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|Judgments - Jones (Respondent) v.Garnett (Her Majesty's Inspector of Taxes) (Appellant)
HOUSE OF LORDS
OPINIONS OF THE LORDS OF APPEAL FOR JUDGMENT
IN THE CAUSE
Jones (Respondent) v. Garnett (Her Majesty's Inspector of Taxes) (Respondent)
 UKHL 35
1. Chapter IA of Part XV of the Income and Corporation Taxes Act 1988 contains anti-avoidance provisions intended in principle to prevent people from reducing their tax liabilities by settlements, gifts or similar arrangements which transfer income or income-producing assets to their minor children or under which they or their spouses retained an interest. These provisions go back many years.
2. The question in this appeal is whether they apply to the arrangements made by Mr and Mrs Jones to distribute the income of a company through which Mr Jones, with back-office support from Mrs Jones, traded as a computer consultant. When Mr Jones was made redundant in 1992, he decided to go freelance. He and his wife acquired a shelf company called Arctic Systems Ltd; the formation agents sold them the two issued £1 shares for £1 each and Mr Jones was appointed sole director. Mrs Jones was appointed secretary. It appears that the agencies through which computer consultants offered their services insisted upon dealing only with companies, presumably to avoid any possible argument that the consultant was in substance an employee.
3. The company then entered into contracts with customers to provide the services of Mr Jones. The performance of these services generated the company's income. Mrs Jones did the book keeping, dealt with the bank and the insurance company, paid tax and VAT and attended to correspondence. This took four or five hours a week.
4. The income was distributed on the advice of their accountant. The agreed statement of facts says that in the relevant year 1999-2000, the company's receipts were £78,355. Mr Jones took £6,520 as salary and Mrs Jones £3,600. The latter is accepted to have been a reasonable figure for Mrs Jones's services but the former figure is, given the company's receipts, plainly less than Mr Jones could have earned in the market. After these and other deductions, the company's taxable profits were £26,372, on which it paid £4,927 corporation tax. It is said to have declared and paid dividends of £25,767.25 to each of the shareholders, but given the amount of distributable profits, this may be a mistake. The precise figures do not however matter. The pattern of distribution over the previous years had been much the same.
5. The tax advantages to Mr and Mrs Jones of receiving the company's earnings as dividends rather than salary were, first, that National Insurance Contribution would have been payable on salary but was not payable on dividends and, secondly, that the dividend payable to Mrs Jones was taxable at a lower rate than it would have been if added to the income of Mr Jones. For these reasons, it was contemplated from the outset that the company would pay Mr and Mrs Jones low salaries and distribute the rest of its income as dividends.
6. The following are the provisions of Chapter IA which are said to apply to these arrangements:
7. Not every transfer of property is a settlement for the purposes of section 660A. There has to be an "element of bounty" in the transaction. This old-fashioned phrase, apparently derived from the judgment of Plowman J in Commissioners of Inland Revenue v Leiner (1964) 41 TC 589, 596 and approved by the House of Lords in Inland Revenue Commissioners v Plummer  AC 896, 913, conjuring up the image of Lady Bountiful in The Beaux' Stratagem, is perhaps not the happiest way of describing a provision for a spouse or minor children. A donation to a spouse or child is traditionally expressed in a deed to be "in consideration of natural love and affection" rather than the donor's bounty. It is nevertheless exactly the kind of thing at which the anti-avoidance provisions are aimed. In Chinn v Hochstrasser  AC 533, 555 Lord Roskill cautioned against treating the word "bounty" as if it had been included in the statute. It seems to me that the general effect of the cases is that, under the arrangement, the settlor must provide a benefit which would not have been provided in a transaction at arms' length.
8. 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. I shall postpone consideration of why the Revenue say that the exception in section 660A(6) does not apply.
9. Park J accepted this argument but the Court of Appeal  1 WLR 1123 did not. Sir Andrew Morritt C said, at para 73, that Mrs Jones had acquired her share "for value", i.e. for £1 "in the context of a joint business venture to which both parties made substantial and valuable contributions". What happened thereafter, namely that Mrs Jones was paid a salary and in addition was paid dividends derived entirely from her husband's work, was not part of the arrangement because these events depended upon the future business of the company and decisions on dividend policy by Mr Jones, all of which were uncertain. They could not therefore supply the necessary element of bounty.
10. I must respectfully disagree. In my opinion the analysis is divorced from reality. Mrs Jones 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 the advice which they had received from the accountant. And that was what happened. Each year the salaries were set at a level suggested by the accountant and the rest retained or distributed as dividend. The decisions were tax driven and not commercially driven. And it was necessary, in order to gain the tax benefit, that Mr Jones should, in a broad sense, transfer some of his earnings to his wife.
