Revenue's revised Section 660A guidance concedes little

The Revenue has just released revised guidance on its approach to Section 660A the anti avoidance legislation on settlements.

Background

The Section 660A settlements legislation saga rolls on. Early in 2003 there were reports in the accounting press and on various web news sites that the Inland Revenue were using the anti settlements legislation Section 660A to attack the tax treatment of dividends within husband and wife companies. One case in particular, Arctic Systems, saw a family company owned 50:50 by a married couple, being assessed for over £40K of taxes and interest going back 6 years. This was apparently on the basis that the dividends received from the company by the wife were really a settlement by the husband upon the wife designed to avoid tax. Hence the Revenue was claiming tax on the basis that under Section 660A these dividends should be taxed as income of the husband – resulting in tax at the higher dividend rate.

In April 2003, in response to requests from tax professionals for clarification of this ‘new’ approach the Inland Revenue published its tax bulletin 64. Here it set out in some detail its approach and illustrated it with a selection of examples. These indicated, for example, that where the company’s main service was selling the expertise of one of the directors then the Revenue would look at the salary taken by that director and, if it appeared to be at a below market rate then they considered that this resulted in a ‘bounty’ being created – that is a bounteous profit, being the difference between the salary taken and a ‘commercial’ salary.

If this bounty was distributed by way of a dividend to the shareholders then the Revenue would look closely at the amounts being received by the shareholders to see if this reward seemed excessive in relation to their investment in the business or their contribution to the business’s activities. If it appeared that income was being transferred from working shareholder(s) to others so as to reduce tax liabilities then Section 660A could be invoked.

This approach was widely regarded by tax experts as being a new interpretation of Section 660A. In particular, in the context of family companies (and partnerships), there was great concern that this treatment was premised on the basis that holding ordinary shares or receiving partnership profit shares could be considered as being arrangements that were wholly or substantially a right to income. It was and is widely considered by tax experts that holding ordinary shares in a company or being a partner in a business was never wholly or substantially a right to income.

For many years now tax advisers had been recommending that, in family businesses, it was perfectly acceptable and even advisable to grant shares to the spouse whose support would be critical to the overall success of the business. The Revenue’s apparently new approach would undermine the basis on which many family businesses had operated for many years and could result in large unforeseen tax bills for thousands of businesses and their owners.

Such was the concern of the tax profession that in September 2003, in a move of unprecedented solidarity, all the leading professional bodies involved in accountancy and taxation matters sent a formal submission to the Inland Revenue that questioned the validity of the Revenue’s approach and set out their specific concerns over the examples the Revenue had used.

In response the Revenue replied with a statement that, in essence, said that:

· their approach was not new but had been applied over several years (albeit in only a few cases that had not been publicised),

· that their approach was not incorrect technically and

· that certain tax experts had publicly agreed with their rationale.

In November the professional bodies responded confirming their continuing concerns about the technical validity of the Revenue’s main assumptions and setting out their grave concerns about the difficulties facing thousands of family businesses, who would be uncertain as to whether their past practices would be affected in future by the interpretation of Section 660A.

New Guidance

The Revenue has now responded once again with revised guidance.

For details see their web site here:

revised guidance

The main change is that they have responded to requests for more details by setting out exactly how taxpayers should deal with Section 660A issues in their self assessment tax returns.

But they have refused to concede any ground whatever on their basic premise that ordinary shares and partnerships can be wholly or substantially a right to income. They have given some additional guidance on what might be regarded as a commercial rate of return and on what might be an appropriate level of investment by an individual to justify a substantial share in the profits of the business.

The revised guidance still leaves many key issues unresolved. For example:

1. At what level of contribution from the spouse will the Revenue accept that the legislation does not apply?

2. Does the type of work make a difference? For example if the spouse carries out the same amount of work (say one or two days a week) will the Revenue regard their contributions as being the same if in one case the work is company administration, in another it is research, in another it is technical work but based at home and in the final case it is work at the client sites?

3. How much capital invested in the business is enough?

4. How do the issues of work done and capital invested articulate? For example how does doing no work but investing say £50K compare with working half time and investing £1K?

5. What happens if the situation changes over time – for example the spouse starts by being very active in the business but then gradually reduces their involvement?

6. Section 660A can only be applied to dividends taken out. What will be the Revenue’s attitude if profits are retained for several years and reinvested in assets such as property so that the capital value of the shares held by the spouse becomes significant?

The revised guidance also includes six new examples although several are very similar to earlier examples.

One interesting point that arises comes in the Revenue’s discussion of “what is an uncommercial salary”? . Here they suggest that if an IT contractor had been earning £80K when working for a PLC and then becomes a contractor and earns fees of £120K a year with expenses of say £20K then “we would expect to see (the contractor) drawing a salary of around £80,000” . They go on to add that in that scenario a salary of £40,000 would be uncommercial.

It seems strange that in connection with Section 660A the Revenue accepts that there might be a ‘commercial’ salary. Yet in the context of IR35 they were totally unwilling to accept that the fees earned by a contractor could equate to a commercial salary plus a legitimate element of profit.

Conclusions

We will need to study this revised guidance in more detail. However first impressions are that the Revenue have not conceded any of the many detailed concerns raised by the tax professional bodies in their two papers. It seems likely therefore that clarity will only really come when:

1. we have some test cases to explore key issues like whether ordinary shares can ever be regarded as wholly or substantially a right to income and

2. when test cases have explored the very uncertain boundaries of issues like the level of involvement of the spouse, what is a commercial salary for the main worker and what is a reasonable return on an investment?

For more background and information on Section 660 see our Section 660 forum here:

UKTECH Section 660