Critical Analysis of House of Lords Decision in Jones v Garnett - Article Example

Critical analysis of House of Lords decision in Jones (Respondent) v.Garnett (Her Majesty's Inspector of Taxes) (Appellant) This controversial case relates to the taxability of profits of a corporate business owned by husband and wife. Mr Jones an ex-Information Technology (IT) expert employee set up his own business in 1992 in the form of a limited company soon after his employment ended. He and his wife formed the company with one share each at the face value of £1 per share. The limited company was named Arctic systems. While Mr Jones was the director, his wife was the secretary. Though there was no agreement as such, he was acting as a director as well as an employee of the company. The company purported to provide Mr Jones services to clients through agents for fees. Mrs Jones just worked for the company without earning anything for the company on her own. Her work consisted of book-keeping, liaising with accountants, coordinating with the bank of the company, taking out insurance, preparation of VAT returns, making tax payments for the company, billing for the company, certifying accounts of the company as its secretary, discussing company contracts with Mr Jones, attending to telephone calls and sending resumes, all consuming about four to five hours of work per week. The company received large sums of money by way of fees for services rendered by Mr Jones to its clients. Both husband and wife took small salaries as employees. After deducting the company expenditure including their salaries, corporate tax on the net profit was also paid by the company. The remaining profit after taxation was disbursed as dividends to them by the company. The tax authorities found this as a means to circumvent payment of higher taxes. It was argued by them that while Mrs Jones claimed more than proportionate salary for her limited number of hours of works hardly five per week, Mr Jones took very little salary for the kind of work he provided. And that had he taken more salary, dividends would have been lesser than what had been paid. (Martin) This practice was found out in 2004 by Internal Revenue’s investigation which led to a demand for payment of an extra £ 42,000 as tax invoking section 660A of settlement legislation covering tax liability for six years as a result of purported tax avoidance measure by declaring higher dividends, though the demand was later reduced to £ 6,000 after negotiations. The parties therefore preferred an appeal before the Revenue Special Commissioners with the help of Professional Contractors Group (PCG) (Arctic Systems case) Section 660 A is known as settlements legislation as old as 1930 dealing with cases of attempted avoidance of tax by way giving gifts such as shares through ‘settlement’ with a view to prevent tax payers from transferring sizeable sum of profits on another person who would pay lesser tax than what would have been payable by him had he not transferred. .The tax payer by way of forming a company takes lesser salary so as to avoid higher premiums on National Insurance and disburse balance profits in the form of dividends to share holders including himself. Besides, he also splits his potential dividend between himself and his wife so that tax attracted by dividends at a lesser slab also is proportionately less. This is what is being trying to be stifled by the Inland Revenue by way of Settlements Legislation. Section 660A would apply if spouse is also given shares in the company along with husband or wife as the case may be though not active or not an expert in the line of activity of the relative business of the corporate company warranting a higher salary or dividends. It would not be applied if spouse does not own any share in the company or if the spouse also contributes equal amount of expertise and brings in income as the other spouse (Arctic Systems Case) The additional tax attracted will be computed by taking into account of dividend paid to spouse for six years to which 25 % will be added plus 6% towards interest per year. The Special commissioners decided against Jones. The casting vote of the Chairman under regulation 18(2) was not considered appropriate especially because the Inland Revenue was attempting to charge tax under Taxes Acts. Since the counsel for Jones requested the Chairman of the Special Commissioners Dr Brice for a guideline decision for use in future occasions, she could have left the question open for judicial review instead of exercising her casting vote.The court of appeal had to consider the following substantive issues. Whether the Chairman Dr Brice was justified in deciding that dividends paid to Mrs Jones were in fact a statutory settlement under section 660A of ICTA 1988 and that settlement of shares was a right to income as mentioned in section 660A(6) in order to attract section 660A(1). In the appeal from the decision of the Special Commissioners, Park J concurred with Dr