Disguised Remuneration. A fragile state: Part 2

E Pluribus Unum?

“One from many”, became the de facto motto of the newly independent USA reflecting the determination to form one nation from what had been disparate states.

Both tax planners and HMRC often approach case law with a similar aim albeit from a different direction. The object is to extrapolate from one case where a scheme has been litigated (one decided in favour of or against the Appellant as appropriate) and to argue that the result applies to the many other taxpayers who have used the same or a similar scheme.

Of course the other side will then argue that their case can be distinguished from the test case in some way. In the previous article A fragile state: Part 1 I said that going forward, given the potential need for many taxpayers to consider their options, for example by taking advantage of a settlement opportunity or proceeding with litigation, it might be useful to look at 3 disguised remuneration (DR) cases, Rangers, [2017] UKSC 45, Marlborough (TC08246) and Strategic Branding (TC08348) While the latter two were subject to appeal to the higher courts, a compare and contrast might be useful to try and identify criteria which had influenced the courts’ judgement as to whether or not the planning had succeeded in achieving its ends.

My initial article referred to the fragility of a “good system”. In this post-match analysis, readers may remember that in the USA the de facto motto of “E Pluribus Unum” was subsequently replaced by the current formal motto of “In God We Trust”.

Rangers

When Rangers was appealed to the Supreme Court from the Scottish Court of Session, many commentators believed that the appeal of the taxpayer would succeed. The thinking was along the lines that while it might be all very well to play fast and loose with the rule of law north of the border, the Supreme Court would be reluctant to look though a properly constituted legal trust which had issued legal loans. How times change.

The Supreme Court agreed with the Court of Session that the loans constituted diverted earnings and so were taxable under ITEPA 2003, s 62. There was no need to fall back on Part 7A of the Act.

Of the three cases, Rangers is the only one where the courts have decided that the loans fell under s62. While that point will no doubt be reconsidered in any appeal on Marlborough and Strategic Branding, it may be noted that Rangers was also the only case which did not involve an owner managed business. The employees were usually but not exclusively football players for the club and had no role other than employees. Unlike in the other two cases, they were not directors and they were not shareholders. As such, the argument that money which came into their possession was for some reason other than employment was more difficult.

Marlborough and Strategic Branding

In both these cases a structure was set up which resulted in a loan being made to an individual who was an employee, a director and a shareholder. In the former the loan was not deemed to be employment income, in the latter it was caught under Part 7A and so was counted as employment income.

In brief, in Marlborough Dr Thomas was a dentist operating through a company, Marlborough DP Limited. The company entered into a tax planning arrangement similar to that in Strategic Branding (see A fragile state: Part 1) where, if successful, the contributions paid by the company to the remuneration trust (RT) would be deductible in computing CT and the loans from the trust received by Dr Thomas would not be taxable. In the words of Mr Ghosh QC representing HMRC, Dr Thomas would have entered “a kind of fiscal paradise”.

Is loan “earnings”?

In Rangers, Lord Hodge considered income tax on earnings as “principally but not exclusively a tax on the payment of money by an employer to an employee as a reward for his or her work as an employee”. As noted above, the court considered that the loans paid to the employees constituted diverted earnings and so were taxable under s62.

In considering whether that legislation bit, the court in Marlborough accepted that while the employment did not need to be the sole cause of the payment, it did need to be “sufficiently substantial as to characterise the payment as being from employment”. Considering the evidence, the FTT noted that: there was no contractual obligation on the company to pay Dr Thomas sums for service; the sums paid annually represented the totality of overall profits; Dr Thomas’ evidence was that had he not used the RT the monies would have been taken out of the company by dividends; dividends were a common route used to extract monies from such owner-managed businesses and GAAR guidance accepted that this was outside the scope of GAAR.

In considering the reliability of Dr Thomas’ evidence, the court may have been influenced by the fact that he had admitted there was a tax avoidance motive. By contrast, in Strategic Branding the court seemed unimpressed with Mr Wilson’s assertions that he had proceeded with no tax avoidance motive in mind.

Having considered the evidence, the conclusion of the court was that while the relevant sums had been paid to Dr Thomas with a tax avoidance motive in mind, they had not been intended as a reward for his services. Rather they were a return on the capital invested in the shares and so the loan should be treated as a distribution. The fact that the legal formalities of declaring a dividend had not been followed did not alter the court’s approach. Although it had different consequences, this seems a similar approach to that in Strategic Branding where it was argued that what was in point was the practical reality of what happened rather than the legal form.

Is a loan is caught by Part 7A (and so is to be treated as employment income)

In Marlborough, the Judge considered the legislative requirements: there needs to be “relevant arrangements”; such arrangements are a means of providing a reward in connection with the employment; there is then a “relevant step” taken by a third party which results in the reward. While it was accepted that there was a relevant step, using a similar logic to that applied in considering the ITEPA 2003, s 62 test, the judgement was that the connection between the payment of the loan and Dr Thomas’ employment had not been established.

