ISSUE 69
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Businesses, Individuals and the Settlements Legislation – Part II Introduction
In Tax Bulletin 64 we provided some information and examples on the settlements legislation in Part XV of Income and Corporation Taxes Acts (ICTA) 1988. Publication of that article was welcomed but many people have asked us for some further information on examples 3, 4 and 5. These were cases where the settlements legislation applied to small companies and partnerships. We have also been asked for guidance on completing a SA return where the settlements legislation applies.

As with the original article in Tax Bulletin 64, this article sets out the Inland Revenue’s view of the way the legislation applies.

That view is not accepted by many accountants and tax practitioners.

Unless otherwise stated all references are to ICTA 1988 in this article. The existing guidance on the settlements legislation is found in the Inland Revenue’s Trusts, Settlements and Estates Manual which is available on our website at “www.ir.gov.uk/manuals/the manual/”. That manual will be updated to incorporate this further information shortly.

General
The feedback we have received on the Tax Bulletin 64 article was that the examples were particularly helpful so below we have provided some more examples. However there are some general principles that might also be of use.

Shares
Much of the feedback we have received on the Tax Bulletin 64 article concerned ordinary shares and the rights that they carry. 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.
It has also been argued that as the shares in Young v Pearce [1996] STC 743, were preference shares, ordinary shares cannot also be caught by the settlements legislation. We do not accept that. The Young v Pearce case was determined on the facts in that case and the question whether the settlements legislation can apply to situations involving ordinary shares was not considered.

Partnerships
We have also received feedback on the application of the legislation to partnerships where some argue that the unlimited liability of the partners means the settlements legislation cannot apply. We do not accept that. 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.


Family company / partnerships
We have been asked to reconsider the application of the settlements legislation to family / company arrangements as it has been suggested these involve special factors. We consider this is a misunderstanding of the settlements legislation which was enacted specifically to prevent individuals avoiding tax by diverting income to a family member or friend. An outright gift of money is a bounteous act but does not create a settlement. But an arrangement for one spouse to receive the other’s income via dividends is caught by the settlements legislation. There is a substantial body of case law on “bounty” and the suggestion that the rules should be applied differently in a family situation is not consistent with that case law.

Goodwill
It has been suggested that we have ignored the value of goodwill in a company in determining whether a gift of shares is substantially a right to income. We agree that goodwill can be a valuable asset of a business and each case will depend on its particular facts. In the typical service company scenario to which the settlements legislation may apply, goodwill is personal to the individual who earns the income for the company and does not attach to the company itself. In such circumstances goodwill would not be an asset for distribution in the winding up of the company and it will not enhance the value of the shares.

Spouses
There has been some misunderstanding about how the legislation applies when spouses are involved. 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?” The settlements legislation applies not only where there is a benefit to the settlor’s spouse but also 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.

The whole arrangement
It is essential to look at the whole arrangement when considering whether the settlements legislation applies.
Sometimes the whole arrangement will not be clear until sometime after the company, for example, is set up. So we might need to wait until dividends or remuneration are paid before we can say the legislation applies.

What is a disproportionate return on capital?
We have said that one of the factors we look at when deciding whether or not the settlements legislation applies is whether someone is receiving a disproportionate return on capital invested. In deciding what is disproportionate we look at the return on the actual capital invested and also any risks. So, for example, someone who invests £1 in an ordinary share and gets £35,000 a year in dividends is getting a disproportionate return on the capital. If that £1 had been invested in the stock market or a bank the return would have been much less. On the other hand if an individual is admitted to a partnership they may take on considerable personal financial risk, and the partnership share of the profits might be a fair return for that risk (see example 14 below).

What is an uncommercial salary?
Likewise we have said we look at individuals drawing an uncommercial salary. 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 nonworking spouse then that is uncommercial.
Similarly if one spouse undertakes an average of 8 hours secretarial work a week for a company, and the going rate for a secretary in that area is £6 an hour (£2,496 per year), then we would consider it uncommercial if the spouse was in fact receiving £5,000 a year from the company.
Deciding on what is and is not a commercial salary is not an exact science. It is impossible to give definitive guidance as each case depends on the facts. When in doubt it is useful to consider whether an individual employed at arms length would have accepted the same salary if their friend / relative was not also benefiting from the arrangement.

