In the 1990s and 2000s, Employee Benefit Trusts (EBTs) were a popular way of financially incentivising (normally senior) employees and encouraging loyalty to the company through the distribution of benefits such as company shares.
Over time, these discretionary trusts became more complicated with some seemingly constructed with the sole purpose of avoiding paying income tax or national insurance. This ordinarily involved the company paying an amount into an EBT or an Employer Financed Retirement Benefit Scheme (EFRBS) which would then be distributed to employees in the form of a loan at a low interest rate, subject to neither income tax nor national insurance (and, in most circumstances, also subject to a Corporation Tax deduction). These loans would rarely be paid back before they became due. In 2010, EBTs became the focus of an HMRC spotlight: “EBTs have increasingly been used for avoidance purposes, with the aim of providing employees and directors with benefits in ways that aim to defer, minimise or avoid liability to income tax (and PAYE) and employers’ National Insurance Contributions (NICs).”
Since 2010, successive Finance Acts have targeted EBTs used as a tax avoidance schemes, including introducing Accelerated Payment Notices (APN) and Follower Notices (FN) in 2014. In 2017, HMRC was permitted to charge tax on all loans, taken under the aegis of an EBT or an EFRBS since 1999, which were outstanding on 5 April 2019. The issuing of APNs, FNs and the imposition of the loan charge (which remains in force despite a Government review) have been highlighted as contributory factors in company insolvencies.
Tax avoidance and insolvency
An IP, charged with the administration of a company that had created an EBT or an EFRBS, will explore if it was a disguised remuneration scheme. If it is, then HMRC will be a principal creditor and the directors’ conduct will come under scrutiny. If the EBT or EFRBS was designed to save tax, the company is unlikely to have reserve funds to pay outstanding tax liabilities (indeed, one could argue that having such reserves indicates uncertainty about the legality of the scheme). Without sufficient assets to satisfy the company’s creditors, IPs will consider what claims they could make against the directors under the Insolvency Act 1986 including misfeasance, fraudulent trading, wrongful trading, transactions at undervalue, and transactions defrauding creditors. Alternatively, they could consider the role of the directors’ professional advisers in advising on the structure and implementation of the EBT or EFRBS with a view to launching a professional negligence claim.
Claims against directors
Misfeasance (Section 212 Insolvency Act 1986 (IA86)
The purpose of Section 212 IA86 is not to create a new cause of action, but instead to allow for the litigation of claims by an insolvency practitioner in respect of causes of action that belonged to the company and that the company could have litigated itself before entering liquidation.
A liquidator can bring a misfeasance claim when an officer of a company: misapplied or retained, or became accountable for, any money or other property of the company; is guilty of misfeasance; or has breached their fiduciary or any other duty in relation to their company. An IP needs to explore if the directors’ motive in creating an EBT or an EFRBS was to avoid tax. If so, it could be argued that this was a misapplication of company funds and breach of directors’ duties as detailed in the Companies Act 2006, the importance of which was examined in two court cases in 2017: Ball v Hughes [2017] EWHC 3228 (Ch) and Secretary of State for Business, Innovation and Skills v Akbar [2017] EWHC 2856 (Ch).
In Ball v Hughes, the directors of PV Solar Solutions Ltd, which installed solar panels, were reimbursed through the payment of management fees. In 2013, the directors continued to withdraw substantial sums (c.£750,000) from the company into their directors' loan accounts (despite the reduction of preferential tariffs), repackaging withdrawals as tax credits under a scheme in which they were involved, even after PV entered administration in 2014. The liquidators challenged the loan withdrawals, and the High Court found that the directors had breached their fiduciary duties to the company by not acting in the best interests of the creditors. The directors’ behaviour was in breach of their duty to avoid a conflict of interest by advising on their own remuneration through an EBT of which they were trustees,
Secretary of State BIS v Akbar examined if a director, exercising reasonable care, skill and diligence, would have implemented a particular scheme based on their knowledge at the time, and whether their actions were those of a reasonable director. This case involved an aggressive EBT scheme, known as a gold bullion scheme, that involved the company putting cash into an EBT used to buy gold to sell to employees on deferred payment terms. The employee sells the gold but does not honour their payment obligations to the company, and avoids any tax on the gain. After the company went into administration the court found that the directors had failed to act in its best interests when they respectively caused and/or allowed it to enter into the gold bullion arrangement.
