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Whoopee for the House of Lords! By Simon Sweetman

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26th Jul 2007
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So Jones v Garnett is over, and the appeal by HMRC has been dismissed. Let’s look at why.

Lord Hoffmann explained in the lead judgement

The Revenue's case is straightforward. They say that the acquisition of the company and the transfer of a share to Mrs Jones, enabling her to receive the dividends which were expected to be paid, was an arrangement. It was not a transaction at arms' length because Mr Jones 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 Mrs Jones 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 Mrs Jones's lower rates. The dividends paid to Mrs Jones arose under the arrangement. Mr Jones, 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 section 660G(2). As Mrs Jones was the spouse of Mr Jones, he was to be treated as having an interest in the income derived from her share and that income was therefore to be treated as his income.

He agreed with much of this. The issue of a share to Diana Jones was a gift. No genuinely independent third party would have been treated in that way, and the expectation form the start was that she would profit from dividends.

Crossland v Hawkins has been important here. The taxpayer wanted to make a distinction because in that case Jack Hawkins was bound to the company for a wage of £50 a week. Lord Hoffmann declined to accept that distinction (also here calling Butler v Wilden into play). What happened subsequently to the agreement – which was expected but not guaranteed and in this case was the earning of money by the company – could not be part of the initial arrangement because it was still at that time contingent (unlike in Crossland v Hawkins where the income stream for the company was already guaranteed because it was to receive income from a film which was already arranged). But although the expectation (in the sense of hopefulness) made the matter bounteous, it was not sufficient to mean that all the subsequent events were part of an arrangement. As Lord Hoffmann says (agreeing with Sir Andrew Morritt in the Butler case) what subsequently actually happened was not part of the arrangement but the way in which (as foreseen) income arose under the arrangement.

Note that problems can arise here with words like “foreseen”, “expectation” and “anticipation”, because we need to distinguish what we know is going to happen from what we hope and expect is going to happen. If we know what is to happen, then it can be part of the arrangement. BUT it appears that in either case there can be bounty. I can give you my shares in Bolivian Tramways Inc as a gift, and it is still a gift if I do not know what will happen and whether they will pay dividends.

Lord Hoffmann also adds that this is not “a normal commercial transaction between two adults” and that “it made sense only on the basis that the two adults were married to each other” [OR civil partners OR living together, of course].

Up to this point, then, Lord Hoffmann has gone with the Inland Revenue approach. There is bounty: there is an arrangement (though not everything was part of that arrangement). If there is a gift then in the normal case there is a S.660A settlement.

But then with one bound we are free, because there remains S.660A(6). If there is an outright gift of property from which income arises to a spouse, then that is exempted from the settlement legislation. The Inland Revenue accept this for my Bolivian Tramways shares [because once given I no longer have any control] but had argued that the share in Arctic Systems Ltd – while it was a gift – was merely a gift of property that was wholly or substantially a right to income.

No, said Lord Hoffmann, It is true that the value in the share arose from the expectation that it would generate income. But that is 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 conferring a right to vote, to participate in the distribution of assets on a winding up, to block a special resolution, to complain under section 459 of the Companies Act 1985. These are all rights over and above the right to income. The ordinary share is different from the preference shares in Young v Pearce (1996) 70 TC 331, which conferred nothing except the right to 30% of the net profits before distribution of any other dividend and repayment on winding up of the nominal amount subscribed for their shares. Those shares were substantially a right to share in the income of the company.

The other law lords effectively agreed with Lord Hoffmann (though Baroness Hale had her doubts about the settlement point).

So a win for the taxpayers – but a win with implications. This seems to cover the gift of shares as well as the subscription, and it appears to cover the unmarried as long as the donor no longer has any interest in the property – the share issued or gifted to the donee. That is probably the same as situation spouses are put in by S.660A(6). HMRC have always steered clear of advising the non-married couples (the only one of their very many examples drags in “Aunt Jane” to avoid the issue), though I am aware that they have some in their waiting list.

I fear we can now expect new legislation. I hope and expect there will be proper consultation, because the issue of small trading companies must not be allowed to continue to fester.

Links to related items

News
Jones v Garnett: Ministerial statement Knee-jerk reaction from the Treasury

News: Victory for the Joneses

Features and analysis
Analysis and summary of judgment By Nichola Ross Martin.

