The Gazette 1983

GAZETTE

JANUARY/FEBRUARY 1983

Covenants and Irregular. Amounts: Sections 438 and 439 of the Income Tax Act 1967 are the statutory provisions dealing with the payment of tax effective covenants. To be tax effective, the following - conditions must be fulfilled: (1) the husband must have no power of revocation, (2) the husband must have divested himself absolutely of the capital if there is a capital settlement, and (3) if there is an income settlement, then unless the disposition is made for valuable and sufficient consideration, the income must be payable to or for the benefit of an individual for a period which exceeds or can exceed six years. The reference to a period which exceeds or may exceed six years is important. A settlement taking the form of a covenant to pay an annual sum is usually made for seven years but if there is a provision under which the period may be less, e.g. in the event of a death or marriage, it is still covenant for a period which may exceed six years. If the covenant is effective for tax purposes the annual amount (subject to what follows below) can be deducted by the husband from his taxable income and will be assessed on the wife. If the husband and wife are liable to tax at different rates, the tax saving by using a covenant will broadly be the difference in the rates of tax multiplied by the annual amount of the covenant. For example, if the husband is liable to tax at 60% and his wife is liable at 35% and an annual sum of £1,000 is paid by the husband then the effective cost to him is £400 (because he may reduce his taxable income liable at 60% by £1,000, thereby saving £600 tax which he would otherwise have to pay). The wife is liable on £1,000 at her rate of tax, 35%), leaving her with net income of £650. Therefore, at a cost of £400 to the husband, he has put £650 in his wife's hands. The saving of £250 represents the gross amount of the covenant, £1,000, at the differ- ence between the spouses respective tax rates, i.e. 60% minus 35% = 25%. If the proposal is to pay an annual sum which can vary from year to year great care is needed. The circumstances in which this might arise would include: (a) where the annual sum is to be agreed annually between husband and wife, (b) where the agreement provides for a different amount each year, e.g. £1,000 in the first year, £1,100 in the second year, £1,200 in the third year, etc., (c) where the annual amount is to be increased by a fixed percentage, say 10%) each year, (d) where the annual amount increases in relation to the Consumer Price Index, (e) where the annual amount or part of the amount is to be calculated by taking a percentage, say 40% of the husband's income or profits. The difficulty that can arise in these payments is that to be effective for tax purposes there must be some constant element in the yearly payments for the period of the convenant. Where different sums which

have nothing in common are to be paid year by year it is probable that only the smallest amount would be regarded as payable for the seven year period. For example, if the covenant provided for £1,000, £1,500 in the second year, £2,000 in the third year, and so on increasing by £500 each year, the only sum which is payable for a period which may exceed six years is the £1,000. The payment in year 3 of £2,000 in a seven year covenant is only payable for four years. Accord- ingly, the tax effective transfer of income from husband to wife would, in the circumstances, only be £1,000 per annum. The excess over £1,000 each year would be regarded as the husband's income and could not be deducted by him in computing his tax liability. The relevant U.K. cases are D'Ambrumenil v. IRC (1940) 23TC440, IRC v. Prince-Smith (1948) 25TC 84 and IRC v. Mallaby-Deeley (1938) 23TC153. In view of these decisions a covenant which provided that the annual sum would be as agreed annually between husband and wife would probably be effective for the seven year period only in respect of the lowest amount so agreed. In IRC v. Black (1940) 23TC715 it was suggested that the constant element introduced by the promise of some fraction of the husband's income each year would be sufficient and that the whole of the variable amount annually paid by reference to the formula would be effective for tax purposes. There have been no Irish decisions similar to the Black case. Assuming the Irish Revenue applied the principles laid down in the U.K. cases the tax treatment of the amounts payable in the five circumstances listed above would be as follows: (1) Where the annual amount is to be agreed annually between husband and wife, then only the lowest figure is effective for tax purposes. (2) Where different amounts are stated for each year in the covenant then only the lowest amount will be effective for tax purposes. (3) Where the covenant provides that a fixed sum will increase by 10% per annum I understand the Revenue's view is that the sum each year is effective for tax purposes. I find this a surprising decision in view of the decided cases. Stating that a fixed sum will be increased by 10% each year is scarcely different from actually applying the percentage and putting the sums so arrived at in the covenant yet the tax treatment is different. (4) No Revenue practice has been established in relation to a covenant where the fixed sum increases in relation to the Consumer Price Index. In view of the Revenue practice at (3) it would seem logical that they should accept that the total sum as calculated each year by the increase in the Consumer Price Index would be effective for tax purposes. (5) The Revenue will follow the practice laid down in IRC v. Black (above). That is, they will treat as tax effective the sum arrived at each year by applying to the husband's profits or income a certain percentage. It is clear that great care is needed in the wording of these provisions in the covenant as the law and practice in Ireland is uncertain. In cases where a substantial doubt about the tax effectiveness of the

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