Arctic Systems Section 660 case: closing day
The case of Geoff Jones (GJ) and his wife Diana (DJ) closed at lunch time today after the Revenue's barrister, Rupert Baldry (RB) had spent another half hour closing his case and the Jones's counsel, Malcolm Gammie (MG) had spent a further hour and a half responding and drawing his case to a close. The Commissioners have retired to consider the arguments and confirmed that they would give their judgement as soon as they can but that it would take quite a while to review all the documents and arguments and reach a conclusion. I suspect we are talking at least 4-6 weeks.
Today's events
First in response to comments that my commentary on yesterday was sexist because of the detail I went into regarding the two lady commissioners I apologise if it offended anyone. I have to say that what you got was the expurgated version. Susie Hughes exercised her editorial powers to cut even more personal comments I made about the Commissioners, which might have put the 'sartorial' element of the comments into context.
This was not intended to be sexist but merely to add some colour to what had seemed a very long day by painting a picture of the personalities involved! That I did not comment on the men's attire was purely a reflection that their attire did not seem to reflect their personalities while, for the ladies, it did!
Suffice to say that today everyone was very smart and, as per usual, at the start of the morning DB had pity on the men and gave us permission to remove our jackets in view of the heat!
RB opened the morning by confirming that he had completed his review of the case law. He then clarified a few issues of evidence and summarised what he saw as the main planks of the Revenue's case.
Revenue's summary
RB's first point was that the company, ASL, was set up after GJ knew he would be able to secure a contract. The company was set up and the first contract entered into within two weeks of GJ being made redundant.
His second point was that the dividends drawn from ASL represented most, if not all of the company's reserves, with very little being retained in the company. Neither point was elaborated upon but there was a distinct inference that this was, in some way, not the actions of a normal company.
RB then recapped the Revenue's approach to the legislation. That first you identify what the arrangement is – and in this case the Revenue see it as the acquisition of the share by DJ, plus GJ working for a low salary thereby allowing DJ to benefit from the dividends out of the resulting profit. In RB's view this was looking at the whole arrangement in the way the legislation intended. He commented that these transactions taken together had "sufficient unity".
Once the arrangement has been identified there then had to be an element of bounty. It was this test, RB contended, that removed the concern that any form of arrangement might fall within the legislation. In this case the Revenue claims there is a bounty – in that DJ benefits from the profits generated by GJ via his work and as a result of his drawing a low salary.
RB compared this approach to that advocated by MG, which tried to look at what Parliament intended. In RB's view the Revenue's approach was more disciplined and logical. Nevertheless even if you followed MG's approach RB argued that, yes, the arrangements were intended to be caught by the legislation.
In RB's view this type of income alienation – using company shares – is exactly the type of arrangement that Parliament intended to catch. It was no different to the use of company shares as had been found to be a settlement in the Hawkins and Mills cases.
RB disputed MG's view that the arrangement was somehow different just because GJ had been required to use a company in order to gain work via an agent. RB made the point that merely because GJ needed to work through a company it did not mean that DJ needed to be a shareholder.
RB responded to MG's earlier arguments about the Taxes Acts not dealing with Human Capital – namely income forgone. RB argued that here we are not dealing with income forgone but with income arising to DJ that should be taxed as income of GJ. The settlement provisions were not creating a new source of income.
In RB's view Parliament had anticipated that the effects of separate taxation would affect husband and wife transactions – hence the creation of a specific exemption for outright gifts in section 660A(6). We could not infer from what Parliament had specifically dealt with in the legislation that they did not intend that joint ownership of companies could be a settlement.
Finally RB stated that it was the Revenue view that it made no matter whether DJ had acquired the shares herself or had been gifted them by GJ.
At this point RB invited questions and Special Commissioner JP asked RB to confirm that the Revenue was not suggesting that the Commissioners needed to consider what would have been the correct market rate salary for DJ? RB agreed that this was not the case. He then added that ASL had been acquired as a shell company with £2 share capital. However if a company had a potentially profitable contract and a worker who had agreed to work for a low salary this could affect the value of the company. Hence the issue of value could vary from company to company.
This concluded RB's case.
I must admit that I was surprised that RB had not raised the issue of whether ordinary shares were wholly or substantially a right to income. However, discussing this with Anne Redston afterwards, she confirmed that the Revenue was not claiming that DJ had been given the shares in ASL by GJ. The exemption in Section 660A(6) related to gifts between spouses and the condition that was included in Section 660A(6)(b) - which excluded from that exemption gifts that were "wholly or substantially a right to income" – therefore only applied to gifts. Hence this issue was not likely to be dealt with in this case.