This contrast with the decision in Strategic Branding. Mr Ghosh QC acting for HMRC had argued that the whole point of Part 7A was that it did not apply the same test as s 62. The language of Part 7A received careful consideration by the Judge with some interesting comments on how “in connection with” should be construed. The Judge did not accept Mr Ghosh’s submission that, since Part A is anti-avoidance legislation, it is intended to be construed broadly preferring to construe the meaning from the language actually used. Mr Ghosh also pointed to the centrality of Mr Wilson in his different roles to the arrangements and the steps, the fact that all the monies contributed to the RT had been generated by his work and the fact that he was not taking a salary or dividends from the company. The Judge accepted that it was reasonable to suppose that the central or most important characteristic of the arrangement was a means of providing loans in connection with Mr Wilson’s employment. The “relevant step” is thus connected to the employment and Part 7A is in point.

“Wholly and exclusively”

If a contribution to the RT is an expense incurred wholly and exclusively for the purposes of the trade it qualifies as a CT deduction under CTA 2009, s 54(1).

In both Marlborough and Strategic Branding considerable attention was paid to the case law which considers “exclusively”. If the expenditure is incurred for some purpose other than trade then it is not deductible. However the object of the expenditure must be distinguished from its effect so the existence of a private advantage, such as a tax advantage, does not necessarily mean that the expenditure is disallowable. Against that, where the result of an activity “inevitably and inextricably’ follows on from the activity in question, then it can be treated as the purpose of the activity and the conscious motive of the taxpayer is not decisive.

In Marlborough, the question of a deduction did not arise following the decision of the court that the loan which was provided from the contributions by the company was a distribution. Nonetheless the court did address the HMRC contention that even if the loan was treated as employment income the contributions did not satisfy the legislative test of “wholly and exclusively”. On the facts, the Decision was that the contributions did satisfy the test. However in the panel of two judges there was one dissenting voice but Judge Morgan used her casting vote.

A different conclusion was reached in Strategic Branding. It was accepted that while in many situations one would expect to see a correlation between the deductibility of the payment (for CT purposes) and the taxability of the receipt (for IT purposes) there is no required connection and in fact the legislation (at CTA 2009, s 1290) contemplates taxable receipts with no deduction.

Considering the facts of the case and whether the contributions were made for the purpose of enabling the company to carry on and earn profits in the trade, the Judge noted that: she was not satisfied that the contributions were made for asset protection; she did accept that at least an element of the contributions were made because Mr Wilson wanted to benefit his family and to build relationships with potential customers; obtaining a CT deduction for the contributions was important to Mr Wilson and it was his expectation that there would be no tax payable if amounts were lent to him. Taking these points into account, she concluded that the contributions to the RT were not made wholly and exclusively for the purposes of the company’s trade.

Success in a fragile system

A fragile state: Part 1 considered the principle of fragility – that a good system must meet a number of requirements simultaneously which means that good systems are inherently fragile. Where we have ambitious tax schemes which, in the words of Mr Ghosh QC, strive to enter “a kind of fiscal paradise”, the challenge to meeting the different requirements of complex legislation is exacerbated by the different and unique fact patterns of each client. To adapt the words of Tolstoy, each unhappy taxpayer is unhappy in their own way.

DR schemes have to persuade the courts that: monies expended by the company in making contributions to an RT should have a tax consequence of reducing taxable profit; while essentially the same monies should have no tax consequence when reaching the pockets of an individual. That is not legislatively impossible but one starts the argument from the position of slightly raised eyebrows.

Also, the legislative requirement in achieving the deduction is that the expenditure meets the test of being “wholly and exclusively for the purposes of the trade”. By contrast, in arguing that monies reaching the pocket of an individual should be taxable, the test is whether “it is reasonable to suppose” that such monies are “in connection with the employment”. As seen in the arguments above, the former test is more difficult to satisfy than the latter.

In God We Trust

The article started with a reference to the current motto of the USA. Given the difficulty of anticipating the outcome of complex litigation with any certainty, it is tempting to adopt that motto. However, advisers may also bear in mind the thought that God helps those who help themselves. With that in mind:

• If a taxpayer has entered such a scheme then, looking at the current case law, an appeal should be considered following any closure notice from HMRC.
• The fact pattern of the client should be considered in the light of existing case law (and any appeals of decisions to the higher courts).
• There are likely to be different appetites for a fight among different taxpayers depending on factors such as cost and length of time before any final resolution.
• Consideration needs to be given to the terms of any Settlement Opportunity which may be offered by HMRC.
• If HMRC issue a Follower Notice, is this in line with the comments in Haworth on the further care HMRC should be using in the issuing of such Notices.
• In the use of such schemes, the nature of the documentation supporting the scheme can come under scrutiny (as in Strategic Branding where some documentation was considered a “sham”). This has potential implications for the penalty position and, in extreme cases, whether the case could be subject to a criminal rather than a civil route.
• Apart from any financial or criminal consequences, degrees of culpability have implications for the discovery window available to HMRC.

Our current pandemic has taught us that life is a balance of risks and rewards. The same applies to tax planning. 2022 is likely to see HMRC moving to issue closure notices on a number of cases. The options for what to do next will vary as will the individual circumstances. Some big decisions lie ahead.

This article was first posted in Taxation 4 February 2022