INCOME TAX—SETTLEMENT—MEANING

House of Lords
Lord Hoffmann, Lord Hope, Lord Walker, Baroness Hale and Lord Neuberger
25 July 2007

A transfer of shares entitling a spouse, inter alia, to dividends in a company owned by her and her husband and used as a vehicle to offer the husband’s services may constitute an “outright gift” for the purposes of s 660A(6) of the Income and Corporation Taxes Act 1988 (ICTA 1988).

Michael Furness QC and Rupert Baldry (instructed by the Solicitor for Revenue and Customs) for the HM Revenue & Customs (HMRC).
Malcolm Gammie QC and Keith Gordon (instructed by Nelsons, Leicester) for the taxpayer.

The taxpayer and his wife formed a company in 1992 (holding one share each) which offered the services of the taxpayer as a computer consultant. The wife was employed for a few hours a week dealing with book-keeping and related matters. The taxpayer and his wife received low salaries; primarily their income was distributed by way of dividends.

This lessened national insurance contributions and the dividend payable to the wife was taxed at a lower rate than it would have been had it been added to the taxpayer’s income. HMRC assessed the taxpayer to income tax in respect of the dividend paid to his wife in 1999–2000 of £25,767.25 on the basis that the taxpayer was liable to income tax on the dividends paid to his wife from the company as “income arising under a settlement” which was to be treated as income of the taxpayer as settlor pursuant to ICT 1988, s 660A(1). The definition of “settlement” in s 660G(1) included “any disposition, trust, covenant, agreement, arrangement or transfer of assets”. The special commissioners and the High Court found in favour of HMRC, but the Court of Appeal allowed the taxpayer’s appeal. HMRC appealed.

LORD HOFFMANN: 

HMRC’s case was straightforward. They said that the acquisition of the company and the transfer of a share to the wife, enabling her to receive the dividends which were expected to be paid, was an arrangement for the purposes of ss 660A(1) and 660G(1). It was not a transaction at arm’s length because the taxpayer would never have agreed to the transfer of half the issued share capital, carrying with it an expectation of substantial dividends, to a stranger who merely undertook to provide the paid services which his wife provided. That provided the necessary “element of bounty”. The object of the arrangement was to keep the entire income within the family but to gain the benefit of using up the wife’s lower rates. The dividends paid to the wife arose under the arrangement. The taxpayer, by working for the company, provided it with the funds which enabled the dividends to be paid. He was therefore a settlor within the meaning of s 660G(2). He was to be treated as having an interest in the income derived from the wife’s share and that income was therefore to be treated as his income.

The High Court accepted that argument but the Court of Appeal did not. Sir Andrew Morritt C said, at para 73, that the wife had acquired her share “for value”, ie for £1, “in the context of a joint business venture to which both parties made substantial and valuable contributions”. What happened thereafter, namely that the wife was paid a salary and in addition was paid dividends derived entirely from her husband’s work, was not part of the arrangement because those events depended upon the future business of the company and decisions on dividend policy by the taxpayer, all of which were uncertain. They could not therefore supply the necessary element of bounty.

His lordship disagreed. The analysis was divorced from reality. The wife could not have been issued with a share without the agreement of her husband and when he agreed to that arrangement, it was expected that he would take a low salary and that substantial dividends would be distributed. That was what happened. The decisions were tax driven and not commercially driven. And it was necessary, in order to gain the tax benefit, that the taxpayer should, in a broad sense, transfer some of his earnings to his wife.

The case was not a “normal commercial transaction between two adults” within the meaning of s 660B. It made sense only on the basis that the two adults were married to each other. If the wife had been a stranger offering her services as a book-keeper, it would have been a most abnormal transaction. It was only “natural love and affection” which provided the consideration for the benefit he intended to confer upon his wife. That was sufficient to provide the necessary “element of bounty”.
That led to the question of whether or not the taxpayer fell within the exception created by s 660A(6), namely where one spouse made an “outright gift” to the other of the property from which the income arose. Thus a gratuitous transfer of quoted shares from husband to wife, although obviously a settlement for the purposes of s 660A, was excluded from the section and the income was taxed as the wife’s income.

HMRC argued that that did not apply equally to the transfer to the wife in the instant case, for three reasons. First, they said there was no gift of the share by the taxpayer to his wife. He never owned the share which she took. It belonged to the formation agents from whom the wife had bought it for £1.
His lordship held that that narrow analysis of the transaction would be inconsistent with the reasoning by which the transfer came within s 660A in the first place. It was the taxpayer’s consent to the transfer of a share with expectations of dividend to his wife for £1 which gave the transfer the “element of bounty” for the purposes of s 660A. By the same token, it made the transfer a “gift” for the purposes of sub-s (6). And there was no dispute that, if it was a gift, it was outright.

The second argument was that the transfer of the share was not the whole of the arrangement, which included the provision of services by the taxpayer, the dividend policy and so forth. Again, that would be inconsistent with the argument by which HMRC had succeeded on the first point. The transfer of the share was the essence of the arrangement. The expectation of other future events gave that transfer the necessary element of bounty but the events themselves did not form part of the arrangement.

Finally, HMRC said that the property given, ie the share, was “wholly or substantially a right to income”. It was true that the value in the share arose from the expectation that it would generate income. But that was true of many shares, even in quoted companies. The share was not wholly or even substantially a right to income. It was an ordinary share with rights over and above the right to income. Accordingly, the arrangement fell within the exception in s 660A(6) and the appeal would be dismissed.
 

Lord Hope, Lord Walker, Baroness Hale and Lord Neuberger delivered concurring opinions.