Whether dividends paid by a company, owned by the taxpayer and his wife, were liable to the higher rate tax under section 660A ICTA 1988

The taxpayer and his wife were owners of a small engineering company which they had purchased for £320,000 on the retirement of the controlling shareholder. The purchase had been funded by a joint mortgage on their home. Although the wife was equally liable for the loan, she received a much smaller % of the shares in the company than the taxpayer, the shares having been organised into two classes with the wife owning 2% of the A shares in addition to 10% of the non-voting B shares. Dividends were paid in respect of the B shares for the tax years 1999 to 2003 and these were always paid into the taxpayer's loan account for offset against the outstanding loan payments made in relation to the initial purchase of the company.

HMRC's view was that, under this arrangement, the taxpayer was liable to tax on the dividends paid on the B shares as a settler under a settlement within Section 660A ICTA 1988. Their argument was that the taxpayer as owner of the company used his control to declare significant dividends in favour of his wife so that they would attract a lower rate of tax. Further HMRC contended that his wife never received the dividends as they were always retained by the taxpayer to repay the purchase debt.

Accordingly, HMRC issued amendments to the taxpayer's self-assessment returns for the relevant years to increase his tax liability as a result. The taxpayer appealed using the argument that the structure of the shareholdings was deliberate in order to protect his wife from some of the risk inherent in the company whilst at the same time giving her a fair share of the dividends.

The First-tier Tribunal allowed the taxpayers appeal in part. They stated that, a settlement included an arrangement, and that the decision of the court in Jones v Garnett indicated a broad interpretation such that relatively valueless shares given to a spouse where it was intended that future dividends could be paid, could amount to an arrangement. Under the arrangement, the settler had to provide a benefit which would not have been provided in an arms length transaction.

By taking a broad and realistic view of the arrangements, there was a constructive trust in the wife's favour. The purchase of the company was a joint venture to secure their financial future and at the outset there was no intention by the wife to give her half-share to the taxpayer, the parties simply took the advice of their accountant which they did not fully understand to allot her the B shares instead of half the ordinary shares which they had jointly purchased.

The B shares were not a fair recognition of her investment as they were almost valueless. Therefore, a constructive trust in the wife's favour over 40.5 shares arose when they were purchased because she was entitled to half the 85 shares but only received 2.

Those shares were held in law by the taxpayer but on trust for his wife. Therefore when the 10 B shares were allotted to his wife, even though the arrangement was not commercial, it was not gratuitous either. It was recognition, whilst inadequate, of her rights to shares in the company and thus there was no bounty. In all the circumstances, the B shares were not settled by the taxpayer on his wife.

The question also arose whether the B dividends were settled on the wife. Following the expansive wording of ‘arrangement’ within the meaning of section 660G(1), a decision by a controlling shareholder to only issue a dividend on one class of shares could be an arrangement caught under section 660A. However, section 660A could only apply where the arrangement involved gratuity.

To the extent that she was entitled to the dividends, there was no gratuity and therefore no settlement. To the extent that the dividends paid exceeded her entitlement as the beneficial owner of 42.5 of the A shares, there was a settlement within Section 660A.

The First-tier Tribunal ruled that the dividends paid to the wife of the taxpayer did not qualify as a ‘settlement’ under Section 660A, thus overturning HMRC's demands for additional taxes.

The full text of this case is available at http://www.bailii.org/uk/cases/UKFTT/TC/2010/TC00619.html