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Squaring the circle

Last week, I started to look at the recent case of Lancaster v Inland Revenue commissioners. The case concerned the availability of tax relief on interest payments in respect of a loan to a business in which the lender was a partner.

Given the demise of mortgage interest relief and the potentially renewed interest in the effective use of credit balance capital accounts to secure loan interest relief, this case makes interesting reading.

The case involved a series of steps by which capital was released to the partner and reintroduced to the business by his wife. However, very little documentary evidence existed of the arrangement that was contended to have taken place.

As such, the case serves as a warning to those who do not pay sufficient attention to the formalities of any series of transactions. At the very least, each transaction must be self-evident, with proper documentary evidence being recorded.

If a period of time elapses between each step – the longer the better – this will also help. Specifically, in these types of cases, it would also help if the amounts withdrawn and lent back are different.

None of these precautions appear to have been taken in the Lancaster case. Notably, the amounts involved were identical and the withdrawal and subsequent loan were made on the same day, albeit, on the face of it, by different people.

The Inland Revenue&#39s main contention was that the taxpayer did not actually contribute the claimed £30,000 to the partnership within the meaning of s362(1) ICTA 1988. The taxpayer had, in effect, failed to show that he contributed the money to the partnership to be used wholly for the purposes of its trade, profession or vocation.

The Revenue went on to submit that the only purpose served by the credit of £30,000 to the firm&#39s current account was to cover the debt of £30,000 which the taxpayer had withdrawn as the initial step in the scheme which he put in place to claim tax relief. Reference was made to McKnight (Inspector of Taxes) v Sheppherd STC 669 [1999] 1 WLR 1333.

Nor did the taxpayer incur any obligation to repay the loan on which interest was payable. He had never divested himself of, nor invested the donee in, the subject of the gift in any real sense.

It was always the taxpayer&#39s intention to deposit the sum of £30,000 in the firm&#39s account immediately after the sum was withdrawn by him. The alleged gift was subject to the condition that the sum of £30,000 should be immediately repaid. The gift was recoverable and there was no true gift.

Furthermore, the cheque alleged to have been given to his wife alone was, in fact, deposited in the joint account of the taxpayer and his wife. The taxpayer was equally entitled to draw the sum of £30,000 from the account and cannot be said to have borrowed money which was at his own disposal.

Any sums paid by the taxpayer to his wife after August 23, 1990 were not paid in satisfaction of any loan from her but were regular payments for her personal use or gifts. Payments on expenditure incurred by the taxpayer on his wife&#39s share of family holidays were not payments of interest. His wife was never deprived of her money and, accordingly, no interest was due.

Since the taxpayer provided the money, borrowed from the firm&#39s account, the claim that he became liable to pay interest to her for the use of her money lacks all reality and there was no objective evidence to show any obligation from one spouse to the other.

Even if the taxpayer did legally incur a liability to pay interest to his wife, he was not entitled to relief under s353(1).

Under s787 ICTA 1988, the sole or main benefit which might have been expected from the arrangement was to obtain a reduction in his and his wife&#39s liability to income tax. The claim that the arrangements were carried out for the purpose of mitigating the liability to inheritance tax on the taxpayer&#39s death does not preclude the application of s787. The principle in WT Ramsay Ltd v IRC [1981] STC 174, [1982] AC 300 applied in the present case. The transactions were only circular and artificial. There was no commercial or business purpose – the sole purpose was tax avoidance.

The special commissioner concluded: “I have no hesitation in coming to the view that a scheme was effected and arrangements were made such that the sole benefit, in relation to payment of interest, that might be expected to accrue to the taxpayer was the obtaining of a reduction in tax liability. There was no other financial benefit in the entire arrangement. There may be benefits to others in the event, for example, of his wife predeceasing him but that has nothing to do with payment of interest. It has to do with transfer of capital.

“Nor, in any event, am I satisfied that the circumstances of the transaction fall within s362 of ICTA 1988 since the true net result of the circular transaction was that no money was contributed or advanced to the partnership which it did not already have.”

One should not conclude that the decision is evidence that relief can never be obtained on amounts contributed or lent to a business where there has been a prior withdrawal of capital. It does, however, show that both the Revenue and (if it comes to it) the special commissioners will have no hesitation on looking very closely at both the form and substance of arrangements.

Even if all the formalities are complied with, however, it is no protection from potential attack where there is sustainable evidence of pre-ordination and circularity. The only certainty of relief where there is a prior withdrawal is if not only are all the formalities complied with but also it is unquestionably clear that, when the amount is withdrawn from the business, there is no settled or pre-arranged intention to borrow to reinject an amount into the business.

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