11. Authority for taking a broad and realistic view of the matter may be found in several cases of which the most relevant is Crossland v Hawkins  Ch 537. This concerned section 397 of the Income Tax Act 1952, the effect of which is now reproduced in section 660B of the 1988 Act. It is, for all relevant purposes, in terms similar to section 660A, except that instead of applying when an interest under the settlement is retained by the settlor or his spouse, it applies when income arising under the settlement is paid for the benefit of a minor child of the settlor.
12. On 3 December 1954 the actor Jack Hawkins caused a company named Roehampton Productions Ltd to be formed with an authorised share capital of £100, of which two shares were subsequently issued to two clerks employed by his solicitors. On 10 December 1954 he agreed with the company to make his services available as the company should direct for a salary of £50 a week. On 3 March 1955 Mr Hawkins' father-in-law settled £100 on trust for Mr Hawkins' three minor children and the trustees used this money to subscribe for the 98 unissued shares in the company. In 1956 the company was paid £25,000 for Mr Hawkins' services in a film and on 18 October 1956 it paid a dividend of £500 to the trustees, most of which they distributed to the minor children. The question was whether, under the predecessor of section 660B, this income should be treated for tax purposes as the income of Mr Hawkins.
13. The taxpayer argued that there was no arrangement to which the section could apply. At the time when Mr Hawkins agreed to supply his services to the company, the settlement by which his children acquired an interest in the company was not in contemplation. Donovan LJ said, at pp 549-550:
14. Holroyd Pearce LJ pointed out, at p 553, that the whole scheme followed proposals put forward by Mr Hawkins' solicitors and accountants and that
15. Butler v Wildin (1988) 61 TC 666 also concerned the provision for settlements for the benefit of minor children, by then contained in section 437 of the Income and Corporation Taxes Act 1970. In September 1980 two brothers, Graham and Garry Wildin, who each had two minor children, started negotiations with British Rail to acquire a long lease of some land which they thought presented a profitable investment opportunity. They acquired a shelf company with an authorised share capital of £100 and allotted 19 shares to each of the four children. Each child paid for the shares out of money in a savings account. They then arranged for the company to acquire the lease and undertake the development. By 1982 the development was complete. In 1985 the company made a profit and paid the children a dividend. The question was whether it should be treated as income of the brothers.
16. Vinelott J decided, at pp 683-684, that the brothers were parties to an arrangement and that the dividends were paid to the children in consequence of that arrangement:
17. As in this case, the taxpayers argued that there was no "element of bounty" because the children had paid for their shares out of their own money. Vinelott J said, at p 684:
18. As in this case, there was no assurance that dividends would ever be paid. That depended upon whether the company made a profit: as Vinelott J said, at p 685:
19. Similarly, even if the company made a profit, the payment of a dividend depended upon the decision of the brothers who were at all material times the sole directors.
20. Sir Andrew Morritt C distinguished Crossland v Hawkins  Ch 537 on the ground that the arrangement included a binding contract by Mr Hawkins to serve the company for £50 a week. In this case, there was no such contract. Mr and Mrs Jones agreed their salaries retrospectively from year to year on the advice of the accountant. But I do not think that this makes a difference. The Wildin brothers were not obliged to fund the development by the company. They could have stopped at any time. I agree with Park J, who said in this case (at  STC 1667, 1709, para 39) that it would have made no difference if there had merely been expectations that Jack Hawkins would work for the company at a salary to be fixed from time to time and that in practice the salary would be set at a low level. As the value of a share always depends upon expectations of future yield, such expectations would give the shares a far greater value than the nominal sum for which they were transferred.
21. As for Butler v Wildin (1988) 61 TC 666, Sir Andrew Morritt C summarises the facts and remarks without further comment, at para 78, that Vinelott J appears to have considered that the acquisition of the shares, the agreement with British Rail and the development of the land were all part of one arrangement. I do not think that is right, because Vinelott J says (at p. 678) that
22. That is not to say that a series of steps which are contemplated in advance cannot together constitute an arrangement. That appears to have been the case in Crossland v Hawkins  Ch 537. But I would have found it difficult to say that in Butler v Wildin the subsequent agreement with British Rail and the development were part of the arrangement. They depended, as Sir Andrew Morritt said of this case, upon extraneous events and decisions which had not been made. It was the expectation of such events and the hope of profit which, together with the absence of any risk attached to the children's ownership of the shares, gives the "element of bounty" to the arrangement constituted by the allotment. What subsequently actually happened was not part of the arrangement but the way in which (as foreseen) income arose under the arrangement. I think that this analysis (which Keene LJ said he had initially found persuasive) is correct.
23. Carnwath LJ made a rather different point when he said, at para 108, that this was the first time in which the revenue had sought to apply the concept of a "settlement" in sections 660A or 660B to
24. I cannot agree that this was a "normal commercial transaction between two adults." It made sense only on the basis that the two adults were married to each other. If Mrs Jones had been a stranger offering her services as a book keeper, it would have been a most abnormal transaction. It would not have been an arrangement into which Mr Jones would ever have entered with someone with whom he was dealing at arms' length. It was only "natural love and affection" which provided the consideration for the benefit he intended to confer upon his wife. That is sufficient to provide the necessary "element of bounty".
