MPW Chartered Accountants

MPW Chartered Accountants

Businesses, Individuals and the Settlements Legislation

We have been asked by the Chartered Institute of Taxation (CIOT) if we would provide some further information and examples on the settlements legislation in Part XV of Income and Corporation Taxes Acts (ICTA) 1988 especially in the context of its application to businesses and individuals. We are happy to do so. We have incorporated a number of comments made by the CIOT on a draft of this article and the examples it contains, but the article remains an expression of the views and practice of the Inland Revenue and the CIOT does not necessarily agree with all the points made.

Unless otherwise stated all references are to ICTA 1988 in this article.

The settlements legislation was originally enacted in the 1930’s. The legislation was brought up to date in 1995, further amended in 1999 and can now be found at sections 660A to 660G. The legislation not only applies to trusts but can also apply to other situations involving individuals, companies and partnerships. It is these non-trust situations where we have been asked to provide further information.

The existing guidance on the settlements legislation is found in the Inland Revenue’s Trusts Estates and Settlements Manual which is available on our website at www.ir.gov.uk/manuals/tsemmanual/. That manual will be updated to incorporate this additional information shortly.

The settlements legislation is intended to prevent an individual from gaining a tax advantage by making arrangements which divert his or her income to another person who is liable at a lower rate of tax or is not liable to income tax.

Definitions

There are two key definitions when considering the settlements legislation, both set out in section 660G(1):

· Settlement includes any disposition, trust, covenant, arrangement or transfer of assets. Settlement may include a series of transactions which taken together are regarded as an arrangement. The courts have limited the scope of a settlement to where there is some element of bounty, see “CIR v Plummer [1979] STC 793: 54 TC 1”;

· Settlor means any person by whom the settlement was made.

There are some important statutory exemptions from the legislation:

· Section 660A(6) exempts situations where the property passed to a spouse is an outright gift, unless;

o the gift does not carry the right to the whole of the income arising, or

o the property given is wholly or substantially a right to income.

· Section 660A(9)(a) exempts annual payments made by an individual for bona fide commercial reasons in connection with their trade, profession or vocation.

· Section 660A(9)(b) exempts certain donations made to charities.

· Section 660A(9)© exempts income consisting of a benefit under approved pension schemes.

So, in general, the settlements legislation can apply where an individual enters into an arrangement to divert income to someone else and in the process tax is saved. So long as those arrangements are:

· bounteous, or

· not commercial, or

· not at arm’s length, or

· in the case of a gift between spouses, wholly or substantially a right to income.

Does the legislation only apply to transfers to spouses and minor children?

It is a common misconception that the settlements legislation applies only to arrangements involving a settlor’s spouse or minor children. However, section 660A(2) makes it clear the settlor is treated as having an interest in property if “that property or any derived property is, or will or may become, payable to or applicable for the benefit of the settlor or his spouse in any circumstances whatsoever.” It is not necessary for the settlor’s spouse or children to be the people to whom the income is transferred. If the settlor or their spouse retains an interest in the property then the legislation can apply. See example 2 below.

Section 660A applies to arrangements where the settlor, or their spouse, retain an interest in the settlement. Section 660B applies to situations where income not caught by section 660A is paid or made available to a minor unmarried child of the settlor. The 1999 amendments extended the legislation to include income otherwise treated as that of the child with regard to settlements made on or after _9 March 1999. For example a settlor who invests money in a savings scheme which is held on bare trust for their child will find the income treated as theirs under this section if the child’s relevant settlement income exceeds £100 (section 660B(5)). There are further examples involving children below at examples 8 and 9.

How does the legislation apply to non-trust situations?

A very small percentage of the enquiries we currently undertake each year involve the settlements legislation and non-trust situations. However we do seek tax, interest and penalties in appropriate cases. It is not possible to provide a definitive list of the issues we look for when deciding which cases to take up for enquiry, but some of the factors that the Revenue is looking for might include:

· Main earner drawing a low salary leading to enhanced profits from which dividends can be paid to shareholders who are friends or family members.

· Disproportionately large returns on capital investments.

· Differing classes of shares enabling dividends to be paid only to shareholders paying lower rates of tax.

· Dividends being waived so that higher dividends can be paid to shareholders paying lower rates of tax.

· Income being transferred from the person making most of the profits of a business to a friend or family member who pays tax at a lower rate.

