Dividends taxable as employment income

The Upper Tribunal’s judgment in the case of James H Donald (Darvel) Ltd v The Commissioners of HM Revenue & Customs [2015] UKUT 514 was released on 5 October 2015, and concerned planning undertaken by James H Donald (Darvel) Limited (“Darvel”) which was intended to reduce its exposures to PAYE and NIC.

The planning

The case concerned three plans adopted by Darvel, a company owned by Reginald Donald:

  • “Plan 5”, which was introduced in November 2000, under which employees agreed to reduce their salaries to the level of the National Minimum Wage in exchange for shares in a newly incorporated company, J H Donald Company Services Limited (“Services”), which then declared dividends on those shares of approximately the same value as the salary that the employees had forgone;
  • “Plan 7”, which was introduced in October 2005 and went a step further, with employees giving up their employment with Darvel and becoming members of Reedon Partnership LLP (“Reedon”), the participants in the plan then received partnership share, together with shares in a company, J H Donald Retail Limited (“Retail”), on which dividends were declared; and
  • “Plan 2”, which involved the provision of cars to Mr Donald and two other employees.

The First Tier Tribunal Decision

The First Tier Tribunal (“FTT”) had decided that none of these plans were effective, specifically, it held that the payments received by the employees by way of dividends and profit shares were, in substance, earnings from their employment with Darvel and within the scope of Schedule E/ITEPA.  Following the Court of Appeal decision in HMRC v P A Holdings Limited [2012] STC 582, the FTT held that the determining factor of the taxable nature of a payment was not the legal form that the payment took, but its substance (in PA Holdings an employer had arranged for its employees to receive dividends from a special purpose vehicle in place of their bonuses, the Court of Appeal held that the fact that payments had the form of a dividend did not change their essential character as bonus payments).

The Appeal

In making its appeal, Darvel argued that there was overlap between the income tax schedules and that the House of Lords decision in Fry v Salisbury House Estate Limited [1932] AC 432 was authority for the proposition that there was a hierarchy among the Schedules that determined under which Schedule an item of income should be taxed.

On the basis of Fry, Darvel’s counsel argued that the Court of Appeal’s decision in PA Holdings was incorrect and that payments made as dividends were within Schedule F and that the legislation demanded that Schedule F had priority over Schedule E/ITEPA.

Finally, Darvel’s counsel argued that the source of the payments made under Plan 7 was not Darvel, the employer, but Reedon and Retail; the employees had given up their employment relationship with Darvel entirely.

The Judgment

In its judgment, the UT concluded that PA Holdings could be reconciled with Fry, as Fry essentially determined that income tax is a single tax and that the Schedules are, in effect, no more than computational rules governing the taxation of income from different sources.  The key point made in PA Holdings is that it is important to focus on the character of a payment in the hands of its recipient, not the form of the source of that payment.

The UT also cited Shilton v Wilmhurst [1991] 1 AC 684, in support of its view that the source of employment income is not the employer, but the employment relationship – the fact that all of the payments had been made by Services, Reedon and Retail, instead of Darvel, was irrelevant – their source was the employment relationship between the employees and Darvel.

The FTT had ruled that Services, Reedon and Retail were entirely under the control of Mr Donald, who also controlled Darvel, and that these entities were only ciphers.  On this basis, the UT ruled that the FTT had been justified in holding that the employees who had purported to give up their employment with Darvel to become members of Reedon had effectively retained an employment relationship with Darvel.

In summary, the UT upheld the FTT’s decisions that the payments made by Services, Reedon and Retail under Plan 5 and Plan 7 constituted taxable employment income in the hands of their recipients and that PAYE and NIC should have been operated on them.  The UT remitted Plan 2 back to the FTT for them to give fuller reasons for their decision that the provision of the cars to Mr Donald and the other employees should be regarded as having arisen by virtue of their employment with Darvel.

Significance

This case represents the first major test of the decision in PA Holdings: the decision was controversial when it was first announced, as it was widely believed that the provisions in the legislation setting out the order of priority between Schedule E and Schedule F were clear and incontrovertible and many in the profession were disappointed that there was no final appeal to the Supreme Court.

Darvel is a very clear explanation of the logic underlying PA Holdings and follows an increasingly entrenched judicial approach to taxation that looks beyond the legal form of a transaction to its substance.

The case should also serve as a warning to the many companies that have sought to replace earnings and bonuses with dividend payments (often in the form of so-called “alphabet shares”), that HMRC has the support of the courts in its efforts to recharacterise those dividends as taxable employment income.

For further information please contact the TaxDesk on 0845 4900 509 and ask for Thomas Dalby.