25. That brings me to the question of whether the respondents fall within the exception created by section 660A(6). The background to that provision is that until 1989 the income of a wife was deemed for tax purposes to be that of the husband. The then equivalent of section 660(A) therefore had no practical application to a settlement under which income accrued to a wife because that income was deemed in any case to be that of the husband.
26. The question in this case only became of practical importance when separate taxation of husband and wife was introduced by the Finance Act 1989. That did not mean, however, that Parliament was necessarily willing to allow one spouse to reduce his or her liability to taxation by arrangements by which the one transferred the right to part of his income to the other, any more than to their minor children. But section 660(A)(6) (the provisions of which were originally inserted into the 1988 Act by section 108 of the Finance Act 1989) creates an exception for cases in which one spouse makes an "outright gift" to the other of the property from which the income arises. Thus a gratuitous transfer of quoted shares from husband to wife, although obviously a settlement for the purposes of section 660A, is excluded from the section and the income is taxed as the wife's income.
27. Does this apply equally to the transfer to Mrs Jones of her share in Arctic Systems Ltd, from which her dividend income arose? The Revenue say no for three reasons. First, they say there was no gift of the share by Mr Jones to Mrs Jones. He never owned the share which she took. It belonged to the formation agents and Mrs Jones bought it from them for £1.
28. In my opinion this narrow analysis of the transaction would be inconsistent with the reasoning by which I think that the transfer comes within section 660A in the first place. It was Mr Jones's consent to the transfer of a share with expectations of dividend to Mrs Jones for £1 which gave the transfer the "element of bounty" for the purposes of section 660A. By the same token, I think it made the transfer a "gift" for the purposes of subsection (6). And there is no dispute that, if it was a gift, it was outright.
29. The second argument is that the transfer of the share was not the whole of the arrangement, which included the provision of services by Mr Jones, the dividend policy and so forth. Again, I think that would be inconsistent with the argument by which the revenue have, in my opinion, succeeded on the first point. The transfer of the share was in my opinion 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.
30. Finally, the revenue say that the property given, i.e. the share, was "wholly or substantially a right to income". 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.
31. In my opinion, this arrangement falls within the exception in section 660A(6). I would therefore dismiss the appeal.
LORD HOPE OF CRAIGHEAD
32. I have had the advantage of reading in draft the speeches of my noble and learned friends Lord Hoffmann and Lord Neuberger of Abbotsbury. I agree with them, and for the reasons they give I too would dismiss the appeal. I also agree with the further observations of my noble and learned friend Lord Walker of Gestingthorpe.
33. In common with my noble and learned friends, I think that the argument for the Revenue breaks down on the question whether the ordinary share of £1 which was acquired by Mrs Jones was within the exception in section 660A(6)(b) of the Income and Corporation Taxes Act 1988 because it was "wholly or substantially a right to income". This is the final point dealt with by Lord Hoffmann (para 30). It is the second argument for the Revenue in Lord Neuberger's analysis (para 92).
34. The answer to that question does not depend on the particular facts of this case. It applies generally to all transactions containing the necessary element of "bounty" where the property given consists of ordinary shares in a company. For the reasons my noble and learned friends have given, an arrangement by which one spouse uses a private company as a tax-efficient vehicle for distributing to the other income which its business generates is likely to constitute a "settlement" on the other spouse within the meaning of section 660G(1) of the 1988 Act. But so long as the shares from which that income arises are ordinary shares, and not shares carrying contractual rights which are restricted wholly or substantially to a right to income, the settlement will fall within the exception created by section 660A(6). This is an important point of general public interest on which I should like to add these brief comments.
35. The rights which attach to shares in a company depend on the contractual relations between the holders of those shares as defined by the articles of association of the company. It is the articles of association that determine questions between ordinary and preference shareholders as to the right to income in the form of dividends, and the right to the repayment of capital and to participate in the distribution of surplus assets in the event of a winding up of the company. They also determine questions as to the right to attend and to vote at general meetings of the company. The general rule is that the profits of a company belong to the ordinary shareholders, subject to the payment of any preference dividend. Then there is the question how surplus assets not required for the discharge of the company's liabilities or the return of paid up capital to the shareholders are to be distributed in the event of a winding up. The rights of the preference shareholders in any particular case will depend on what the articles of association provide. This is because the rights of the shareholders are determined by the terms of the bargain which they made with the company and with each other. The articles must be taken as a complete statement of the rights of the preference shareholders in the winding up: Scottish Insurance Corporation Ltd v Wilsons and Clyde Coal Co Ltd  AC 462, per Viscount Maugham at p 481, Lord Simonds at p 488.