It is difficult for a company to justify a deduction for amounts
payable to a departing director when there is a contemporaneous
change in control.
In the case of George J Smith & Co Ltd v CIR [1968]
45TC384, the company carried on the trade of advertising agents.
Under service agreements each director was appointed a life
director at a salary of £5,000 a year; and at the same time
the articles were altered to make it impossible for a life director
to be removed by extraordinary resolution without their consent. A
further agreement of the same date provided that the company should
make a bonus issue of shares, and that two director, Lipkin and
True, should renounce part of their allotment to a third, Hazard.
The object of these arrangements was to give Hazard a proper stake
in the company. As a result of the bonus issue and renunciations
the shareholdings of the company became:
The total issued shares of the company being 3,000.
From early in 1962 progressive disagreements developed
between them, centred on Lipkin's inadequacy as a bookkeeper, an
expansion contemplated by him in a contract handled by Hazard, and
a grievance felt by True at a reduction of his remuneration. From
June to September 1963 negotiations ensued between Lipkin, Hazard
and True, in which it was agreed that Lipkin and Hazard should sell
their shares at a fair valuation to True, resign as directors and
receive compensation for loss of office. On 10th September 1963
Lipkin and Hazard each executed transfers of their shares for a
consideration of £3,000. On 30th September, at an
extraordinary general meeting attended by Lipkin, Hazard and True,
it was unanimously resolved that the company should pay £5,000
to Lipkin and £500 to Hazard as compensation for loss of
office as life directors, and Lipkin and Hazard thereupon resigned.
Both True and an accountant expressed the opinion in evidence that
the compensation payments were made to protect the company's trade.
The Commissioners disallowed the expenditure.
Cross J began by explaining that there was not general rule
to prevent a deduction for compensation paid to a retiring director
but that it was difficult for a company to justify a deduction when
there was a contemporaneous change in control, 45TC391G to
391I:
There is, of course, no doubt that compensation paid to a retiring director for loss of office may in certain circumstances be an expense deductible for tax purposes. If, for instance, his colleagues on the board have formed the view that the continuance in office of a certain director is most prejudicial to the prosperity of the company, that in the interests of the company he must be induced to resign and that the sum to be paid to him to secure his resignation is no more than has to be paid for the purpose, then clearly the expense would be deductible - and it would not cease to be deductible because contemporaneously, so as to get rid of him altogether, the retiring director sold his shareholding to his colleagues. But obviously the position becomes more difficult if the payment of compensation occurs in connection with a change in the shareholding control of the company.
The case establishes that it is not enough for the company to
show that the amount paid for the shares reflects a bargain at
arm’s length between the parties; the company must establish
to the Commissioners’ satisfaction that the issue of
compensation has been considered entirely separate from the share
transaction and that the purpose of the compensation is wholly and
exclusively for the company’s trade. After referring to the
decision in James Snook & Co v Blasdale [1952] 33TC244 (see
BIM38340), Cross J went on to explain
why the Commissioners correctly disallowed the expenditure. Cross J
specifically dealt with the point that the price paid for the
shares was not conditional upon the amount of compensation.
For those who do not have ready access to tax case volumes,
the part of Cross J’s judgement on which the above guidance
is based is set out below, 45TC392G to 393C:
There is nothing in the Case to suggest that
the price fixed was conditioned by the amounts to be paid as
compensation, which indeed were unequal, but I would suppose (and
Counsel on both sides I think agreed) that the amounts to be paid
as compensation were agreed between the three persons concerned
before the general meeting on 30th September. By that time Mrs.
Lipkin and Mr. Hazard had executed transfers of their shares and
apparently had received the price for them, but they were evidently
still not only directors but on the register of shareholders.
Moreover, if for any reason the decision at the meeting had been
that the sums provisionally agreed as compensation should not be
paid, it may very well be that the transfer of the shares and the
payment of the price could have been rescinded. However that may
be, it was in fact resolved by all the three shareholders and
directors that the payments in question should be made, and Mrs.
Lipkin and Mr. Hazard thereupon resigned.
Why should the Commissioners have been
satisfied that the decision of the Company taken on 30th September
1963 to make these payments was a decision taken by Mr. True alone,
and not a decision taken by all the three persons concerned? Yet
the reason why Mrs. Lipkin and Mr Hazard voted in favour of the
payments being made is hardly likely to have been because they
thought that the interests of the Company required them to be made.
Moreover, even if one could treat Mr. True as being in control of
the Company at the date of the meeting, there is nothing in the
Case to show that he considered the matter of compensation de novo
on that day. So far as appears, the Company was only implementing
part of an agreement made between the three at a time when Mr. True
was certainly not in control. It would perhaps have been better if
the Commissioners had stated in term the respects in which, on
their view, the facts proved and evidence given fell short of
establishing what the Company had to establish; but, for the
reasons which I have tried to give, I have no doubt that the
conclusion at which they arrived was one which they were justified
in reaching. For those reasons, I will dismiss the
appeal.
