The UK's House of Lords gave its judgement on 7 July in the case of Macdonald (HMIT) v Dextra Accessories Ltd & Others upholding the decision of the Court of Appeal in favour of HM Revenue & Customs ("HMRC"). This article outlines the potential implications of this case for companies that have previously made contributions to an employee benefit trust.

Summary
Dextra Accessories and five other group companies made contributions to an employee benefit trust ("EBT") set up by Cauldwell Holdings Limited (the holding company of the group) in December 1998. The trust deed gave the trustee wide discretion to pay money and other benefits to beneficiaries although the trustee was entitled to take into account the recommendations of the directors of Cauldwell Holdings Limited or other group companies. The potential beneficiaries of the trust included past, present and future employees and officers of the participating companies together with their close relatives and dependants. The companies then sought to deduct such payments in computing their corporation tax liabilities for the accounting period in which the payments were made (the calendar year 1998).

HMRC sought to disallow the payments and although additional issues were raised before the Special Commissioners, the only issue considered on appeal and subsequently by the House of Lords was whether the companies' contributions were "potential emoluments" within the meaning of section 43(11)(a) Finance Act 1989.

The House of Lords, in a unanimous verdict, upheld the decision of the Court of Appeal finding that the contributions to the EBT were potential emoluments within the meaning of section 43(11)(a) as there was a "realistic possibility" that the trustee would use the trust funds to pay emoluments. As a result, this means that the companies could only have a deduction up to the amount of emoluments paid by the trustees by 30 September 1999 (nine months after the end of the period of account in which the payments were made). Relief for the amount disallowed would be deferred until (if at all) emoluments were ultimately paid out by the trustee.

Section 43(11)(a) Finance Act 1989
Prior to the introduction of Schedule 24 Finance Act 2003 which applies to contributions made to EBTs on or after 27 November 2002, section 43(11)(a) denied a corporation tax deduction for "potential emoluments" where "amounts or benefits are reserved in the accounts of an employer, or held by an intermediary, with a view to them becoming relevant emoluments" until the accounting period in which (or within the none month period following which) those emoluments are paid to the employees.

It was accepted, or in the words of the Court of Appeal "rightly accepted" that the trustee was an intermediary for these purposes. A number of commentators have subsequently suggested that for a discretionary trust this view is incorrect as a matter of trust law.

The Dextra case considered the meaning of the phrase "with a view to them becoming relevant emoluments".

What are Emoluments?
It is clear that the term "emoluments" is wider than just taxable emoluments. For example it could include money or other benefits convertible into cash where, for some reason such as a statutory exemption, no charge to income tax arises. However, neither a loan to a beneficiary or the gain on an exercise of an option would be an emolument for these purposes. Hence if the amounts or benefits can be said to be reserved or held with a view to becoming relevant emoluments, if no emoluments are ever paid, no corporation tax deduction would ever be available.

Lord Hoffman considered this specific question as it had been suggested that this was an anomaly unfair to the taxpayer. He cited the fact that the replacement of section 43(11)(a) by Schedule 43 Finance Act 2003 achieved precisely this and that this "anomaly and unfairness has therefore not troubled a more recent Parliament and may not have troubled the Parliament of 1989".

"With a View to Becoming"
Therefore the key issue considered was the meaning of the phrase "with a view to becoming".

The Special Commissioners said that the funds were held "with a view to becoming relevant emoluments" only if the purpose of the contributing company was that they should be used to pay emoluments. In this case, the terms of the trust deed showed that the contributing companies had other purposes as well.

On appeal, Neuberger J upheld the decision reached by the Special Commissioners although he did not agree that the purpose for which the companies made the payments was decisive. The question was, in his opinion, whether they were held by the trustee with a view to becoming relevant emoluments. That, he felt, depended primarily upon the terms of the trust, read against the surrounding circumstances, rather than the purposes of the contributors. He also did not agree that there had to be an exclusive purpose of paying emoluments but that it had to be the principal or dominant intention of the trust. On the facts he decided that the trust deed did not demonstrate such an intention.

