lower rate of income tax than the rightful owner of it. An indication of a violation of the legislation is what is often called an element of ‘bounty’ (i.e. something done out of benevolence rather than commerciality).
Is that settled?
The Arctic Systems case concerned a husband and wife who were both receiving dividends as 50:50 shareholders in a company. The husband generated the company’s income, and the wife carried out administrative work. The issue for HMRC was that husband only took a salary of £6,520 in the relevant year (i.e. 1999/00); way below a commercial salary for an IT consultant like him. As a result, the distributable reserves within the company were artificially inflated, with half subsequently being distributed to his wife. By taking the lower salary and distributing income to another person who was not generating the profits, HMRC said, a settlement had been created and therefore the wife’s income was taxed as the husband’s.
HMRC did not lose this case on the question of whether a settlement was in place or not (the House of Lords held that there was); it lost because Mr and Mrs Jones successfully deployed the spousal exemption clause within (what is now) ITTOIA 2005, 626, which only catches gifts between spouses (or civil partners) which are “wholly or substantially a right to income”. As Mrs Jones was an equal shareholder with equal voting rights etc, what she received was not purely a gift of income; the income matched her underlying shares, which carried all the same responsibilities.
The dividend ‘trap’
A lot of taxpayers have been caught out by the legislation over the last century. Some of those challenged were rather famous (e.g. actor Jack Hawkins and child star Hayley Mills both fell foul of the settlements legislation). They too took very small salaries from the limited companies through which they offered their services to the film industry, resulting in over-inflated reserves.
It’s not just the paying of dividends to other family members which can invoke the legislation; failing to pay dividends to the ‘correct’ person is just as evil in HMRC’s eyes. Whereas the Jones’s got off the hook, Messrs Donovan and McLaren [2014] UKFTT 048 (TC) were not so lucky when they waived their dividends, thus allowing their wives to ultimately receive them. In HMRC’s (and the First-tier Tribunal’s) view, the waivers themselves were gifts of ‘pure’ income and had no commercial legitimacy.
Where are we now?
So, where are we with the settlements legislation? The truth is we are in pretty much the same place as we have been since 1922. Like their forebears, HMRC will pursue those whom they believe is transferring income (or ‘purely’ income between spouses) in any manner which is uncommercial and results in less tax being paid. Alphabet shares, whilst common, are just such a tool for doing this; as are dividend waivers.
It’s a grey area, but essentially the only real advice is, as far as dividends are concerned: wherever possible, don’t vote dividends to family or close-friend shareholders at levels you wouldn’t vote to any other shareholder within the firm.
