When is a return of capital unlawful?

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The last decade has shown a marked increase in the efforts of Government to deter the use of trust schemes as an alternative way of extracting value from a business. Her Majesty’s Revenue and Customs (HMRC) regards the trusts as disguised remuneration schemes whose purpose is to avoid paying PAYE and national insurance contributions. A recent case, Toone and others v Ross and another [2019] EWHC 2855 (Ch), looks at the relevant considerations when distributing company assets and the need to make proper provision for the tax due.

In Toone and others v Ross and another, the High Court had to decide whether two employment benefit trust schemes (EBTs) that involved making payments to employee-shareholders constituted an unlawful return of capital and secondly whether payments to a director resulted in a breach of directors’ duties where the directors had not made adequate provision for the payment of creditors, including HMRC, and the company was or was likely to become insolvent.

Between 2009 and 2013, the directors of Implement Consulting Limited (the Company) paid the Company’s distributable reserves into two EBTs and an interest in possession fund (the IIP) (the Schemes). Those reserves were then paid to the Company’s shareholders in proportion to their shareholdings. In 2011, HMRC gave notice that it was investigating whether tax had arisen in relation to the EBTs. Similar notice was subsequently given in relation to the IIP. The total amount demanded by HMRC in respect of unpaid tax was £1.1m. Furthermore, in March 2013, one of the shareholders received a further £30,000 in expenses.

The Company entered insolvent liquidation in November 2016 and joint liquidators were appointed. The liquidators claimed that the payments to the Schemes constituted unlawful distributions of capital and that the expenses payment was made at a time when the Company was insolvent, and therefore in breach of directors’ duties.

The court held that the payments made from the capital reserves of the Company into the Schemes had all the character of distributions. None of the distributions were supported by board minutes identifying “relevant accounts” or recording a consideration of such accounts. There was also no evidence of any resolutions of the Company’s shareholders, approving those payments, being passed (as required by the Companies Act 2006). The directors failed to take independent legal advice and failed to read opinions from leading counsel provided to the promoter of the Schemes. They did not seek comfort directly from HMRC before causing the Company to enter the Schemes. Properly considered through the eyes of the Company, the payments to the schemes represented returns of capital to shareholders. As the required formalities were not observed, those distributions were unlawful and the Company was entitled to the return of the funds paid out.

Under section 172 of the Companies Act 2006, directors owe a duty to consider the interests of creditors when the company is or is likely to become insolvent. Since the tax liability was due (but not necessarily payable) from the time the Company first transferred money to the EBT the Company was insolvent in 2010. The directors should have known of the insolvency by 2011. At that date, they had been warned by the scheme promoter that tax may be due, they had notice that HMRC was investigating the EBTs and there was evidence of a general decline in trading. Therefore, by paying one of the shareholders £30,000 for his expenses without making a proper provision for creditors, the directors had acted in breach of their duties. The court held that the directors had to account for the loss.

WM Comment

This case illustrates the importance of following statutory formalities, keeping contemporary minutes and passing the necessary resolutions when distributing reserves.