There are a wide range of arrangements that can potentially be caught by the settlements legislation which do not involve a trust. Each case will depend on the facts but some of the most common situations which we see are:

· Shares subscribed at par that carry only restricted rights.

· Shares given away that carry only restricted rights.

· Shares subscribed at par in a company by someone else where the income of the company derives mainly from a single employee.

· A share in a partnership gifted or transferred below value.

· Dividend waivers.

· Situations where dividends are paid only on certain classes of shares.

· Dividends paid to the settlor’s minor children.

These lists are by no means definitive of situations to which the settlements legislation can be applied.

The best way to illustrate how the legislation applies is by using the following examples although it should be noted that these are by no means exhaustive.

Example 1 - Issued shares with restricted rights

An engineering company has 100 ordinary £1 shares. Mr A and Mr B own 50 ordinary shares each. They create a new class of B shares which carry no voting rights and no assets in a winding up. They then issue 50 B shares to each of their wives. Dividends voted on those B shares would be treated as the income of Mr A and Mr B rather than their wives as the B dividends are from shares that are wholly or substantially a right to income and so not exempted from section 660A by section 660A(6). (This example is based on the High Court case of “Young v Pearce; Young v Scrutton [1996] STC 743”).

Example 2 - Gifted shares with restricted rights

Mr C is the sole director and owns all the 1000 ordinary £1 shares in C Limited. His aunt, Mrs D, has always been very kind to him and he wants to thank her for this. He subscribes, at par, for 100 B shares, with no voting rights and restricted rights to capital of £10 per share in the event of winding up. He gifts the shares to Mrs D. Mr C then declares a dividend of £100 per share with Mrs D receiving dividends of £10,000.

This is a bounteous arrangement and we would apply the settlements legislation to the dividends. The property giving rise to the dividends cannot be looked at too narrowly as the shares alone. The wider arrangement must be considered. Because he is in effective control of the company Mr C retains an interest in the underlying property as he could simply pay all future income arising to himself as director’s salary or as dividends on the ordinary shares.

Example 3 - Subscribed shares

E Ltd was incorporated in October 1997 to provide the services of Mr E as an IT consultant to a number of clients working in the pharmaceutical industry. The company’s share capital is £2 consisting of 2 £1 shares. Mr E is the sole director of the company, and his wife Mrs E is company secretary but takes no other active part in the company. From the beginning each subscribed for one share. The company has no significant capital assets. The figures for the first year’s trading are: -

Turnover 100,000_Expenses 5,000 _Salary (Mr E) 10,000_Salary (Mrs E) 5,000 _Dividends 70,000

In this case Mrs E receives a salary for her duties as company secretary, but the whole arrangement whereby Mrs E invests £1 and in return gets a dividend of £35,000 is bounteous. There is nothing to suggest that the dividend is a commercial return on her investment. As there is no significant capital in the company, what has passed from Mr E to Mrs E is substantially a right to income and the whole of the dividend is taxed on Mr E.

In reaching this conclusion, the legislation allows us to look at the whole arrangement. It is the work that Mr E carries out which creates the company’s profits which in turn enable the dividends to be paid. Mrs E’s investment of £1 does not enable the company to make profits and the company itself has minimal capital value. In accepting a salary below the market rate from the company, and thereby allowing some of the income earned to pass to Mrs E as a dividend, Mr E has entered into a bounteous arrangement to divert income to his spouse with the aim of avoiding tax.

Example 4 - Subscribed shares with little capital value then gifted

As in example 3 but in October 1997 Mr E was not married and subscribed for both £1 shares himself. Mr E’s solicitor was acting as company secretary. A year later he got married and gave his wife one of his shares in the company. At this point Mrs E took over the role of company secretary. In the following year Mrs E receives a wage of £5,000 and the company pays a dividend of £35,000 per share.

Since the capital value of the company is insignificant the gift of the share from Mr E to his wife is not exempt from section 660A by virtue of section 660A(6) as the shares are “wholly or substantially a right to income”. Accordingly the settlements legislation applies in relation to Mrs E’s £35,000 dividend payment and the income would be treated as Mr E’s for tax purposes.

Example 5 - Partnerships

Mr F and Mr G are in partnership as second hand car dealers. They do not have any premises but buy and sell cars through auctions and the classified adverts of local papers. The partnership’s only assets are some office equipment worth less than £1,000 and they usually have a couple of cars in stock at any one time. They are successful and the profits of £80,000 a year are split equally between them. They decide to admit their wives to the partnership and amend the partnership agreement in order to split profits equally four ways. Mrs F and Mrs G do no work in the partnership and the partnership has no employees.

