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How Tax Avoidance Can Cause Director Disqualification when Directors overlook to take adequate account of contingent HMRC tax liabilities.

The case of The Secretary of State for Business, Energy And Industrial Strategy v Lummis & Anor [2021] EWHC 1501 (Ch) was all about a tax avoidance scheme that two Directors entered into and as a result, their conduct was called into question by the Secretary of State for Business, Energy and Industrial Strategy.

The two Director Defendants were Lee Lummis (“D1”) and Craig Lummis (“D2”); a son and father team.

The key fact in the case was that the company that D1 and D2 were Directors, being Avacade Limited (“the Company”) went into Creditors Voluntary Liquidation and had entered into tax avoidance schemes.

HMRC served notices on the Company and issued HMRC Tax Determinations on the basis that the tax schemes in its view did not work. There was a scheme from EDF Tax Limited (“EDF”) and then subsequently Qubic Tax Limited (“Qubic”).

Payments Under The HMRC Tax Avoidance Schemes

The payments under the HMRC Tax Avoidance Schemes were recorded in the judgment as follows:

…during 2012 the Company entered into tax planning arrangements involving the creation of an Employer Financed Retirement Benefit Scheme under which substantial amounts were transferred to an off-shore trust company, IFM Corporate Trustees Limited. These amounts were intended for the ultimate benefit of employees but it was anticipated the Company would thus be entitled to deduct Corporation Tax prior to any payment to the employees themselves. The Scheme (“the EDF Scheme”) was created pursuant to advice from EDF Tax. In November 2012, the sum of £1,000,000 was transferred to a trust company under the EDF Scheme. Further amounts were subsequently transferred to trustees in connection with a tax scheme (“the Qubic Scheme”) created by Qubic Tax.

The Scheme (“the EDF Scheme”) was created pursuant to advice from EDF Tax. In November 2012, the sum of £1,000,000 was transferred to a trust company under the EDF Scheme. Further amounts were subsequently transferred to trustees in connection with a tax scheme (“the Qubic Scheme”) created by Qubic Tax.

The HMRC Tax Liabilities

The Court recited the position as to the HMRC Tax liabilities as follows:

It appears that, as yet, there has been no judicial determination on the validity of the EDF Scheme whether in the First Tier Tribunal or otherwise. Moreover, no evidence was adduced before me as to HMRC’s prospects of successfully establishing its case in relation to the Company’s putative liabilities. The Company’s liabilities, if any, in the years 2011-2012 and 2012-2013 arise from the EDF Scheme and its liabilities in the years ending 2013-2014 and 2014-2015 arise from the Qubic Scheme. HMRC have issued a Jeopardy Corporation Tax Amendment against assessments for 31st March 2012 and 31st March 2013 with Regulation 80 determinations and Section 8 Notices. For the years 2011-2012 and 2012-2013, they now contend that the Company’s liabilities respectively amount to £250,880 and £3,010,126. By letter dated 18th February 2016, HMRC advised Clarke Bell of an “…HMRC announcement in 2013 to issue Accelerated Payments Notices against liabilities arising from tax advantages gained from what HMRC considers to be an Avoidance Scheme”. It also appears Mr Begley referred to such notices at a meeting, on 31st August 2016, with Mr Morton of Clarke Bell and the Defendants. However, this aspect of the case is obscure. If such notices were served, it is unclear what, if any liabilities might have been incurred under them.

The Awareness Of The Tax Avoidance Risk And Director Disqualification

The Court decided that the two Directors (D1 and D2) were aware that the HMRC tax avoidance schemes were occasioned by some risk, notably the Promoter of the HMRC tax avoidance scheme that was central to consideration of the Directors’ disqualification proceedings, EDF, had warned D1 and D2 as follows on or about 25 September 2012:

Firstly, it is obvious from the correspondence with EDF Tax before the Company entered into the EDF Scheme that EDF Tax were well aware HMRC would, in all likelihood, investigate the scheme and there was every possibility it would be challenged. In guidance published as long ago as 5th August 2010, HMRC had already issued a warning that they believed such schemes to be ineffective and EDF Tax can be taken to have been aware of the guidance. They thus set out to warn Mr Craig Lummis the EDF Scheme would come under scrutiny. By their letter dated 25th September 2012, they stated “it was almost guaranteed that HM Revenue & Customs will enquire into the planning.” Elsewhere in the letter, they observed that it was the current practice of HMRC to look at a representative sample of clients. If they accepted the tax deduction, all cases would be closed, whether in the sample or not. If they decided to submit a challenge, the sample cases would be narrowed to select one or two cases to be heard before the First Tier Tribunal. They also advised that “ultimately if HMRC are successful and a tax liability arises then an interest charge would arise on the unpaid tax from the normal due date“. Although it was addressed to Mr Craig Lummis marked “strictly private and confidential to be opened and read by” only by him, it was a significant document with important ramifications for the Company and, indeed, for Messrs Craig and Lee Lummis themselves. Mr Lee Lummis was aware of the proposals. I am also satisfied Mr Craig Lummis received the relevant correspondence and, in the absence of good reason for him to exclude such correspondence from Mr Lee Lummis, I am satisfied that it was shown to Mr Lee Lummis. Although Mr Lee Lummis stated, in cross examination, he had no recollection of seeing it, I am satisfied the Defendants would each have read and considered it before committing the Company to the EDF Scheme.