Brice’s stand. He opined that statutory provisions of the Acts and settlement have so developed overlapping successive Finance Acts. The key sections to be considered were s.660A (1), (2), (6) and (10). Counsel Mr Jones referred to as many as 14 cases to facilitate understanding the nature of settlement and the term ‘bounty’. But Park J considered a selected few and discussed them. He opined that in Cooperman v Coleman (1939) 22 TC 594, a settlement could arise without creation of trust and that income in the form of dividends could be called a settlement. Secondly in the case of Butler v Wildin (1988) 22 TC 594 and Young v Pearce (1996) 70 TC 331, it was described how income of a dividend through shares could be termed a settlement. It was found in both the cases, individuals were the prime movers for the companies and the shares issued to their family members were at very low prices and the dividends received by them were substantial. Thomas V Marshall 34 TC 178 was also referred by Park J to substantiate the definition of settlement. Crossland v Hawkins (1961) 39 TC 493 was cited by Park J as a very crucial one. In this, Jack Hawkins an actor served as an employee of a service company in which his children were given shares through trust funds given by Hawkins’ father Even though Jack had no active involvement of this arrangement, he was still considered as the settler of an arrangement for the benefit of his children. Even though Hawkins differed from the circumstances of Jones v Garnett in that Hawkins had already been an employee of the company before roping in of his children as share holders of that company as against the fact that Mrs Jones subscribed to the shares of Arctic before Mr Jones was to undertake any contract, Park J did not consider them as different. And Mills v IRC (1974) 49 TC 367, (1975) AC 38 also was similar to Hawkins. Here the actor was a child while shares were held by trustees. Still Miss Mills was considered as settlor as part of settlement. Further though there are no such statutory provisions, courts have devised a ‘bounty’ test to be applied to decide if the settlements are in the form of bounty. In IRC v Leiner (1664) 41 TC 589 and in Bulmer v IRC (1966) 44 TC 1, (1967)1 CH 145 it was held that there was element of bounty and that settlement arrangement was purely for commercial reasons. But in Park J’s opinion Jones v Garnett had an element of bounty in spite of the bonafide commercial purposes for which the arrangement was made. IRC v Plummer (1980) AC 896 has established that bounty must be present for any arrangement being termed a settlement, though that case was inconclusive. The authorities in the present case held that dividends were an outright gift. Park J considered that looking at the fact that a company was set up by Jones, Mrs Jones took a lower salary than the market rate in order to draw more dividends, it was quite apparent that the arrangement was in furtherance of a settlement. He did not agree with Special Commissioner Miss Powell that there was no element of bounty. But he pointed out that because Mrs Jones took one share from the company implied it was for providing bounty in future. Therefore Park J concluded that Mr Jones deliberately created a structure to sacrifice income for Mrs Jones to enjoy as a dividends abnormally and therefore the share income amounted to gift and therefore exemption under section 660A could not apply. Martin says that the crucial factor asserted in the appeal was that the bounty would take place in future can not be called a settlement. Martin says that what ever be the intention, it so happened that Mr Jones could divert his income to his wife in the form of higher dividends than they would have been if proportionate salaries had been paid to her and hence necessarily the outcome resulted in the nature of a settlement. (Martin) Martin’s personal reaction as a tax expert is as follows. My Practical Tax guide No.15 in the series gives detailed guidance on this subject for spouses and civil partnerships in business. Now fully updated in the wake of this judgement. If this has soured your views on tax planning, then my advice is quite simple, pay market value salaries at all times. By “market value”, I mean in this case, calculate your salary as if the company was totally within IR35, and make a deemed payment calculation under those rules. Arctic is a case involving a service company, and it is apparent that it was picked for that reason. When the Chancellor talked about “the right amount of tax”, it is plain that he had service companies in mind. For those in other types of business, you will have very little way of calculating a salary at “the going rate” or “market rate” unless your job involves exactly the same duties as a normal employee. It will be unlikely that you will find one, as a normal employee is not a director, does not run the risks and rewards of running their own business, and maintains a constant income stream. It is not too late