In both cases, the courts considered the timing of the schemes, when the payments were made, and the actions of the individual(s) implementing the scheme. However, breach of duty would have been more difficult to prove had those directors acted upon professional advice, unless they acted knowing that the scheme may be challenged in future, or if they had acted against professional advice and had not put money aside to pay a future tax bill. Nonetheless, it must be remembered that claims alleging, for example, breach of duty in failing to exercise reasonable care, skill and diligence will be statute-barred after six years from the date that the misfeasance or breach of duty occurred.
Fraudulent Trading - s213 IA86
If, during the course of a liquidator’s investigations it appears that the company carried on trading with the intent to defraud creditors, then a liquidator can seek a declaration from the court that anyone who was knowingly a party to the fraudulent activity must contribute to the company’s assets.
This will therefore catch directors who continue trading intending to defraud the company’s creditors. Fraudulent trading also constitutes a criminal offence under Section 993 of the Companies Act 2006.
However, it is questionable if entering, or continuing to contribute to, a tax avoidance scheme (as opposed to evasion) while the company is insolvent amounts to defrauding HMRC. In Jetivia SA & Anor v Bilta (UK) Ltd & Ors [2015] UKSC 23, the liquidators relied on s213 to bring a claim against a company’s former directors and a Swiss company for their involvement in a fraudulent scheme. The directors attempted to appeal the liquidators’ claim on the basis of the ex turpi principle but their appeal was rejected by the Supreme Court. In HMRC v Stephen West [2018] UKUT 0100 the Upper Tribunal (UT) held that the director of an insolvent company was personally liable for wilfully failing to pay PAYE and NICs due on a bonus paid to clear his loan account before the company went into liquidation.
Wrongful Trading - s214 IA86
If during the course of a liquidation it appears that a person who is, or was, a director of the company knew, or ought to have concluded, at some point before the start of the liquidation that there was no reasonable prospect that the company would avoid an insolvent liquidation, then the liquidator can seek a declaration from the court that the director contribute to the company’s assets.
Wrongful trading is measured by the increase in the company’s net deficiency of assets from the time when they realise – or ought to have realised – that the company was not going to avoid an insolvent liquidation. If there has not been an increase in the company’s net deficiency in assets, then the court will not make an order; conversely, if there is an increase in the company’s net deficiency in assets, the maximum quantum of any liability for wrongful trading will be the amount of that increase.
What is important to bear in mind is that the service of an APN, an FN, or the crystallisation of the Loan Charge, may make insolvency inevitable.
A liquidator has a high threshold to establish wrongful trading and if directors can demonstrate that they did everything they could to minimise potential losses to creditors, such as taking advantage of the EBT Settlement Opportunity (withdrawn on 31 July 2015) or the November 2017 settlement terms, they may be able to avoid liability. However, a liquidator could look at the directors’ actions upon receipt of correspondence of HMRC opening enquiries, Regulation 80 determinations, and/or Section 8 decisions to evidence whether a director ought to have known of the possibility of liquidation.
In Grant v Ralls Builders Limited (in liquidation) the court ruled that the directors should have known, at least six weeks before the company ceased trading, that insolvency was unavoidable. However, no order was made as there was no overall detriment to creditors despite trading while insolvent.
Transactions at an Undervalue - s238 IA86
If a company has made a gift or entered into a transaction for either no or little consideration and that transaction was entered into during the two years before the onset of insolvency, and the company was unable to pay its debts or became unable to pay them as a result of the transaction, then a liquidator can apply for a court order to restore the position to what it would have been had the transaction not occurred.
To prove that a payment of funds to an employee is a transaction to an undervalue, a liquidator may find it difficult to substantiate the consideration in return of the payment. This was evident In Ball v Hughes, where the Judge found that the payments to an employee were not a transaction at an undervalue due to the significant work he did for the company.
Transactions Defrauding Creditors – S423 IA86
A transaction may be set aside under this section if it was entered into at undervalue and the purpose of the transaction was to put assets beyond the reach of the person making a claim against the company.
A subjective test is applied to proving the relevant purpose. Therefore, if this cause of action is pursued by a liquidator in connection with the use of an avoidance scheme, then they must show that the overriding purpose of the transaction was to prejudice HMRC’s interest by avoiding certain tax liabilities – and the latter objective is, of course, the purpose of these schemes.
Directors are aware of their duty to ensure their company pays tax on behalf of itself and its employees. Contributing funds, which would otherwise be available to pay such tax, to a tax avoidance scheme means that those funds are now out of HMRC’s reach.
