Court of Appeal bends the rules to strike down tax avoidance scheme
11 January 2012
In the recent case of The Commissioners for HM Revenue and Customs v PA Holdings Ltd, the Court of Appeal held that a tax avoidance scheme was ineffective. The court's judgment is not only relevant to tax avoidance schemes and could theoretically have an adverse impact for a substantial number of owner-managed businesses, even where no tax avoidance is involved.
The case demonstrates the courts' increasing hostility to tax avoidance schemes and their willingness to "bend" the law in order to strike down such schemes. Arguably, however, the Court of Appeal has taken this approach a step too far and it is likely that the judgment will be widely criticised and may well be appealed
The broad purpose of the scheme was to pay what were in substance bonuses to employees but for the payments to be taxed at the rate applicable to dividends (25%) rather than the rate applicable to income from employment (40%). These rates have now been increased to 36.1% and 50%.
In broad terms, the scheme involved the following steps:
- The "bonus money" was contributed by the employing company to an employee benefit trust. This did not result in a charge to tax because the trustees of the employee benefit trust held the money for the benefit of all employees, not for the benefit of specific individual employees - so there was no individual employee who could be taxed as a result of the contribution.
- The employee benefit trust applied the money in subscribing for shares in special purpose vehicles: one company for each employee. Shares in those companies were transferred to the employees. As a result of the way the arrangement was structured, the transfer of the shares in the companies to the employees did not give rise to charges to tax.
- The companies then paid dividends of the money to the employees. It was accepted that the payments were taxable. The question was whether they should be taxed as dividends (applicable rate 25%) or as employment income (applicable rate 40%).
The general charge to tax on employment income applies to any payments which derive "from" an employee's employment. This charge will catch most "normal" payments of salary or bonuses. All the courts which heard the case found that, as a question of fact, the payments were "from" the employment and were therefore caught by the charge on employment income. The "bonus money" had been funnelled by the employer through the EBT and then through the companies; its ultimate source was clearly the employees' employment, even though it was paid in the form of a dividend. It is difficult to disagree with this conclusion.
The lower courts had also found as a fact that the payments from the special purpose vehicles did constitute dividends and were therefore also caught by the separate tax charge on dividend income.
The tax legislation contained a seemingly clear solution: section 20(2) of the Income and Corporation Taxes Act 1988 stated that if income is taxable as dividend income it could not be taxable in any other way. The lower courts had held that this provision applied so that the charge to tax on dividend income took priority over the charge on employment income, and the applicable rate was 25% rather than 40%.
The Court of Appeal decided that, once the lower courts had decided the payments were caught by the charge to tax on employment income, it was impossible for them also to be caught by the charge on dividend income. In other words, the finding of fact that the payments were employment income made it impossible for them to be dividend income as well. It seems difficult to square this conclusion with the drafting of section 20(2), which clearly contemplates that payments can be both dividend income and something else, and creates a specific priority rule to deal with this. There is also a logical problem with the Court of Appeal's reasoning. The lower courts had found that the payments from the special purpose vehicles were dividends as a question of fact. The Court of Appeal could equally have held that the finding that the payments were dividends displaced any possibility of their also being employment income. Of course, this reasoning cannot be applied both ways without giving rise to a contradiction. Arguably, the purpose of section 20(2) is to provide a way out of the dilemma - but the court held that this provision did not apply.
The judgment is not only relevant to tax avoidance schemes. In reality, when an owner-manager chooses to draw money from his personal company as a dividend rather than as salary, that dividend will be theoretically caught by the employment income tax charge. The Court of Appeal's judgment does seem to give HMRC the ability to impose a higher rate of tax (potentially up to 50%) on "normal" dividends paid from personal companies. It was previously thought that section 20(2) ensured dividends paid to owner-managers could only be taxable at the dividend rate but this view cannot stand with the PA Holdings judgment. There have been indications from HMRC that they do not intend to attack owner-managers who are not engaging in tax avoidance. However, it is hardly satisfactory that this should be left to HMRC's discretion, rather than enshrined in law.
Please contact John Manis on firstname.lastname@example.org or (0117) 902 7764 or Nigel Popplewell on email@example.com (0117) 902 2782 if you have any queries.