Malcolm Gammie's response
As is the case in an appeal the appellant has the right of a final response to the case made by the Revenue so the last 90 minutes were taken up by MG's response to RB's case.
MG agreed with RB's view that the case being argued for the Jones was complex. MG said it was inevitable in issues like this where you are trying to prove a negative (i.e. that this was not a settlement). His role was to try and show that words in the legislation, that appeared to say that the legislation applied, in fact did not.
MG said he could have argued a simpler case – namely that there was no bounty. There was no bounty when the company was set up and no bounty attached to the dividends. Bounty was not a statutory test – there was no reference to it in legislation. It was a concept, a judicial gloss, which arose from case law and had been used to identify transactions that did not fall within the legislation.
Regarding the Hawkins and Mills cases MG confirmed that what he was arguing was that part of the arrangements in those cases involved the creation of a settlement that included a bounty. It was the bounty that brought the arrangements within the settlements legislation not the settlement per se. MG agreed that if GJ had set up the company, entered into a long-term service contract for a low salary and then given shares to DJ then that would have been a settlement. Then MG would be arguing that it was an exempt settlement by virtue of Section 660A(6) – gifts between spouses.
But the Jones situation was totally different from Jack Hawkins saying to expert lawyers and accountants "devise me something to enable me to pass income to my children".
As MG explained in 1992 the Jones had gone to the accountants, John Steven Accountants (JSA) and explained their situation. In MG's view whether it was the accountant or GJ who said they needed to use a company does not matter. They had gone there jointly with the view that they wanted to do something together to earn a living. They had shared most of the assets in their marriage and they were going to share this. DJ was going to work with GJ in the business. She had management experience he did not. It was probably the accountant who said why not split the company 50:50. The accountants said it was standard practice. So it is. There are a huge number of companies out there with a similar structure.
In MG's view it was not done as a means of getting round the settlements legislation – this was not what the legislation was about. Parliament knew this situation was not covered. When they dealt with the settlements legislation in 1989 in the run up to separate taxation they did not deal with these companies because they did not need to – they were not to be included.
MG was adamant that Parliament would not have left this 'unexploded mine' lying there to trap thousands of companies sometime in the future. Even the Revenue had taken about 6 years to wake up to the possibility that the legislation could be used in this way.
As MG explained, when the Jones's went to the accountants they walked in with two pounds for the share capital and walked out with two £1 shares. Apart from that their position was no better or worse than when they went in.
Even if GJ knew he was likely to get a contract soon that did not invest the shares with any more value.
MG argued that according to the Revenue the "arrangement" was the combination of the acquisition of the shares by DJ and GJ's agreement to work for the company for a low salary. The Inspector argued that it was a settlement because GJ gave away his earning capacity. However the evidence was that there was no such agreement. GJ did not have a service contract with ASL. Salaries were determined from time to time based on the accountant's advice.
When they left the accountant's offices with their two £1 shares no bounty had been created. By contrast, in the Hawkins case, for example, Hawkins had agreed to serve the company for a low salary.
So MG explained, the Inspector argues that as and when it was decided to draw a low salary and then a dividend was declared that this was the settlement. But, MG argued, if the settlement was not a settlement on day one it cannot be converted into a settlement by later decisions on salaries and dividends.
MG then discussed RB's view that the shares in ASL were "settled property". As MG put it
"I am confused as to whether the shares were settled property when the Jones left the accountant's office or at a later date or whether they can be settled property one day but not the next depending on whether a dividend is paid?"
MG asked if settled property can be created in the blink of an eye only to disappear again? In MG's view what was not settled property at the start could not become settled property at a later date.
In addition MG argued there was no bounty when the company was set up and whatever bounty arose later does not alter the character of earlier transactions.
In MG's view if the Inspector is right in his view of the arrangements then this affects every company where spouses own shares and work in the company and will require them all to consider from time to time if they are paying the right salary. In MG's view this was untenable especially in the light of self-assessment.
MG again reviewed some of the case law to refute RB's views on the relevance of each case.
In conclusion, MG compared his arguments to a Morecambe and Wise sketch where Eric Morecambe was playing the piano for Andre Previn. When Previn queried what Morecambe had played he responded that he was playing all the right notes but maybe not in the right order! MG said he felt a little similar. He was clear that he had covered the right issues but conceivably not in the right order.
He argued that there was no bounty on day one when the shares were issued. But even if there was then he would be entitled to rely on the exemption for outright gifts in Section 660A (6). This case was not the same as the Young and Pearce preference share case as the Jones's had the right sort of shares. This was as close as we got to discussing the issue of whether ordinary shares were wholly or substantially a right to income.