Therefore, it depends when the scheme was implemented and when the transaction(s) took place as HMRC has regularly released ‘Spotlights’ and correspondence to scheme users outlining their views on tax avoidance schemes, over a number of years.
In Toone & Ors v Ross & Anor [2019] EWHC 2855, the judge found that the directors breached their duty by sanctioning payments from the company, via an EBT, to shareholders. These payments were not only dividends rather than employee remuneration, they were also subject to tax when made, making the company insolvent at that point and, as funds were no longer available to pay the company’s debts, in breach of its duty to its creditors. The judge ordered the directors to account for the loss.
Defences of directors
Quantum Meruit / Unjust Enrichment
To claim unjust enrichment, IPs have to prove the director(s) received payments, to which they were not entitled, to the detriment of the company. Traditionally, courts have been cautious when deciding if remuneration payments are reasonable as employees are entitled to receive proper compensation for services rendered. Therefore, IPs may struggle to recover funds paid as reasonable remuneration for services supplied, as shown in Ball v Hughes where the judge commented on Global Corporate Ltd v Hale [2017] EWHC 2277 (Ch):
“Ultimately, however, it will be for other courts to determine the fate of Re Global. For present purposes it suffices to state that the decision is distinguishable from present facts. In Global, the director was already a PAYE employee who had been in receipt of a salary for a number of years prior to the events in question. In the present case, the Respondents did not have employment contracts and had consciously decided against the same.”
Acting honestly and reasonably - s1157 CA06
If a director can prove that they relied upon legal advice, acted honestly and reasonably, and had regard to all the circumstances of the case, they may be able to apply for a court order to be relieved from liability under CA 2006.
Likewise, if the director can prove they acted honestly and reasonably, a claim for breach of duty (misfeasance) will be difficult to uphold. In a recent decision by the Supreme Court (Burnden Holdings (UK) Ltd (In Liquidation) v Fielding) the judge commented: “Directors are not required to be accountants and the comments of Lord Davey and Lord Halsbury LC in Dovey v Cory [[1901] AC 477] as to directors being entitled to rely on the judgment of others whom they appoint to carry out specialist financial roles within the company are as pertinent today as when they were made in 1901.”
Claims against accountant / tax advisers / promoters
For those directors who relied on professional advice, IPs could investigate pursuing a negligence claim against those professionals who advised on the tax avoidance scheme. To establish a professional negligence claim, the IP will need to establish the following:
- The professional owed the company a duty of care;
- That duty of care was breached;
- The breach of duty caused a loss;
- The loss complained of was reasonably foreseeable.
First, the IP needs evidence that the relationship between the company and the professional was based on a legal footing, whereby the professional was legally obliged to adhere to a standard of reasonable care when carrying out services on the company’s behalf. A contract or retainer between the company and the professional would be sufficient proof.
Second, the IP needs to prove that the professional breached their duty of reasonable care by comparing their actions to those carried out by other reasonable, responsible professionals under the same circumstances; a negligence claim does not automatically arise just because a professional has got something wrong. If the professional provided satisfactory disclaimers and explained the potential risks involved, and it can be reasonably assumed that other reasonable professionals would have pursued a similar action, then no breach of duty will have occurred.
Summary
Any claim in relation to EBT or EFRBS schemes will depend heavily on the timing and circumstances of when the scheme was entered into, the volume and timing of the payments made and the actions of the director(s). In weighing up whether a claim ought to be made, insolvency practitioners should consider:
- Whether the scheme was entered into before or after 5 August 2010;
- What advice the director(s) received at the time (if any) and their reliance upon that advice;
- Whether the monies paid under the scheme represented reasonable remuneration (at least in part);
- What action was taken by the director/s after HMRC intervention.
Given HMRC’s determination to crack down on tax avoidance schemes, and its efforts to seek further legislative powers to stop directors and shareholders misusing insolvency to side-step their tax liabilities, the pressure on IPs to investigate whether or not they can claw back monies from those schemes is likely to increase. The burden of proof will lie with IPs and, as outlined above, that is not necessarily an easy process. Given the cost of litigation, and the uncertain outcome (potentially leaving an IP open to an adverse costs award) all IPs should seek legal advice from lawyers familiar with EBTs and other tax avoidance schemes before embarking on a particular course of action. To date case law indicates that each matter will turn on the strength of the evidence available so it is imperative to carry out thorough due diligence before committing to the courts.
Israr Manawer
October 2019
This article was first published in the 2019 winter edition of Recovery, the magazine published by R3, the trade association for insolvency professionals.
