Husband & wife companies – constructive trusts in tax
In many cases where one spouse decides to set up or buy a company through which to earn a living, tax advice has meant that it is usual to involve the other spouse as an owner of some shares. The dividend income can then be split favourably between them to avoid one spouse paying unnecessary higher rates of income tax by being the sole recipient of any dividend income.
HMRC tried to apply the settlement code to such situations and despite their failure in the Arctic Systems case have recently tried again in the case of Patmore v HMRC  UKFTT 334  WTLR 125.
In the case of Jones v Garnett (HMIT)  EWCA Civ 1553 15/12/05;  UKHL 35;  WTLR 1229 (‘Arctic Systems’) HMRC sought to apply the settlement code contained then in s.660 ICTA 1988 to the payment of dividends in order to assess the payments made to Mrs Jones on Mr Jones instead. Under s.660A(2) a settlor was regarded as having an interest in property if that property, or any derived property, was, or could become, payable to (or applicable for) the benefit of the settlor or their spouse in any circumstances whatsoever.
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In that case, the company, Arctic Systems Limited, was owned equally by Mr and Mrs Jones, who each held one share. The shares were issued when the company was incorporated and they had purchased the shares at their nominal value of £1. Mr Jones was the main worker and Mrs Jones performed various support services. Modest salaries were paid and dividends were paid in addition to the salaries. The point at issue was whether the dividends were income arising under a settlement by Mr Jones on Mrs Jones. If it was held that there was a settlement, under anti-avoidance rules, then the dividends would be taxable on Mr Jones, who was a higher rate taxpayer whereas Mrs Jones was not. The case was decided in favour of HMRC by the Special Commissioners and in the High Court. However, both the Court of Appeal and the House of Lords found in favour of the taxpayer, although for slightly different reasons.
The response of the Government was to immediately issue a Ministerial Statement stating that the changes would be made to tax legislation to ensure their view would be put on a clear statutory footing. Proposals have been made but it was announced in the 2008 Budget that implementation would be postponed for a year until April 2009 while further consultations take place. In fact no legislative changes were introduced in April 2009 and as the proposals appeared time consuming for the taxpayer and would have been difficult to operate for HMRC it is likely that no action will be taken to introduce them for the foreseeable future.
The facts of Patmore
On 14 January 2000 Mr & Mrs Patmore purchased 85% of the shares in Cambridge Dynamics Ltd. a manufacturing company for which Mr Patmore had worked for some time. The purchase price was £320,000 payable in three tranches and subject to adjustment depending on profit.
98% of the shares were held in Mr Patmore’s name and only 2% of the shares purchased were held in Mrs Patmore’s name despite the first tranche of the purchase price being funded by a mortgage secured on their jointly owned home. The second tranche was sue on 1 October 2000 and the final tranche on 1 October 2001. Mr Patmore became the sole director of the company.
On 31 March 2000 changes were made to the share capital. The existing shares were named ‘A’ shares and 100 new £1 shares were created called ‘B’ shares. 10 of these new B shares were allotted to Mrs Patmore.
Subsequently, the company paid Mrs Patmore a number of dividends on the ‘B’ shares which allowed the company to credit to Mr Patmore’s loan account. He then used the money to help repay the outstanding payments under the share sale agreement.
The issues in dispute
- What were the reasons for the structure?
- Were the B shares settled on Mrs Patmore by Mr Patmore within the meaning of the provisions relating to settlements in s.660A ICTA 1988?
- Were the dividends on the B shares settled on Mrs Patmore by Mr Patmore, again within the meaning of s.660A ICTA 1988?
Reason for structure
To allow Mrs Patmore to receive dividends without taking on the same amount of risk as Mr Patmore in respect of payments due under the share sale agreement.
There was an implicit agreement that she would receive most of the dividends and she originally intended that these monies would be used to pay off the mortgage on the house not to pay off sums due under the share sale agreement. These payments had been intended to be met by dividends paid on the A shares owned by Mr Patmore.
Unfortunately, this arrangement was undermined by the fact that Mrs Patmore signed the share sale agreement and was jointly and severally liable for the payments due under it. She was forced to pay over the dividends she received to meet the payments under the agreement because the business did less well than expected.
Did Mr Patmore settle the B shares on Mrs Patmore?
On the basis of Jones v Garnett shares which had little or no value when settled could nevertheless be the subject of a settlement. Once settled the dividends arising would be subject to the settlor’s rate of tax. There was no need for a formal trust deed. Under s.660G ICTA 1988 the definition of ‘settlement’ included an ‘arrangement’. This is precisely what had arisen – an arrangement by which the dividends on the valueless B shares would be paid to Mrs Patmore.
However, the tax liability under s.660A could not arise simply because there was an arrangement there also had to be an element of gift i.e. not something which would have formed part of an arm’s length transaction.
Since Mrs Patmore was jointly liable with her husband on the mortgage and also on the debt due for the outstanding purchase price under the share sale agreement there could not be said to be an element of gift in relation to the B shares. She had contributed equally to the purchase price but in return she had only been given 2% of the shares and then given 10 B shares which had no right to a dividend.
The Judge decided that there was in fact a constructive trust in favour of Mrs Patmore over 40.5% of the A shares because of her equal contribution to the purchase of them and she was entitled to receive half of the 85% (i.e.42.5%) ‘A’ shares purchased rather than merely 2%.
It was said that the transfer of the almost valueless B shares to her was in recognition of what she owed under the agreement and could not amount to any ‘bounty’ on her part.
Did Mr Patmore settle the dividend payments on the B shares on Mrs Patmore?
The decision by the controlling shareholder (i.e. Mr Patmore) to only pay dividends on one class of shares rather than on another class could amount to an ‘arrangement’ but again it was necessary to establish an element of gift for this to constitute a settlement. Whilst the arrangement was not commercial there was a lack of commerciality on both sides.
If the dividends paid to Mrs Patmore exceeded her entitlement to dividends, as the beneficial owner of 42.5% of the A shares, then there was a settlement in respect of the excess.
Whilst there was an exemption from the settlement scheme in the legislation where outright gifts were made (which was relevant in the Arctic Systems case) s.660(A)(6)(b) said that the exemption did not apply where the property given was wholly or substantially a right to income, which was the case here.
As a result of this analysis, the assessments which HMRC had made on Mr Patmore in respect of the dividends paid to his wife were to be upheld but only to the extent that they exceeded her entitlement to dividends on the assumption she was a 42.5% A class shareholder.
The idea of a constructive trust applying in this case was in fact one devised by the Judge and had not been contemplated by the parties. It may yet be challenged on appeal.
Whilst the invocation of a constructive trust in this case may well have resulted in a fair outcome the practical problem for practitioners is the lack of principle to apply to future similar cases.
We have seen how the application of the common intention constructive trust principles to cohabitants and their assets has increased the difficulty of giving advice as to the outcome of any dispute over the size of beneficial ownership. Similarly, when advising husbands and wives and civil partners on the acquisition of shares in a company practitioners need to bear in mind that the actual allocation of shares may not in the end be determinative of the beneficial ownership of those shares.
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