Revenue's revised Section 660A guidance in Bulletin 69
Back in December 2003 we noted that the Inland Revenue were in the process of producing additional guidance on Section 660A to augment the guidance they gave in April 2003 in their tax bulletin 64.
This revised guidance is contained in Tax Bulletin 69 (see here Tax Bulletin 69) which the Revenue has just published. Notwithstanding the views expressed by professional tax bodies in several representations made to the Revenue since April 2003, the Revenue are sticking to their view that the anti avoidance settlements legislation can be applied to situations where spouses, partners or friends have acquired ordinary shares in the family business or are partners in a business partnership.
The Revenue acknowledge that their interpretation of Section 660A “..is not accepted by many accountants and tax practitioners.”
Ordinary shares
Their view regarding shares is summarised as follows:
“Whilst the rights and obligations associated with a share are relevant they are only part of the issue. We have not suggested that, for the legislation to apply, an ordinary share itself must be wholly or substantially a right to income. We 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.”
They also re-affirm their view that, while the most recent case law on the matter (Young v Pearce [1996] STC 743) concerned preference shares, this does not mean that the legislation cannot apply to ordinary shares but that it will be applied to all types of shares depending on the facts of each case.
Partnerships
Tax bulletin also looks again at partnership situations in the light of comments that as partnership involves unlimited liability sharing in partnership income cannot be wholly or mainly a right to income. In the Revenue’s view:
” It is important, in relation to partnerships, to look at the whole arrangement to see whether someone is getting a disproportionate return on their contribution because they are related to, or friends with, the settlor. If they are then the legislation applies even if a partnership is being used.”
New issues?
In the main, therefore, the Revenue have mainly used TB69 to confirm their view of the way in which the settlements legislation can be applied to family companies and partnerships. There is little by way of new arguments. However TB69 does offer up an interesting insight into what the Revenue regards as a “commercial” salary. They also provide additional advice on how income caught by the settlements legislation should be reported on self-assessment returns by commenting in detail on each of the examples that they used in TB64 to illustrate their views. Finally they have added some further examples of situations where they would or would not seek to apply Section 660A.
Commercial salary
On the issue of what is a commercial salary the Revenue gives the following example:
“ In deciding what is uncommercial we look at the going rate for the job and also an individual's previous earnings. So if an IT consultant was earning £80,000 a year when employed by a plc and she then sets up her own IT consulting company and earns fees of £120,000 a year with expenses of £20,000 we would expect to see her drawing a salary of around £80,000. If instead her total salary is only £40,000 with £40,000 going to a non-working spouse then that is uncommercial”
It is interesting that, for Section 660A, the Revenue is prepared to discuss what is a commercial salary. However, when IR35 was first proposed the Revenue refused to consider possible alternatives that would establish an acceptable level of salary after which a contractor could make a profit.
Hence we have the anomalous situation that in the context of Section 660A the Revenue accept that, using the above figures, a salary of £80,000 is commercial. However in the context of IR35 they would not necessarily accept that the expenses of £20K were valid, and would not regard the £20K profit as being a reward for being in business but would seek to tax it as salary.
This example is also rather simplistic. What will be the Revenue’s view when a contractor loses a permanent position at a salary of £80K a year and, in their first year of freelancing, instead makes perhaps £30K in fees? What is their “commercial” salary then? Can they argue that they have made a loss of £50K to be carried forward to set against their “commercial salary” in the future? Clearly any freelancer who tries that argument will get short shrift from the Revenue! What happens if in year two the freelancer’s company earns £100K in fees. Is the commercial salary now £30K, or is it back to £80K? Perhaps it should be the average of the two years, that is £65K?
Also what the Revenue’s example does not go on to say is whether they would be happy to see the acceptable ‘profit’ of £20K being split 50:50 with a non working spouse or would they still argue that receiving a dividend of £10K in return for a share investment of perhaps only £1 was still avoidance? In the new examples given by the Revenue in TB69 (see below) it suggests that the Revenue would still seek to attack the transfer of profits from the working shareholder to the non-working shareholder. This is clearly an area where the debate will continue for some time to come.