This is a bounteous arrangement transferring income from one spouse to the other. The settlements legislation will apply and Mr F and Mr G continue to be taxable on half the profits each.

Example 6 - Dividend Waivers

Where a company with few shareholders declares a final dividend when one or more of the shareholders has waived their right to a dividend in circumstances where other shareholders may benefit, it is possible the settlements legislation could apply.

For example Mrs H owns 80 ordinary shares in H Limited. _Mr H owns 20 shares. In 2000 the company made a profit of £25,000. Mrs H waived her right to any dividend. The company then declared a dividend of £1,000 per share, and Mr H, who had no other income, received a dividend of £20,000.

We would apply the settlements legislation in these circumstances. Clearly a dividend of this amount could not have been paid from the company’s profits on all the shares, so the waiver arrangement enhanced the dividend paid to _Mr H. £16,000 of the dividend paid to Mr H is attributed to Mrs H under section 660A because the waiver was a bounteous arrangement.

Example 7 - Dividends on certain shares

As in example 6, but in this case Mrs I owns A shares and _Mr I owns B shares. Both A and B shares rank equally. Again profits of £25,000 are made and a dividend of £20,000 is voted on the B shares while no dividend is voted on the A shares.

Clearly by not voting dividends on the A shares (which rank equally with the B shares) this is a bounteous arrangement as the dividend paid on the B shares could only be paid if no dividend was declared in respect of the A shares. £16,000 of the dividend paid to Mr I is attributed to Mrs I under section 660A because the decision to only vote dividends on certain shares was a bounteous arrangement.

Example 8 - Children - gift of shares from parent

Mr J owns all 100 issued £1 shares in J Limited. Mr J is the sole company director and is the person responsible for making all the company’s profits because of his knowledge, expertise and hard work. Mr J gives each of his four children 10 shares. Dividends are paid.

Section 660B applies and attributes the dividends paid to the children to Mr J for tax purposes. This is because Mr J has paid the income to his unmarried minor children.

Example 9 - Children - gift of shares other than from parent

As in example 8, but the 40 shares held by the children were originally owned by their grandmother who had subscribed for them at par when the company was set up but shortly afterwards had gifted them to her grandchildren.

Section 660B applies and attributes the dividends received by the children to Mr J for tax purposes. Since Mr J is the person responsible for making the company’s profits and decides on the level of dividends paid, it is Mr J who is the settlor rather than the children’s grandmother.

The legislation could apply in a similar way if the children had subscribed for the shares themselves with money received from a third party or even from bank accounts in their own names.

Where does the legislation not apply?

In most everyday situations involving gifts, dividends, shares, partnerships, etc. the settlements legislation will not apply. If there is no “bounty” or if the gift to a spouse is an outright gift which is not wholly, or substantially, a right to income, then the legislation will not apply. For example:

Example 10 - An outright gift to a spouse

Mrs L owns 10,000 ordinary shares in a FTSE 100 company. Those shares are worth £40,000. Mrs L gives those shares to her husband. Mr L is now entitled to all the dividends from the shares and can sell the shares if he wants and keep the proceeds. This is an outright gift of shares that are not wholly, or substantially, a right to income since they have a capital value and can be traded, so the settlements legislation does not apply.

Example 11 - Subscribed shares

Mr M is the sole director and owns all the 100 ordinary shares in M Limited, a small manufacturing company. The company employs 10 people and owns a small factory, a high street shop, tools fixtures and fittings and 3 delivery vehicles. Mr M draws a salary of £30,000 each year and receives dividends of £20,000. Mr M then gifts 50 shares to his wife who plays no part in the business. Mr and Mrs M then each receive dividends of £10,000.

We would not seek to apply the settlements legislation to the dividends received by Mrs M. This is because the outright gift of the shares cannot be regarded as wholly or substantially a right to income. The shares have capital rights and the company has substantial assets so on the winding up or sale of the business the shares would have more than an insubstantial value.