There was no bounty on day one and there was nothing between day one and, say, day 100 that the Revenue could drag in that they could say there was bounty in it. What the company earned belonged to DJ and GJ in the proportion they held their shares. There was no bounty involved in not taking a commercial salary. Failure to pay a commercial salary was not a bounty of a nature that was encompassed within the Taxes Acts. Foregoing something you do not have is not a bounty.
MG concluded by stating that RB argued that GJ provided funds to the settlement by working for the company. But in MG's view the settlements legislation is all to do with providing funds to something that is already a settlement. To say that providing funds for a dividend is a settlement is wrong. The shares were never settled property. DJ had owned them from the start and had bought them at the right value. Whether DJ or GJ had taken a commercial rate of salary was neither here nor there.
Costs
Having concluded the case there was just the issue of costs to deal with. RB recounted again that the Inspector had been told early on that GJ had been the subject of an earlier enquiry. In 2002 when the Inspector made the assessment he assumed he had all the papers that there were.
In March 2004 they had received a letter from the appellants outlining the issues and which raised the discovery point. The Revenue's solicitor had instructed the Inspector to contact the local office in Horsham for any files they had relating to the enquiry and they were told there were none. However in May 2004 having received the appellant's skeleton the Revenue contacted the Horsham office again and were then told that yes there was a file – it had been filed separately in the investigations section.
When this was shown to the Inspector he concluded that had he had it before he might not have raised the discovery assessment. In view of this the Revenue had decided to cancel that assessment.
RB concluded by saying that the Taxes Management Act only provided for the granting of costs where the Revenue's action had been "wholly unreasonable" and in his view their actions fell short of this.
MG responded by reminding the Commissioners that DJ had informed the Inspector early in the investigation that there had been a prior enquiry. The Jones's advisors had told the Revenue in August 2003 that they would be contesting the discovery issues because of this prior information. The Revenue knew it was an issue on appeal and it was not adequate to say that they had looked for the file but had not found it. The Inspector was duty bound to investigate what the Revenue already knew about the Jones's and he should have told someone to find the file. In MG's view if this did not qualify as 'wholly unreasonable' then he had difficulty conceiving what would qualify!
DB concluded by thanking all concerned and saying that there was a lot for the two of them to consider and that they would be as quick as they could be in getting the opinion out but it would take some time.
Conclusions
So after observing this case for two and a half days what is my conclusion?
If the case is decided on the weight of argument then the Jones' should win as Gammie spent twice the time arguing his case. But life is not that simple. At the end of the day we have two quite basic arguments.
MG believes that the arrangements in question are not a settlement and were never intended by Parliament to be encompassed within the settlements legislation. RB disagrees. He thinks the legislation is quite clear.
MG also argues that a settlement needs to exist on day one and that creating a bounty does not create a settlement unless the settlement already exists.
MG's arguments about the impracticality of the Revenue's position and how it poses tremendous problems for taxpayers seems very logical and intuitively right. How can we have a situation where a settlement may or may not exist depending on whether at any moment in time the working shareholders are drawing market salaries or not and paying profits out as dividends?
The Commissioners asked whether they were being required to judge what a commercial salary was and RB said no. But it seems to me that that is exactly what is being asked of taxpayers – and of Commissioners if they go to appeal. In every case like this there will be an issue of whether the worker has been paid a commercial salary or has created a bounty by drawing a lower than commercial salary. So what is a commercial salary will always be in question. That seems an invidious position for taxpayers or Commissioners to be in.
It seems clear from the line of arguments the Revenue took that, regardless of the outcome of this case, some situations will face more problems than others. Having a service contract that lays down a low salary seems to be a potential problem. Transferring shares after the company is established will raise issues of value. Having a situation where the non-contracting spouse is clearly uninvolved in the business will create difficulties. MG made much of the fact that DJ was involved right from the start and was involved in meetings with the accountants.
Who will win? I am quietly optimistic that the Jones's will win based on the issues raised in the hearing. MG made a strong case for why it would be wrong for the Revenue's view of the legislation to prevail when the legislation seems so unclear. I think the Commissioners might be very unwilling to set a precedent that could have a serious impact on thousands of businesses.
So the Commissioners may well favour the appellants on the grounds that if the Revenue are really concerned they can appeal – which shifts the onus onto a higher Court. Or, perhaps more likely, if the Revenue lose they have the opportunity in the coming pre budget report review on small businesses to clarify the issue once and for all and to make the legislation clear.
Hence any victory for Mr and Mrs Jones would at least provide relief from any attack on past events and would only leave the future in doubt from the risk of the Revenue changing the legislation.
We will have to wait and see.
Kevin Miller, MA FCA