Transactions After Cessation Of Trading

The Court found that after the Company had ceased trading on 1 August 2014 (by which time it had transferred its database to a connected company, Alexandra Associates (UK) Limited (“AAL”)), it then transferred £1,294,000 to the two Directors and in doing so entered into transactions that were not free from doubt as to the HMRC tax position:

They can also be taken to have been aware that the ultimate outcome of any litigation with HMRC was not free from doubt and there was a significant risk the EDF Scheme would thus attract a substantial tax liability.

The Court’s Analysis: Tax Avoidance And Director Disqualification

In assessing the arguments concerning Director Disqualification the Court had this to say:

Section 6(1) of the Company Directors Disqualification Act 1986 provides that disqualification is mandatory in the case of directors of an insolvent company if their conduct as a director makes them unfit to be concerned in the management of a company. In Re Grayan Building Services Limited (in liquidation) [1995] Ch 241 at 253, Hoffman LJ observed that this requires the Court to determine whether their conduct “viewed cumulatively and taking account of any extenuating circumstances, has fallen below the standards of probity and competence appropriate for persons fit to be directors of companies”. In making this determination, it is axiomatic that the court is concerned solely with the conduct identified by the Secretary of State as grounds of unfitness.

In the present case, the Secretary of State relies on the conduct of the Defendants in causing the Company to enter into the disputed transactions between 1st August 2014 and 6th November 2015, a period commencing with the cessation of trade and ending with the insolvent liquidation of the company.

It is now established that the directors of an insolvent company are under a duty to have proper regard for the interest of the company’s creditors, Jetivia SA v Bilta [2016] AC 1 (Lord Toulson and Lord Hodge at [123]). This duty arises when they “know or should know that the company is or is likely to become insolvent” and “in this context, ‘likely’ means probable”, BTI 2014 LLC v Sequana SA [2019] BCC 631 David Richards LJ at [220]). If “the directors know or ought to know that the company is presently and actually insolvent”, David Richards LJ suggested, at [222], it is “hard to see that creditors interests could be anything other than paramount”. In this part of his judgment, he drew no distinction between insolvency on a cash-flow and balance sheet basis. However, at [213], he referred to West Mercia Safetyware Ltd (in liq) v Dodd (1988) 4 BCC 30, as authority for the proposition that, when the company is “actually insolvent”, insolvency on either basis will suffice and it is implicit in his analysis at [224] that insolvency on a cash-flow basis is enough where the company’s total assets exceed the liabilities on its balance sheet and the statutory restrictions on the payment of dividend are not engaged.

In the light of these principles, I am satisfied that the Defendants were under a duty to have proper regard for the interest of the Company’s creditors from 1st August 2014, at the latest, when the Company can be seen to have been insolvent on a balance sheet basis. If there could be any room for doubt that the Company was insolvent on 1st August 2014, the Company was by then at the latest likely to become insolvent in the sense envisaged by David Richards LJ in BTI 2014 LLC v Sequana SA (supra).

The Defendants’ general duty to have proper regard for the interest of the Company’s creditors was to be discharged in conjunction with their duties, as directors, to act in good faith, to avoid conflicts of interest and exercise reasonable skill and care. It applied to the interests of the Company’s creditors as a whole and, subject to issues of security or priority, it would have precluded the Defendants from treating some creditors more favourably than others in the absence of good reason to the contrary. This is so regardless of whether doing so might have given rise to a statutory preference.

Although HMRC were to be treated only as contingent creditors, they fell within the class or classes of creditors to whom the Defendants owed a duty. At all material times prior to the liquidation and, indeed, at the time of the liquidation itself, the Insolvency Rules 1986 were applicable. This statutory regime has been superseded by the Insolvency (England and Wales) Rules 2016 but remains in similar terms. By Rule 12.3(1) of the 1986 Rules, “provable debts” was defined so as to include present, future, certain or contingent claims and, by Rule 13.12(1), “debt” was defined so as to include any debt or liability to which the Company was subject on the date it went into liquidation or to which the Company may become after that date by reason of any obligation incurred before it. Consistently with re Nortel GmbH [2014] AC 209 (in which the Supreme Court concluded that a financial support direction issued by the Pensions Regulator after a company entered insolvent administration was treated as a provable debt), the Company’s liabilities, if any, to HMRC in respect of the EDF Scheme would have been provable or deemed provable as a debt or liability to which the Company might become subject under Rule 13.12(1)(b). This was at least notionally the case throughout the period in which the Company entered into the disputed transactions.