Additional examples involving a company
Examples 3, 4 & 5 plus examples 11, 12 & 13 explained circumstances in which the settlements legislation did and did not apply to some company and partnership situations. We have been asked to provide further examples like these, which are below

Example 16 - Subscribed shares
T Ltd was incorporated in October 1997 to provide a consultancy service to the health sector. Mr T is an IT specialist with a number of years experience in the health sector and Mrs T is an ex-nurse who specialises in producing computer based learning materials for hospitals. The company’s share capital is £10,000 consisting of 10,000 £1 shares. Mr and Mrs T are both full time working directors of the company. From the beginning each subscribed for 5,000 shares. The first year’s accounts show that each director received remuneration of £30,000 and that profits available for distribution were £50,000. £30,000 profits are retained in the company to build up the business. A dividend of £2 per share is declared and paid – each shareholder receiving £10,000.
There is no bounty here and no arrangement to which the settlement legislation can apply.

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.

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.
“Additional Information” box explaining why the £10,000 of dividends received are not on the return would be helpful.

Example 20 - Gifted Shares
Mr W & Mr X are founder shareholders and directors of a successful hardware shop run through a company called DIY Ltd. The company was set up to acquire the partnership trade carried on by the two shareholders. At the time there was a single shop, the trade plus assets were worth about £50,000 which were transferred to the company and the company issued 10,000 £1 shares to the partners in return. Over the years the company has grown. It now owns a chain of 8 DIY stores. Some premises are owned and others rented. The company owns a number of delivery vans and employs 50 staff. The shares have increased in value from £5 per share to £75 per share. Mr W and Mr X respectively gift some of their shares to their wives. Mrs W & Mrs X are given 2000 shares each. Dividends are paid on all shares. Although this is a bounteous transaction it is an outright gift that is not substantially a right to income, because the company has significant capital assets, and is therefore excluded from the definition of settlement by section 660A(6).

Further examples involving a partnership

Example 21
Mr Y, an architect, commences business as a sole trader. The business is successful and a few years later annual profits are in the region of £80,000. The business has insignificant capital and there are no employees. The business is transferred to a new partnership of Mr & Mrs Y. A deed is created under which profits are to be shared equally Mrs Y subscribes no new capital and carries out no work whatsoever for the partnership. Profits for the year are £80,000 and £40,000 belong to Mrs Y. This is a bounteous arrangement transferring income from one spouse to another. The settlements legislation will apply and Mrs Y’s share of the profits will continue to be assessed on Mr Y.

Example 22
Mr Alpha and Mr Beta are in partnership as second hand car dealers. They own the freehold premises through which the partnership trades (valued at £200,000) and routinely carry a stock of 50 used cars. The business is successful and has established goodwill in the locality as a reliable trader. It employs a number of salesmen and office staff. Profits of £100,000 a year are split equally between the partners. They decide to admit their wives to the partnership and amend the partnership agreement in order to split profits and capital equally four ways. Mrs Alpha and Mrs Beta do no work in the partnership. Although this is a bounteous transaction it is an outright gift that is not substantially a right to income and is excluded from the definition of settlement by section 660A(6).

Summary
Whether or not the settlements legislation applies to an arrangement depends on the particular facts of the case. It is necessary to look at the arrangement as a whole. If there is a bounteous arrangement which effectively transfers income earned by one person to another resulting in a reduction in overall tax liability the arrangement will be liable to challenge under the settlements legislation.
When considering whether or not the settlements legislation applies it is worth remembering that Parliament introduced the settlements legislation to prevent individuals transferring their income to a relative or friend in order to avoid tax. It therefore follows that a simple test to indicate whether or not the legislation might apply is to consider whether the same arrangements would have been made with a third party at arms length.