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HMRC internal manual

Business Income Manual

Wholly and exclusively: commencement, cessation or sale of business: compensation to directors following dispute

S54 Corporation Tax Act 2009

Where there is a change of control - usually non-allowable

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] 45 TC 384, 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. 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 directors, Mrs Lipkin and Mr True, should renounce part of their allotment to a third, Mr Hazard. The object of these arrangements was to give Mr Hazard a proper stake in the company. As a result of the bonus issue and renunciations the shareholdings of the company became:

  • Mrs Lipkin, 1,015 shares
  • Mr Hazard, 990 shares
  • Mr True, 995 shares

The total issued shares of the company being 3,000.

From early in 1962 progressive disagreements developed between them, centred on Mrs Lipkin’s inadequacy as a bookkeeper, an expansion contemplated by her in a contract handled by Mr Hazard, and a grievance felt by Mr True at a reduction of his remuneration. From June to September 1963 negotiations ensued between Mrs Lipkin, Mr Hazard and Mr True, in which it was agreed that Mrs Lipkin and Mr Hazard should:

sell their shares at a fair valuation to Mr True

resign as directors, and

receive compensation for loss of office

On 10 September 1963, Mrs Lipkin and Mr Hazard each executed transfers of their shares for a consideration of £3,000. On 30 September, at an extraordinary general meeting attended by Mrs Lipkin, Mr Hazard and Mr True, it was unanimously resolved that the company should pay £5,000 to Mrs Lipkin and £500 to Mr Hazard as compensation for loss of office as life directors, and Mrs Lipkin and Mr Hazard thereupon resigned. Both Mr 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 no 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:

`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 Tribunal’s 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] 33 TC 244 (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.

The part of Cross J’s judgment on which the above guidance is based is set out at pages 392-393:

`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.’