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Replies (12)

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By AnonymousUser
27th Jul 2007 09:12

Not necessarily
In a private company the ordinary shares give the owners rights to the asset of the company. But whether they take those assets in the form of income dividends or capital distributions is entirely a matter of their choice.

So the most that can said is that ordinary shares in a private company are substantially a right to income and/or capital.

That is surely a very different thing, even economically and financially speaking, to a right to income simpliciter without the right to the underlying assets that produce the income - eg a preference share or a rental stream.

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By martinfoley07
27th Jul 2007 11:41

hear what you say E.C......
...but you would be hard pressed to find many economists or financiers to agree with the underlying proposition.
On the specifics of the case, this is in the context of their Lordship's taking the broad view (which I agree is the view to take) of the "arrangements" made in the case. Luckily they did not choose to take a similarly broad view on the ordinary share rights in the case.

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By Lesstaxman
27th Jul 2007 14:30

paradise lost???????
Ok so their lordships decided that there was "bounty" here in the form of a gift from Mr Jones to Mrs Jones of something which was presumably her subsequent ability to enjoy his income in the form of company dividends - but they then go on to decide that an ordinary share is not "substantially a right to income" and therefore an exempt gift for a spouse. Whilst it is good to see the case won by the Joneses, (didn't they do well!), this is less than a satisfactory outcome. In the context of a consultancy business such as this was I find it less than convincing to say that this share was anything other than substantially a right to income. What we presumably take from this is that preference shares or restricted rights "A" shares etc etc are now at risk of a more confident HMRC challenge. For the future it cannot be long before we see some new special rate of CT introduced by the Chancellor to seek to resitct the advantages of ordinary share structures such as the joneses used, or perhaps a return to Investment income surcharge or even close comapny apportionment? plus ca change!!!


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By bseddon
27th Jul 2007 15:05

Surely the law lords are right
While you may not be able to find economists or financiers that take the law lords line, I'll bet that small or start up businesses funded by VCs will recognise the position the law lords have taken with respect to the benefits conferred by ordinary shares.

While each share might be a right to income (definitely in the future) the legal agreements such as the articles don't usually dwell on this point but instead focus on the share as an instrument of company control or influence through its right to a vote. In my experience this leads VCs to require at least 25.1% of the shares in exchange for their investment. Not so they can expect at least this share of the profit but so that they are able to exercise sufficient control control of their investment under the companies act.

Artics Systems may not be VC funded but it doesn't mean that the meaning of an ordinary share should be any different for a close company than it is for any other company.

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By MBK
27th Jul 2007 15:31

Martin - surely you miss the point...
An Ordinary Share is not a right to income at all. It only provides / allows for an income to be paid in the form of a dividend if whoever is in control of that income decides to pay an income in that form. You seem to be focussing on income rather than rights.

It is, of course, possible that a shareholder controls the distribution of the income of the company may have the necessary degree of control - but Mrs Jones didn't.

Huge numbers of companies never pay dividends. If you take the Lords viewpoint that you have to establish whether there is an arrangement at the outset, how are you ever meant to decide which shares have to be defined as "..substantially a right to income"?

Interesting that our government says they will legislate to effectively reverse the decision. If it's that easy, why didn't they do it years ago.

As another correspondent says, Mr Murphy seems to know what is "fair and right". But that depends upon your starting point - which he conveniently forgets to define!

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By martinfoley07
26th Jul 2007 23:43

the article highlights...
...what a narrow squeak the judgement was.

Their Lordships took a "legal" (and wrong !!) view that ordinary shares do not represent "...substantially a right to income".
They would be hard pressed to drum up many financiers or economists who would agree their view on that matter.

Of course they are "substantially" (as defined in OED) a right to income (in economic terms and any financial sense whatever) .
If they were not, capitalism would be dead !!!

The fact that they also have several other legal (and even commercial/social rights, if you will) does not come close to upsetting that fundamental.

Are they different (legally and economically and financially) to preference shares? You bet.
That fact does not come close to upsetting the fundamental either.

Thank goodness a narrow legal view over-rode any realistic financial/economic view - and it's not often you can say that !!

Now onto the debate about how we decide what is a "fair" tax.
Although Richard (Murphy) apparently knows the answer to that one !!

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By NeilW
27th Jul 2007 17:26

Remember we are talking about tax here
Which inhabits a world akin to 'Second Life' except that it is much more mysterious and unfathomable. (What would be the tax equivalent of Heizenberg's Uncertainty Principle I wonder).

