23 Mar Family businesses and the settlements anti-avoidance rules
The ‘settlements’ income tax anti-avoidance rules are found in ITTOIA 2005. The principal sets of rules are respectively the ‘revocable, or settlor interested’ settlement rules (ITTOIA 2005, s 624), and the ‘settlements on minors’ rules (s 629).
For the purpose of these rules, the term ‘settlement’ is a lot wider than the concept of a formal trust, drawn up by a solicitor, and signed and sealed; under ITTOIA 2005, s 620 it can include, for example, any kind of ‘arrangement’.
The rules referred to here as the ‘revocable, or settlor interested’ rules apply where the person who has made the settlement or arrangement is in a position to take the money or asset back. The second applies where parents make any kind of arrangement in consequence of which their ‘minor’ (under 18) children receive income.
In both cases, the effect of the anti-avoidance legislation applying is that the person who has made the arrangements/settlor is taxed on the income as if it were their own.
The ‘grandparents’ scheme’
A few years ago, this arrangement was very popular, and made use of the fact that the ‘settlements on minors’ anti-avoidance legislation only applies to parents, not grandparents.
This is an example of the way it worked.
Example: Share subscription by grandparents
Mr and Mrs Stephens are running a very successful estate agency business and can afford to send their children to a private school as a result.
It does rankle with them, though, given that they are effectively saving the state money by educating their children privately, that they have to pay ‘through the nose’ (as they see it) on taking sufficient dividends out of their company to meet the school fees, as well as their living expenses. So, when a ‘clever’ tax adviser suggests using the grandparent’s exception (as it might be called) to the ‘settlements on minors’ rules, they bite her arms off.
The scheme was set up, often by the grandparents subscribing for new shares in the company, and then putting those shares on trust for their grandchildren. Often the amount subscribed was a fairly nominal amount, but nevertheless, the shares so issued immediately started paying substantial dividends to the children (or rather to the schools where the children were educated).
All seemed to be well with such ‘clever’ arrangements for many years until HMRC started attacking them. The grounds of their attack were that the actual income of the company, used to pay the dividends, was a result not of the grandparents’ investment in the company, but of the parent’s physical efforts in earning the profits of the company. Given how wide the rules against ‘arrangements’ are, it is quite easy to agree with what HMRC are saying here.
Arguably the only situation where the rules can be avoided is where the grandparents’ investment in the company is so substantial as to give rise to the income as a reasonable return on investment. If it was wished to pay dividends of £40,000 a year on the grandparents’/trust’s shares, you would possibly be looking at needing the grandparents to invest as much as £1 million in the shares in the company to do this. Even then, it would be necessary to be able to prove to HMRC, on enquiry, that the £1 million was a necessary investment in the company in order to bring about greater profitability. All in all, it’s usually easier simply for the grandparents to settle money on their grandchildren if they have this kind of sum to spare.
A variant of the same principle in the context of an investment business is a family investment limited liability partnership (LLP) or company which has grandparents and their grandchildren as members usually with the parents’ generation being involved as members as well.
An investment LLP, funded by the grandparents, is actually a very flexible and tax-efficient way of allocating income to the grandchildren. Unlike simply handing over assets, the LLP structure enables the grandparents to continue to control and safeguard the family investment assets, whilst at the same time, utilising their grandchildren’s personal tax allowances and lower rate bands.
As far as it can be seen, the ‘revocable settlements’ rules would not in practice be applied by HMRC to the amount received by the grandchildren, even if it varies from year to year, providing that this amount is unquestionably theirs and cannot be clawed back by the grandparents. However, because of the risk of the ‘settlements on minors’ rules, one would tend to advise against the parents’ generation introducing any capital value into the LLP. At best, this could ‘muddy the waters’ in respect of any income that their minor children derive from involvement in the LLP or company.
Husband and wife
Another high-profile example of the application of the settlements rules by HMRC, in this case unsuccessful, was in the area of husband and wife owned businesses, with the key legal case being the so-called ‘Arctic Systems’ case (Garnett v Jones  STC 1536).
This involved a consultant operating through a personal limited company in which he and his wife held shares. Although in practice he did most or even all the work for the company, dividends were paid in substantial amounts to his wife. HMRC claimed that the dividends paid to Mrs Jones should be taxed on Mr Jones because they comprised a ‘settlement’. Having succeeded in this claim in all lower courts, HMRC eventually lost in the House of Lords, which decided that it was consistent with the whole scheme of ‘independent taxation’ of husbands and wives, introduced in 1990, that diversion of income of this sort would happen between spouses. Under the principle that ‘Hansard’ can be cited in deciding what legislation means, the court referred back to comments by the then promoter of the Budget changes to the effect that the government accepted that diversion would occur between husband and wife as a result of the new rules.
HMRC being bad losers, their immediate reaction to this, in late 2007 when the impact of the case was being felt, was to announce new legislation to counter the effect of the decision. However, the proposed changes would have been very difficult for professionals to administer, involving a value judgment in each case as to how much each spouse actually contributed in terms of effort, etc. So, it was announced that the proposed changes would be postponed. Immediately following on this announcement came the 2008 financial crisis, and the proposed changes somehow got lost in the confusion. The result is that Arctic Systems is still good law, and effectively it is ‘open season’ on spouses making arrangements of this sort to utilise what would otherwise have been un-utilised personal allowances and lower rate bands.
However, avoid ‘funny’ shares which could be seen as merely a mechanism to pay income. Typically, these shares might have no voting entitlement, and also restricted or nil rights to assets on winding up. It’s best to issue straightforward ordinary shares to each spouse; although it does seem to be permissible for these to be different classes, so that different rates of dividend can be paid for tax efficiency.