Example 12 - Subscribed shares

Mr N wants to set up in business as a bookseller. He needs at least £100,000 to buy premises, equipment and stock. He sets up a company and he and Mrs N each subscribe for 40,000 ordinary £1 shares at par and the company borrows £20,000 from the bank. Mr N draws a salary which after four years is £40,000. Mrs N does not work for the company. Company profits are used to repay debt and expand the business. The business does well and after 6 years the profits are sufficient to pay a dividend of £10,000.

We would not seek to apply the settlements legislation to the dividend of £5,000 received by Mrs N. There is no bounty as Mr N draws a commercial salary for his efforts and the dividend is a commercial return on the initial investment which was vital at the commencement of the business and contained a clear element of risk.

Example 13 - A partnership

Mr and Mrs O and their friend Mr P have a business idea. They want to open a Cycle Repair Shop. Mrs O does not want to work but agrees to invest in the business without taking an active part, that is to say she is a sleeping partner. Each partner invests £10,000 and the £30,000 is used to lease a shop, buy equipment and stock and keep the business going until trade builds up. Under the partnership agreement Mr O and Mr P receive £500 a week with all the remaining profits split three ways between the partners.

The business is a huge success and makes large profits and continues to grow. Within five years Mrs O is receiving £50,000 a year as her share of the partnership profits. Although Mrs O does not work in the business, and her initial investment has turned out to be very successful, the settlements legislation would not apply to treat her share of the partnership profits as Mr O’s. Mrs O’s original investment was vital to get the business started and she risked losing it if the business failed.

Example 14 - A partnership

Mr P is a self-employed engineer engaged on specialist work for a number of clients in the construction industry. Mr P employs his wife, who plays an active part in the business including ordering and collecting specialist parts. Mrs P is paid a salary of £20,000. The profits of the business are £40,000. Mrs P owns a substantial property inherited from her mother.

Because of a number of claims made against Mr P, his insurers want to raise premiums by £20,000. He doesn’t think he can afford this so his insurers agree to not increase the premiums if Mr P agrees to pay the first £25,000 of any claim. Mr P and Mrs P enter into an equal partnership. Accordingly Mrs P no longer draws a salary but is entitled to a share of the profits as well as being exposed to the liabilities of the partnership. The property she owns is therefore potentially at risk.

Mrs P’s share of the profits is £30,000. Mrs P therefore has extra overall income of £10,000 because she has taken on the risk of the partnership liabilities including that associated with the £25,000 excess on the insurance policy. There is therefore no bounty and the settlements legislation would not apply.

Example 15 - Gift of shares other than from parent

In 1960 Mr & Mrs Q and Mr & Mrs R set up a small family cleaning company. In total there were, and still are, 100 £1 ordinary shares in the business. Initially Mr Q and Mr R each subscribed at par for 40 shares and Mrs Q and Mrs R each subscribed at par for 10 shares.

When Mr & Mrs Q died they each left their shares in the company (50 in total) to their daughter, Miss Q. When Mr R also died he left his 40 shares in the company to his daughter Mrs S. Miss Q and Mrs S are both directors of the company and carry out its day to day running. The current turnover of the company is approximately £1,000,000 per year and its capital value is over £250,000. Miss Q and _Mrs S each receive a salary of £60,000 per year. Each year a dividend of £500 per share is paid.

Mrs R has retained her original 10 shares in the company since 1960. Without discussing the matter in advance with either Miss Q or Mrs S, Mrs R decides to give her shares to her five year old granddaughter who is also Mrs S’s daughter. Mrs R makes the gift on her granddaughter’s next birthday.

The settlements legislation would not apply to this case since Mrs R retains no interest in the shares which she gives to her granddaughter and is therefore not a settlor within the meaning of section 660G. Nor is Mrs R’s decision to gift the shares to her granddaughter part of a wider arrangement with Mrs S to settle income on the child.

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 may be liable to challenge under the settlements legislation.

A purely commercial transaction or series of transactions at arms length is outside the meaning of ‘settlement’. Most commonly the legislation will apply where individuals seek to divert income to members of their family or to friends. A good test of whether or not the legislation could apply is to consider would the same payments be made to a person who acquired shares in a company or a share of a partnership at arms length. Or whether income is being paid simply because the recipient is your spouse or child or some other individual you might wish to benefit.

If you have any comments on this article and the issues raised you can contact the Editor of Tax Bulletin at the Inland Revenue or at the CIOT contact Liz Lathwood, Technical Officer, Chartered Institute of Taxation, 12 Upper Belgrave Street, London, SW1X 8BB.