What Martin forgets is that we are talking about 'income' in its strictly tax sense, not in its economic sense.

And as we all know (I hope) it is perfectly possible to build up funds in a small company and then liquidate the company. You would then have capital, not income!

So an ordinary share in an OMB can by 'wholly or substantial a right to capital' if you desire it to be so.

And that is why the exemption applies.

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By martinfoley07
27th Jul 2007 17:35

well. my fault .....
...for starting a red herring since the case is over, but just some quick follow ups:
(i) Jon ; it is totally true that the ordinary share gives various legal entitlements. But the fundamental financial/economic raison d'etre of owning an ordinary share is the future income. There is no other rational financial motive, even if there be possible other motives (eg buying a share in a company where you wish to turn up at AGM and protest against their green policies)
(ii) Steven ; you are discussing/arguing a different set of points and issues altogether. You are correctly pointing out that HMRC's various rules and laws and views are totally fragmented and utterly inconsistent ; 100% agreed.
(ii) Neil ; I agree the Lawlords were debating the point in the context of tax (and agree your views thereon!!). But the Lawlords, in assessing the first ("arrangement ") point, took the wider view. As I said originally, it's as well thay did not take the wider view on the second point. Of course, instances exist of folk taking a tax capital gain and not tax income by liquidating (or indeed selling), and the tax system works that in different ways (although as you point out, the economics is essentially the same). But given the Jones clear cut instance, the Lawlords could have trampled a very different path.
Whatever, my fault for starting a side debate which probably has not much future purpose but only thanks past lucky stars. I can't readily see how it can help or hinder the Treasury in creating new legislation (famous last words).

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By AnonymousUser
27th Jul 2007 20:01

Move on
We think we understand where this decision takes us and things will get clearer still.

But what will this proposed legislation anti-avoidance look like? It's fairly easy, as the Revenue assert, to draft legislation to catch the Arctics of this world - but Arctic is at one very extreme end of the family ownership spectrum.

Supposing it's more difficult to identify the principal earner. Supposing the secondary earner is nevertheless an active contributor. Who will make these judgements?

As we all know, this fiasco has arisen from separate taxation and the new premier's fiction that national insurance is not principally taxation, which has led to the complete reversal of the income of choice for owner/managers. Those of my advanced years will remember when it was different and dividends were the expensive method of taking personal reward.

Last point - every computation illustrating the "tax" cost comparison of salary/dividend fails to acknowledge that S2P has real benefit. So NI cost, considerable though it be, can provide a material uplift in state index linked pension. So it's not all one way.

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Richard Murphy
By Richard Murphy
10th Aug 2007 11:12

If the big onstacle is NI
then I could live with a merger so long as the issue is properly tackled.

But, candidly I see my suggestion as pragmatic, easy and more managable and so a winner.

But I'm open to persuasion...if that's all that stands between us

Richard

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By martinfoley07
09th Aug 2007 19:53

had a quick look....
...at the paper, Richard, and
(i) there is a lot in there that I agree with
(ii) there is quite a bit I don't agree with.
Not very helpful, so I hope I get time over next few weeks to comment, but personal circumstances may preclude that.

On one key "nettle" if we are going for genuine root and branch reform.
I remain unconvinced by arguments for continuing to separate NI from mainstream Taxes, despite agreeing there are significant obstacles. I think we do have to address whether this is tax by any other name or if we wish to separate it. The latter is surely a dead duck in economic reality, so let's accept it. It's (un?)arguably too huge a distortion at the heart of the system to leave it there.
(a) Your argument about the psychology of it (headline rates etc) is valid, but are we not able to get past this?
(b) do not agree that pensioners as a body are, by definition, unfairly treated if the distinction is dropped. More to the point, that matter could readily be addressed if folk wanted to treat them differently. So I honestly regard that as a red herring (wittingly emotive or otherwise - you can just see the politicians on that one) in any NI debate.

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Richard Murphy
By Richard Murphy
09th Aug 2007 11:30

Arctic Systems: Moving on
Martin Foley (amongst others) challenged me on this issue. I have written a paper on how to resolve the issues raised by the Arctic Systems case. It is available at http://www.taxresearch.org.uk/Blog/2007/08/09/arctic-systems-moving-small-business-taxation-on-in-the-uk/

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