Income shifting cases

A review of several tax cases highlighting when IR35 applies - or not.

In this case, the controlling directors and sole shareholders of a trading company arranged for preference shares in the company to be issued to their wives. The company subsequently declared substantial dividends to the holders of the preference shares. HMRC issued assessments on the basis that the transactions amounted to an 'arrangement', and hence to settlements in which the settlers retained an interest, by virtue of ICTA 1988, s660A.

ICTA 1998, s660A(1) states that:

'Income arising under a settlement during the life of the settler shall be treated for all purposes of the Income Tax Acts as the income of the settler and not as the income of any other person unless the income arises from property in which the settler has no interest.'

The High Court  upheld the assessments, holding that the transactions were within the statutory definition of a settlement and that the preference dividends fell to be treated as income of the settlers, i.e. Mr Pearce and Mr Scrutton, rather than their wives.

This is one of the most significant and high profile tax cases in recent years and the outcome was highly relevant to a great many taxpayers and the outcome was of great significance.

An IT consultant, Mr Jones, purchased a newly-incorporated off-the-shelf company and retained one of the two issued shares, and gave the other to his wife. The taxpayer was appointed as the company's sole director, while his wife was appointed company secretary. The company began to carry on an information technology consultancy business with the taxpayer carrying out the consultancy work, while his wife carried out some administrative work, totalling about four or five hours per week. The company paid them both small salaries but large dividends.

HMRC argued that the payments made to the taxpayer’s wife were disproportionate to her contribution to the business and raised assessments on Mr Jones, treating the income as his, on the grounds that this represented a settlement under ICTA 1988, s660A and was taxable under ITTOIA 2003, s624. Mr Jones appealed, contending firstly that the distribution of the company's profits did not amount to a 'settlement', and that the transfer of the share to his wife had been an outright gift to his wife, within the exception now contained in ITTOIA 2005, s 626.

The House of Lords rejected Mr Jones’ contention that there was no settlement, stating that the transaction would not have occurred at arms length with an unrelated third party and contained a sufficient element of bounty to constitute a settlement. However the transfer of the share to Mrs Jones had been an 'outright gift between spouses', within s 626, so that the charging provision in s624 did not apply. Lord Hope of Craighead observed that:

'an arrangement by which one spouse uses a private company as a tax-efficient vehicle for distributing to the other income which its business generates is likely to constitute a “settlement” on the other spouse … But so long as the shares from which that income arises are ordinary shares, and not shares carrying contractual rights which are restricted wholly or substantially to a right to income, the settlement will fall within the exception'. 

The taxpayer’s appeal was therefore upheld.

The key difference between this case and the Pearce/Scrutton case was that Mrs Jones received ordinary shares in Arctic Systems Ltd, carrying full voting rights. This brought her within the exception to the settlement legislation in what was then ICTA 1988, s660A(6) (subsequently rewritten to ITTOIA 2005, s626).  Conversely, Mrs Pearce and Mrs Scrutton were given non-voting shares with no right to participate in the surplus at a winding-up.  The exception only takes effect if the gift is not one which is wholly or substantially a right to income.

In this recent and very important case, HMRC must have expected a 'win', given the precedent established in the Pearce/Scrutton v Young case.

The salient facts of the case were as follows:

• Mr Patmore agreed to purchase the small manufacturing company for which he had worked, in instalments;
• the purchase consideration was to be paid in instalments; the first instalment of £100,000 was financed by way of a second mortgage on Mr and Mrs Patmore’s jointly owned home. The remaining instalments were to be financed by dividends to be paid by the company;
• the ordinary share capital was allocated 98% to Mr Patmore and 2% to Mrs Patmore;
• there was a subsequent reorganisation of the share capital and Mrs Patmore was issued with a 10% holding of non-voting B ordinary shares;
• dividends were paid on the non-voting B shares between 1999 and 2003. These dividends were credited to Mr Patmore’s directors loan account, to finance outstanding instalments for the purchase of the company.

HMRC argued that the dividends were taxable on the husband under ICTA 1998, s660A on the following grounds:

• the issue of the B shares to the wife was a right to income only;
• as the funds were credited to the husband’s director’s loan account, he derived a benefit from the income.

Because of the way that the purchase was funded, the Tribunal decided that Mrs Patmore should have received 50% of the original shares and the fact that she did not meant that Mr Patmore held 48% of the shares in a 'constructive trust' in her favour.

The Tribunal held that the dividends in excess of the 50% to which Mrs Patmore should be entitled, did indeed constitute a settlement and should therefore be disclosed on Mr Patmore’s tax return.

This has proven to be a controversial decision as English law only recognises certain categories of constructive trust, such as mutual wills or the common intention to share ownership of land. The common intention to buy shares does not appear to be one of them.