Although HMRC were thus to be regarded as creditors with the Defendants under a duty to have proper regard to their interest as such, there is no suggestion HMRC were entitled to any special status. In view of the nature of the Company’s liability to the Crown, it does not form part of the Secretary of State’s case that the Defendants somehow took advantage of the Crown’s forbearance so as to warrant a case based on unfitness in the sense envisaged by Dillon LJ in re Sevenoaks Stationers (Retail) Ltd [1991] Ch 164 at 184.

Moreover, the Brazil land transaction was no more than a makeweight in the Secretary of State’s case. Mr Lee Lummis did not identify the Brazil land as an asset in the Company’s affairs and no doubt, for that reason the liquidator took no action to realise it. However, on the available evidence, the land remains undeveloped; it is of limited value and, albeit contrary to the statement of affairs, the Defendants accept it should be treated a company asset. Moreover, it does not fit comfortably with the sworn ground of unfitness. I am not satisfied this materially adds to the ground of unfitness on which the Secretary of State relies.

Nevertheless, in my judgment, the Defendants caused the Company to enter into the transactions in relation to the client database and the directors’ loan repayments of £647,000 without proper regard for the interests of the creditors as a whole, including HMRC. The Defendants were thus in breach of their duty to the creditors. I am also satisfied that their conduct fell below the standards of probity and competence that could reasonably have been expected of them as directors.

By disposing of the client database to Alexandra Associates, they divested the Company of its intellectual property and business goodwill without introducing assets for the general benefit of its creditors. They also benefitted personally from the transaction as shareholders of Alexandra Associates. On behalf of the Defendants, it was submitted that the Company also benefitted from the transaction because the database would not have been easily marketable and the purchase price was utilised to reduce the amounts that the Company owed to the Defendants on their directors’ loan accounts. However, no evidence was adduced to suggest that the Defendants properly explored the opportunities that would otherwise have been available to the Company and the effect of the transaction was to divert the asset to a third party without introducing funds for the benefit of the Company’s ordinary creditors.

Similarly, the Defendants transferred to themselves £647,000 each out of the pipeline monies at a time that the Company had ceased business and had no intention or realistic expectation of re-commencing the business. Whilst they were able to ensure that the Company’s indebtedness to its ordinary trading creditors was discharged in full, this ultimately left the Company with no funds to meet its contingent liabilities to HMRC. According to the Company’s Statement of Affairs, which the First Defendant signed on 6th November 2015, the Company had no assets at the time it went into liquidation. At no stage did the Defendants make any provision at all out of the Company’s assets to meet its contingent liabilities to HMRC nor, indeed, did they explore the options that might have been available to do so, whether by crediting funds to a suspense account, insuring against the risk of a successful claim or otherwise. Whilst the Defendants were themselves creditors, they benefitted personally from the transactions at the expense of HMRC who were also creditors.

In his closing submissions, Mr Berkley invited me to conclude that the Defendants acted on the advice of Mr Begley. On this basis, he submitted that the Defendants should not be adjudged unfit. However, I have reached the conclusion that the Defendants did not ask Mr Begley for specific advice about the risks inherent in proceeding with the relevant transactions under insolvency legislation, particularly in connection with the Company’s contingent liabilities to HMRC and, in a wider sense, whether it was proper for the Company to proceed with the transactions in the light of such liabilities. In the absence of a request for such advice, Mr Begley did not alert the Defendants to such risks and did not warn them that the transactions would involve any impropriety or lack of probity. However, as directors, the Defendants had overall responsibility and they initiated or can be taken to have initiated the relevant transactions in the knowledge that the transactions would divest the Company of assets which would otherwise be available for its creditors, in particular HMRC, if and when the Company went into liquidation. The risks and impropriety of proceeding with the transactions on this basis ought to have been apparent to the Defendants in the absence of specific advice from Mr Begley. Following the transactions, the Company would have no substantial assets to meet its contingent liability to HMRC. In my judgment, the Defendants’ conduct thus fell below the standards of probity and competence appropriate for the directors of a company. Disqualification is mandatory.

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Elliot Green

Licensed Insolvency Practitioner & Chartered Accountant. We Know Insolvency Inside Out.