Revenue rejects professional bodies on Section 660A

On 11 September I reported that, in an unprecedented move, seven leading professional bodies had written jointly to the Inland Revenue to express concern about the Revenue's interpretation of the Section 660A settlements legislation.

The Inland Revenue has now published their response.

It can be found here:

Businesses, Individuals and the Settlements Legislation

In it they are essentially sticking to their guns and telling the professional bodies that their carefully considered concerns about Section 660A carry no weight with the Revenue. In summary they are confirming that, in their opinion:

· Their approach is not new but has been consistently followed since the taxation treatment of husbands and wives changed in 1989 (until then a wife's income was aggregated with that of her husband so any settlement did not make any difference.

· Tax professionals have been aware for some years that the Revenue was taking this view of the legislation.

· Some tax professionals are in agreement with the Revenue so it was incorrect to claim that the Revenue's approach was in conflict with accepted tax practice

· Because of these points they would not agree to the suggestion that they should not seek to apply their approach before April 2003, the date of their contentious Tax Bulletin 64, in which they set out their views and a number of examples.

· They dispute claims that this legislation could affect 100,000s of companies. In their view there are about 30,000 companies that have two shareholders, one or two directors and which pay dividends.

It appears, therefore, that we are at an impasse, which will only be resolved by a test case.

In the Revenue's view they will:

”look at the whole arrangement, as the legislation requires. The relevant questions are: What has been invested? What assets, trade, profession have been placed in the company and by whom? Who does what to earn the income of the company? Is the remuneration paid at a commercial rate for the job? Is someone getting a disproportionate return on the capital they have invested because of their relationship with the settlor? All these issues must be considered and if the shares are being used as a vehicle for diverting income then the legislation may apply.

With respect to partnerships the Revenue again looks at the whole arrangement to see whether someone is getting a disproportionate return on their investment because they are related to, or friends with, the settlor.”

In response to comments that their approach failed to recognise the contribution that spouses made to the family business the Revenue commented:

“We have not suggested that a "non fee-earning" spouse makes no contribution to a business. The question, in the context of the settlements legislation, is "What contribution does that spouse make and how commercial is the reward for it"? While the settlements legislation does apply where there is a benefit to the settlor's spouse it also applies to any settlement where the settlor retains an interest in the settlement whoever the beneficiary may be. In a service company it is usually the person with the specialist knowledge who retains the interest because s/he controls the source of income. Also it should be noted the legislation is neutral, referring to "settlor" and "spouse".“

They also state that:

“All factors are relevant and as already stated a key feature of the cases into which the Revenue have raised enquiries is the arrangement whereby a high earning individual agrees to work for a company for a very low rate of remuneration and allows a significant part of the earnings which they generate to be paid to someone else.”

The way ahead?

So where does this leave small businesses? Clearly the uncertainty remains. The Revenue view leaves many businesses unclear as to whether their arrangements can be attacked or not. A key issue will be the response of the Special Commissioners to any test cases that are brought in the future. We understand that Qdos Consulting are dealing with several Section 660A cases and that one or two are likely to progress to the Commissioners in the next six months or so.

Hopefully such a case will clarify the fundamental issue of whether ordinary shares can be caught under the Settlements provisions as the Revenue claims and, if so, set some parameters that will enable tax-payers to have a better idea of what criteria the Revenue will have to use to be successful in the application of Section 660A to small businesses.

If businesses want to reduce the chances of a future claim then the Revenue's comments give some clues as to what factors reduce the risk of a claim, such as the main fee earner taking a “commercial salary”. Quite what this is still highly debateable, but it is almost certainly a lot less than the 95% of fees (approximately) that IR35 taxes as salary.

It must help to record as fully as possible the contribution that the spouse or partner makes to the business in order to show that their reward is not disproportionate. A system like UKTECH's Freelancer's Outside IR35 (“FO35”) will help to guide freelancers on matters to consider and record.

Finally, it is also worth noting that the Revenue claim they have only investigated about 200 cases since 1992 and have no plans to raise the level of Section 660A cases they target. They are relying on tax-payers voluntarily complying with the Revenue's view of the legislation. They have also confirmed that:

“Interest cannot be waived but we have agreed that penalties will not normally be sought for 2002-03 and previous years in cases like examples 3, 4 & 5 involving the settlements legislation.”

So we still remain in an uncertain situation. Until the basic issues are clarified by test cases any drastic changes in company structures seem premature. However, as we have indicated before certain arrangements remain especially vulnerable and should be avoided if possible. These include:

· the use of special classes of shares which divert income to other shareholders without any of the other rights and responsibilities of ordinary shareholders and

· the use of dividend waivers to enable some shareholders to receive larger shares of profit than could otherwise be paid.

We will have to await the first test cases and hope that they provide the clarification that is needed.

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