On what basis can the Inland Revenue challenge the deductibility of payments made by a trader as remuneration to a relative (eg a spouse or child)? When can the Revenue properly contend that the sums are not deductible for tax purposes? The position is, sadly, no longer as clear as it once was.By s.74(1)(a) of the ICTA 198 8 remuneration to employees of a business will be deductible in computing taxable profits if it is 'wholly and exclusively...expended for the purposes of the trade...' Until recently it was settled law that in determining whether the statutory test was met the trader could not rely on a purely subjective interpretation of the payments made and that the Revenue could not rely on a purely objective interpretation.

A trader was not entitled simply to say: 'I decided to pay my spouse £5000 for his/her work in the business this year and my commercial judgment of the value of the services rendered cannot be called into question when considering the deductibility of the sums.' The trader's view that the expenditure is for the purposes of the trade is not enough alone.

Equally, the Revenue was not entitled to say in such circumstances: 'The figure of £5000 is in fact in excess of a commercial rate for the services rendered (measured against all available evidence) and is thus, per se, not deductible.' The proper approach was, instead, that a trader's commercial judgment of the value of services rendered was accepted unless the circumstances were such (eg because the payment far exceeded a commercial rate) that it could not be said that the trader had made a bona fide, genuine assessment of the value of the services.

In effect, a mixed 'subjective/objective' test.This approach derived support from the early authorities in this area, namely Johnson Brothers & Co v CIR [1919] 2 KB 717, Stott & Ingham v Trehearne (1924) 9 TC 69 and Copeman v William Food & Sons Ltd [1941] 1 KB 202.

In each case the facts were such that the presumption that the sums paid were bona fide for services rendered by the recipients was clearly rebutted.

In Johnson Brothers each of three sons was paid the same amount irrespective of the time they spent working in the business and in any event received a sum which was way in excess of the commercial rate for the job.

In evidence it was admitted that the excess was paid 'on account of family feeling'.

In Stott & Ingham two sons received the same amount from the business notwithstanding that one was away fighting in the war and in each case the payments made were way in excess of those which had been made in earlier years.

In Copeman in circumstances where the salaries paid to the owner's children were manifestly excessive, Lawrence J held that it was the general commissioner's duty to decide how much of the sums paid by the company were properly incurred for the purposes of its trade -- ie how much was properly referable to the services rendered.

(Perversely, when the matter was referred back to the general commissioners to determine whether, and if so to what extent, the particular payments were excessive, the commissioners apparently decided that the sums were deductible after all.)However, this well understood approach has now been called into question by the judgment of Vinelott J in Earlspring Properties Ltd v Guest [1993] STC 473 where (in relation to a point unfortunately not considered subsequently by the Court of Appeal -- see [1995] STC 479) his Lordship has indicated that the Revenue may now be able to challenge payments made by a trader to relatives if there is evidence that the level of payment has been motivated by tax planning considerations.

His Lordship states: 'Bearing in mind the very large leap in salary...the fiscal advantages in the diversion of earned income to [the recipient] (which would not be aggregated with [her husband's] income) and the facility the remuneration afforded her of enabling large premiums to be paid into a pension fund for her benefit, the commissioners were entitled to conclude that the remuneration...represented in part a diversion of income made to achieve a fiscal purpose.'The sums in question were held not to be deductible.

If, by this, we are to understand that remuneration which is so excessive as to lead to the conclusion that it is not a genuine payment for services rendered (and, in any event, has been arrived at for other tax reasons) is not deductible then the position is little altered.

The 'fiscal motivation' is simply additional evidence of the clear uncommerciality of the payments made.

However, if the Inland Revenue seeks to rely on Earlspring to support a challenge to the deductibility of sums which are themselves commercially justifiable but which have been arrived at partly with tax matters in mind -- for example remuneration for secretarial and administrative duties set just below the lower rate or basic rate tax bands -- then the traditional approach outlined above will have been altered considerably.

In effect the Revenue will feel free to challenge any sum which is 'suspiciously' close to the relevant band limits for the years in question even if they can be justified by reference to commercial levels of remuneration.This, in my view, is not a correct approach in law, for the simple reason that in attempting to characterise receipts or expenditure the motivation for them (especially so-called 'tax planning motives') is to be ignored.

As Lord Goff states in Lawson v Johnson Matthey plc [1992] 2 WLR 826 at 837: 'The question is...whether...the payment is to be characterised as a payment of a capital nature.

That characterisation does not depend on the motive or purpose of the taxpayer.' (See also the speech of Lord Templeman in Ensign Tankers v Stokes [1992] 1 AC 655, where his Lordship makes clear that fiscal motivations cannot alter the classification of a transaction as 'trading' or 'not trading'.) As long as the level of remuneration is a genuine assessment of the value of the services provided it should not (and does not) matter whether the amount has been arrived at by reference to tax considerations, other 'non-commercial' matters or even signs of the Zodiac.

If it is the 'proper' pay for the job, it is deductible.Quite how the Revenue will seek to rely on the High Court decision in Earlspring now that this aspect of the case has escaped challenge in the Court of Appeal remains to be seen.

Anyone advising family companies will, however, have to be aware of the potential change in approach and, in particular, of the need to consider with clients the wisdom of setting remuneration levels at just below tax rate bands.

Now, more than ever, traders will have to demonstrate that salaries paid to relatives are realistic and commercial.1995