It is not uncommon for HMRC enquiries into the business accounts of an individual or company to result in additions to turnover and profits. For example, unexplained lodgements into a private bank account will probably result in HMRC seeking to assess them as undeclared takings. HMRC will more than likely contend that the accounting double entry in those cases will be drawings for a self-employed individual, or possibly a debit to the director's loan account in the case of an owner-managed company.
In TSD Design Development Engineering Ltd v Revenue & Customs  UKFTT 247 (TC), a director and shareholder, Mr D, appealed on the company's behalf against an HMRC assessment to increase profits in respect of omissions. The basis for the appeal was that the relevant amounts had been extracted by the company secretary (Mrs D) without Mr D's or the company's knowledge, and that the company should not be taxed on monies it had not received.
HMRC contended that Mr D's administration of the company had been neglectful, and that he was aware of the extractions by Mrs D but did nothing to prevent them. HMRC considered that either or both of Mr and Mrs D had received the extracted monies, and that those funds should be treated as loans to them from the company and taxed accordingly.
Mr D accepted that the company’s financial affairs were left to his ex-wife and the company’s accountant, but denied any knowledge of his ex-wife’s activities in withdrawing money from the company. The tribunal decided on the evidence that Mr D did not take proper care, and that it was not appropriate for him, as managing director, to abrogate all responsibilities for running the company and to seek to rely on the company secretary and the accountant to advise him of any wrongdoing. The tribunal also believed that both Mr D and Mrs D were aware of the failure to disclose all of the company’s income, but did not believe that Mr D was unable to keep a track of the company’s financial affairs.
The tribunal held that Mr D had been negligent with regard to the company’s affairs, and added that it was clear from case law that a default by directors can and should be assessed to tax on the company. The tribunal were satisfied from the evidence that Mr D and Mrs D were aware that some of the company’s income was not being paid into the company’s account, and that the amounts withheld should be treated as loans under what is now CTA 2010, s 455 (previously ICTA 1988, s 419). The company’s appeal was dismissed.
HMRC referred the tribunal in TSD Design to a number of previous cases, including Stephens v Pittas Ltd  STC S76. Interestingly, HMRC argued that the decision in Stephens v Pittas Ltd supports the view that a misappropriation treated as company income should be liable to charge under what is now CTA 2010, S 455. However, the tribunal in TSD Design pointed out that this was not correct. In fact, in Stephens v Pittas Ltd, Goulding J commented as follows:
“The crucial question, as it seems to me, is this. Did the company pay the money in question to Mr Pittas? He undoubtedly took it from the company's till, or from the company's debtors, but did the company pay it to him? It is of course tempting to identify an individual with a company where you have a case that is so nearly a one-man company as this, but one cannot answer questions under this legislation by any identification of that kind, for as I have said the very basis of the scheme of taxation is the distinction between the company and those interested in it.”
The judge went on to say:
“In my view an outright misappropriation of a company's money cannot be treated as the act of the company except possibly if all the corporators of a solvent company consent to it.” He added:
“Once you treat Mr Pittas and the company as separate persons, as you must under this legislation, in my view the company cannot be said, in the circumstances found by the commissioners, to have made an advance or a loan to Mr Pittas.”
So why did HMRC in TSD Design advance the Stephens v Pittas Ltd case to support its argument for a charge under ICTA 1988, s 419? The tribunal referred to the following comment by Goulding J in Stephens v Pittas, which may help to explain HMRC’s apparent mistake:
“ …If it could truly be said that the company paid the money in question to Mr Pittas, then I think it might be possible to say that the company had advanced the money to him even if the payments were illegal under the Company Acts or a fraud on the minority shareholder…”.
Interestingly, that case does not appear to feature in HMRC's manuals or any guidance on its website.
As mentioned, in TSD Design, the tribunal considered that Mr D and Mrs D were aware that some of the company’s income was not being paid to the company’s account, and held that such amounts should be treated as loans for s 419 purposes. However, this treatment should not necessarily be regarded as the automatic consequence of a misappropriation of company profits.
The current legislation on loans to participators of close companies in CTA 2010, s 455 requires that the company “makes a loan or advances money” to the participator (or associate). As indicated in Stephens v Pittas, an individual and a company are separate persons, and a loan or advance to the individual cannot be treated as such without the consent of the company (or to be more precise, the persons who control it). However, in many cases misappropriations will be made by a controlling director, which arguably increases the likelihood of a s 455 charge.
HMRC states that company funds misappropriated by a director are “normally” assessable on the company (with a potential liability under s 455), unless the facts show that the extractions can be regarded as employment income of the director/participator instead (EM8510). The basis for settlement will depend on the particular facts and circumstances of the case. However, in the absence of evidence one way or another, HMRC’s “preferred” route is to treat extracted funds as additional company profits and as loans to a participator (EM8605).
Interestingly, for the purposes of the beneficial loan legislation for employment income purpose (ITEPA 2003, s 175), HMRC does not treat the debt incurred by the director in respect of the extracted funds as a ‘loan’ until there is an intention for it to be repaid (EM8610). However, HMRC adds: “there is no 2 out of 3 rule for CT, s 455 and s 175 liabilities. Whether liability arises must be decided applying the statutory guidance and Departmental guidance for each separately”.
At the end of an HMRC enquiry resulting in additions to company profits due to a misappropriation by a director/shareholder, the most appropriate tax treatment will need to be considered in terms of whether the extracted funds are treated as a loan to the individual or employment income. The misappropriation does not automatically result in a s 455 charge, even if that is HMRC’s preferred route.
If the facts do not point clearly to one treatment or another, it may be helpful to ‘do the numbers’ and calculate the tax position under both routes, with a view to arguing the most beneficial tax treatment overall (ie for both the company and individual).
Mark McLaughlin CTA (Fellow) ATT TEP