Self Assessment Returns
The new TB suggests that where the settlements legislation applies the taxpayer whose income was reduced by the ‘settlement’ should account for the ‘settled’ income on their tax return in the section designed for income from Trusts and Settlements. Meanwhile the spouse or partner who actually received the income would put nil in their return in respect of that amount of their income that was being accounted for by their spouse or partner but would also explain what had happened in the additional information section of the return so that the Revenue could reconcile the return to the other information they held. This would explain, for example, why someone holding half a company’s shares did not disclose half the dividends that the company’s accounts showed as being paid in that year.
New Examples
Amongst the new examples included in TB69 is one relating to a freelancer working through a composite company. This is as follows:
Example 17 - Subscribed shares
Mr U is a self-employed IT consultant. He reads an advert on a specialist website and as a result he decides to offer his services through a "composite" company set up by another company specialising in taxation services. Under an agreement he will subscribe for a special class of share (a £1 "U" share), which has rights to all his earnings less a "commission" paid to the organisers. When the agreement is sent to him for signature there is a box to tick if he wants a share issued to anyone else. He ticks the box and asks for an additional share to be issued to Mrs U. Apart from subscribing £1 for the share, Mrs U takes no part in the business. During year one his efforts contribute income of £68,000 to the company. The company retains sufficient to cover expenses and tax and the balance remaining of £54,000 is paid to Mr and Mrs U as dividends who each receive £27,000.
This is a bounteous transaction caught by the settlements legislation. In reaching this conclusion it is necessary to look at the whole arrangement. The substance of what has happened is that part of Mr U's earnings have been paid to Mrs U.
Two linked examples explore the issue of gifting shares between spouses:
Example 18 - Gifted Shares Mrs V carries on a trade as a designer through a company V Ltd. She is the sole director and sole shareholder of 100 £1 shares subscribed for at par on the company's formation. The company's accountant acts as company secretary. The company has insignificant capital. In a typical year the company's gross income is in the region of £60,000 p.a. After expenses (including Director's remuneration of £25,000) and providing for tax, the profits available for distribution are £24,000. Dividends of £20,000 are paid to Mrs V. In the following year Mr V, who worked for another company, is made redundant and loses his source of income. Mrs V gifts half her shares to Mr V. Mr V carries out some part-time secretarial work for the company for which he is paid £5,000 p.a. At the end of the year gross income is £65,000, Mrs V votes herself £10,000 remuneration and after other expenses and tax the balance of £40,000 is paid out as dividends - each spouse receiving £20,000. This is a bounteous arrangement, whereby Mrs V has transferred part of her income to her spouse, and it is caught by the settlements legislation. In reaching this conclusion it is necessary to look at the whole arrangement. What has happened is that part of Mrs V's earnings have been paid to Mr V. Two of the key elements in the arrangement are that the expertise and earning capacity of Mrs V have been provided to the company at undervalue and Mr V is paid a market rate for his work.
Example 19 - Gifted Shares The facts are as above but Mrs V continued to pay herself a commercial rate of remuneration of £25,000 leaving only £20,000 to be distributed to the two shareholders. The gift of shares is a bounteous transaction which diverts £10,000 of income to Mr V and in the absence of any capital in the company those shares represent substantially a right to income. So the exemption in section 660A(6) for gifts between spouses does not apply and the dividends are assessable on Mrs V.
Example 19 suggests that, in the example given in the earlier discussion of what is a commercial salary, even if a commercial salary of £80K is taken any dividends that are paid to a shareholder, who is not active in the business, will still be attacked as being a settlement.
Conclusions
Tax bulletin 69 makes it clear that the Revenue are now entrenched in their view of Section 660A. Clearly only case law will now offer any hopes of shifting the Revenue’s position. As reported elsewhere the first test case that we are aware of, Arctic Systems, seems likely to be coming to Court in April or May this year.
While that case may offer clarification of how Section 660A should be interpreted we also have the spectre of IR591, which is due to be clarified in the budget due on 17 March 2004. The changes to be introduced by IR591 may well mean that in future freelancers will need to grapple with a new range of issues.