to re-structure your business in view of the decision in this case, and if you have any doubts take advice. As to the prospect of being assessed on your spouse’s dividends for the last six years. I can only add that each case is decided on the facts, and if you are picked for investigation, specialist advice in this area is worth the extra cost. (Martin) The above decision by the High Court was appealed against in the Court of appeal which held that there was no bounty as such since Mrs Jones paid for her share and merely because the corporate set up facilitated a way tax planning, it can not be called a deliberate way of settlement as a gift and therefore decided in favour of Mr Jones. However there were still some unanswered questions as commented by Martin. Unanswered questions Certain observations were made during the hearing and one was that Mrs Jones worked for nothing in the years when IR35 was thought to apply and so she conferred bounty herself. Does this mean that she can also be a settlor? Should all the dividends be deemed Mr Jones’ if the settlement provisions do apply, surely Mrs Jones is entitled to something for her efforts to share in the risks and rewards of the joint venture? Finally, if there is a settlement, then it must comprise of settled property. What is the settled property, and if there is settled property why does the exemption not apply to exempt it? Lord Justice Keen observed that “bringing the case within the scope of the settlement provisions would represent an unjustified extension of their scope. (Accounting web) House of Lords on appeal from the HMRC, carefully and extensively handled the issue. The Lords did agree there was an element of bounty and amounted to settlement since it was a planned affair between the husband and wife as advised by their accountant. But Lord Hoffman turned to the crucial issue as to whether the gift was wholly and substantially a right to income and whether the transaction could fall within the ambit of exclusion within subsection 6 of S 660 A. Lord Hoffman agreed with the tax payers contention that there was no right to income in ordinary share which had a right to vote, participation in the assets distribution unlike in the case of preference shares which had the right to a definite income. There was a significant difference between an ordinary share and preference share. The case of Young v Pearce involved preference share. And hence ordinary share having no right to income fell within the exclusion. (Whiting) The above alternating decisions from one court to another do call for a discussion whether the HMRC’s attempt to tax the couple meet with the cannons of Taxation. Adam Smith’s cannons of taxation still hold good and are the foundation of all arguments for taxation principles. First, Cannon of equality. It expects that sacrifice by the tax payers should be guided by equality. Equality does not mean flat or fixed amount of tax common to all. It depends upon the quantum of income, taxpayers’ economic position or ability to pay. Hence rich should pay not only proportionate to their income but also a little more. Second is the cannon of certainty. Though it should be certain, it should not be arbitrary. The time of payment, mode of payment, quantum of payment and there should be clarity and they should be unambiguously clear and not left to the discretion of the tax authorities’ whims and fancies and capable of being twisted by them to suit their convenience. In the present case, warning the tax payer beforehand and making it applicable for the future would have warranted little protest. Hence the important cannon of certainty was totally absent in the HMRC’s taxation of the Jones couple’s income. The Exchequer Secretary to the Treasury’s remarks that Government are committed to taxiing the arm’s length transactions which are apparently between kith and kin and with a view a circumvent the provisions of taxation may be correct in view the cannons of equality. But the existing legislation lacks clarity, the second cannon of taxation. If there had been a certainty prohibiting arms length transaction without exclusion, the case would have not have generated this much heat. After all, the couple has taken the route of the corporate form of business to avail of the tax advantage. Either the corporate formation between couple should have been prohibited or there should have been no exclusion provisions to justify HMRC’s failed action. The success of Government’s proposal to legislate afresh in view the House of Lord’s decision also will depend up on the how the new legislation will be meeting the cannons of taxation. References Accounting web.co.uk ‘Tax zone” 31st May 2007 Arctic Systems Case accessed 13 Jan. 08 Arctic systems Case accessed 13 Jan 08 Martin Ross Nichola “Expert analysis of Arctic Systems S660 judgement” accessed 13 Jan. 08 < http://www.contractoruk.com/> Whiting John, Tax Partner, PricewaterhouseCoopers LLP “House of Lords warms the Arctic” Read More