The Court of Appeal overturned this decision, deciding that funds were held with a view to becoming relevant emoluments if they were held on terms which allowed a realistic possibility that they would become relevant emoluments - the subsection being concerned with what may happen in the future rather than an examination of the reasons, motives or purposes with which some action was done in the past. If Parliament had intended that it should be "for the sole purpose" or "with the principal or dominant purpose" then Jonathan Parker LJJ felt that Parliament would have used such language. In addition, he was concerned that the notion of the trustees having an intention in respect of the use of the fund in advance of the exercise of their discretionary powers would be artificial and possibly unlawful.

Finally the House of Lords agreed with the Court of Appeal with the written judgement being given by Lord Hoffman who stated that he agreed with the Court of Appeal largely for the reasons given by Jonathan Parker LJJ. He added that he thought that the whole of the funds were potential emoluments in the ordinary use of language as they could be used to pay emoluments. Whilst "potential emoluments" is a defined expression that did not, in his opinion, mean that the choice of words adopted by Parliament must be wholly ignored. He added that "If the terms of the definition are ambiguous, the choice of term to be defined may throw some light on what they mean". His view, again agreeing with the Court of Appeal, was that the words must have similar meaning in both the phrase "held by an intermediary" and "reserved in the account of an employer".

What are the Implications of Dextra?

Companies that have made contributions prior to 27 November 2002 to EBTs where emoluments were not paid out by the trustees within nine months of the end of the accounting period need to consider what action, if any, to take.

HMRC Approach
HMRC have recently published a note on this case which can be found at http://www.hmrc.gov.uk/practitioners/macdonald-v-dextra.htm. HMRC believe that the Dextra case is of wider importance and see it as part of its continuing attack on "tax avoidance schemes" citing the fact that "contributions to EBTs have been a feature of a number of marketed tax avoidance schemes" and the note sets out HMRC's view as to when relief might be available for contributions made before 27 October 2002. The deductibility of contributions made on or after that date now being governed by Schedule 24 Finance Act 2003.

HMRC, not surprisingly, takes the view that the decision applies to all contributions to EBTs where there is a realistic possibility under the terms of the trust deed that funds will be used to pay emoluments, however wide the discretion given to the trustees. HMRC have set up a team within the Anti-Avoidance Group to "project manage" cases to "ensure that the tax outstanding is collected systematically and consistently".

Until the House of Lords decision was given, it is understood that inspectors were under instructions not to close any open Corporation Tax Self Assessment enquires. However, now these enquiries are likely to be closed rapidly with HMRC either denying relief or deferring it.

What is less certain is whether HMRC will also seek to reopen closed years. This is likely to depend, amongst other things, on the extent to which contributions in these years were properly disclosed.

Inheritance Tax
There is a potential knock-on effect for "close companies" caught by Dextra. Assuming one accepts the proposition that a contribution to an EBT is a disposition which is a transfer of value for Inheritance Tax purposes (i.e. one that is intended to confer gratuitous benefit) the issue for close companies has always been whether such contributions result in the participators being treated as making such transfers as a result of which inheritance tax charges can arise.

Two different exemptions have typically been relied upon in such cases. Section 13 Inheritance Act 1984 ("IHTA") broadly provides that such contributions will not result in charges under section 94 IHTA if the transfers are to EBTs which satisfy the conditions of section 86 IHTA (not normally a problem) and beneficiaries under the EBT have shareholdings of less than five percent. However section 12 IHTA provides relief even where the conditions of section 13 are not met providing that the contribution is allowable for income or corporation tax purposes.

Conclusion
Any company that is potentially affected by Dextra may wish to consider whether its facts can be distinguished from those in the case. For example, where arrangements (often referred to as "symmetry") were introduced where the contributions made to EBTs were made to fund the spread on exercise of options (i.e. the difference between exercise price and market value of the shares on exercise) then it should be possible to argue that section 43 will not apply. Where arrangements cannot be distinguished on the facts then it is to be expected that HMRC will seek to defer or disapply any corporation tax deductions.