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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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