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Capital Allowances and the CSA

Lynsey Cade-Davies discusses the implications for self-employed NRPs of the judgment in Smith v Secretary of State for Work and Pensions [2006] UKHL 35

The Implications for self-employed NRPs of the judgment in Smith v Secretary of State for Work and Pensions [2006] UKHL 35

Lynsey Cade Davies, Pupil, 29 Bedford Row

The mother appealed to the House of Lords against the Court of Appeal's decision to deduct capital allowances in assessing a self employed Non-Resident Parent's net income. The appeal was allowed. (12/07/06)

This case is the latest in a string of cases to criticise the CSA and its complex, burdensome legislation. Specifically it concerns the interpretation of an ambiguous regulation, best described by Lord Nicholls as an 'unhappy piece of drafting' which relates to the calculation of a self-employed NRP's income. It is another example of the current CSA's ineffectiveness in dealing with individual circumstances and thus demonstrates the need for a return to the discretionary jurisdiction of the courts.

The case concerned the liability of a sole trader, Mr Smith, to pay maintenance for the support of his three children under the Child Support Act 1991. A particular feature of his trade was that it generated substantial capital allowances for income tax purposes.

The principal issue therefore, was whether capital allowances should be included or excluded in calculating net income for child support purposes. On the basis that the capital allowances for the relevant year amounted to £148,628, the child support assessment would be based on an income of £20,892. Had capital allowances not been deductible the relevant income would have been £169,520. The Child Support Commissioner concluded that the father was not entitled to deduction of capital allowances. The father appealed to the Court of Appeal, reported at [2005] 1 FLR 606, which reversed the Commissioner's decision and remitted the matter to the appeal tribunal to determine the father's liability after deduction of capital allowances. The mother appealed.

The House was called upon to interpret the phrase 'total taxable profits … as submitted to the Inland Revenue … in accordance with their requirements by or on behalf of the self-employed earner' in paragraph 2A(2) and 2B(2) of Part 1, Chapter 2 of Schedule 1 to the Child Support (Maintenance Assessments and Special Cases) Regulations 1992 (SI 1992/1815) as amended by the Child Support (Miscellaneous Amendments) Regulations 1999 (SI 1999/977). This phrase is used for determining the earnings of a self-employed NRP. Before the regulations were amended in 1999 the NRP's income was always calculated in accordance with paragraph 3 of the same Schedule. This paragraph makes it entirely clear that capital allowances are not to be deducted in assessing net income. Paragraph 2A was intended to be the primary means of determining earnings but the original paragraph 3 was not revoked and now applies as a default provision. It applies where it is not reasonably practicable for the NRP to provide information in the form submitted to Inland Revenue, where that information is too old or where it does not accurately reflect the NRP's normal weekly earnings. Their Lordships agreed that the two methods of calculation under the respective paragraphs could and did produce unsatisfactory and unfair results to PsWC.

Their Lordships considered at length the inconsistency between paragraphs 2A and 3. They recognised the newly introduced paragraph 2A was intended to simplify the maintenance calculation. However their Lordships disagreed as to whether this intention extended to a substantive change to the principles governing the calculation of net income.

Mr Smith and the Secretary of State relied upon the use of 'total taxable profits' in the self-assessment tax return used by the Inland Revenue to point towards allowing deduction of capital expenditure. The phrase can be found at Box 3.92, which relates to a figure reached after deduction of capital allowances.

The two possible interpretations therefore, were as follows:

(A) the annual trading profit net of allowable expenses, which is the profit chargeable to income tax under Schedule D, contended for by Mrs Smith; or

(B) that amount less the capital allowances the trader can claim against it for the tax year in question, which is the net figure carried to his taxable income in working out how much tax he actually has to pay.

Held, allowing the appeal (Lord Nicholls and Lord Rodger dissenting), that construction of paragraph 2A does not allow for the deduction of capital allowances. Accordingly the decision of the Child Support Commissioner should be restored.

The amendments in 1999, which led to the enactment of paragraph 2A, were intended to simplify the administration in the hope of speeding up the assessment of parents' liability for child support. There is no indication that Parliament intended to make a substantive change to the principles by which self-employed earnings are calculated. To the contrary, the regulations were introduced to simplify CSA calculations. Therefore the change was an administrative improvement, not a change of substance. Moreover, there is no rational reason why capital allowances should not be deductible in paragraph 3 cases but should be deductible in cases covered by paragraph 2A. It is an inexplicable anomaly and Parliament should be presumed not to intend to produce such a result. Furthermore it is inappropriate to attach too much weight to the coincidence of the wording in box 3.92 of the tax return, as it could not be assumed that the draftsman had such a form before him.

It is easy to understand why Parliament chose to ignore capital allowances in the original scheme and continued to do so on amending that scheme in 1999. Lord Walker, who delivered the leading judgment, justified the difference between tax legislation and child support legislation in the context of a child support system which aims to make a NRP's obligations to his children the first charge on his spendable income. He rejected Ward LJ's reasoning in the Court of Appeal that the family should share the burden of the economic reality of capital allowances. He considered that capital allowances have enabled Mr Smith to build up a profitable and expanding business of which he has had the benefit whereas Mrs Smith has carried the burden of maintaining the children. Baroness Hale further emphasised that child support liability is calculated by reference to income not capital and it would be very strange if capital expenditure could have the effect of drastically reducing the proportion of income to assess child support. Furthermore she recognised that capital allowances are used as an instrument of fiscal policy and reflect past rather than present expenditure. As such they are not connected with a parent's ability to pay. Indeed, her Ladyship highlighted the actual effect of capital allowances is to increase the amount of money in a NRP's pocket by reducing the amount of tax to be paid.

In rejecting the Respondents' submissions it was acknowledged that the unfairness created by interpretation B is not removed by observing paragraph 3 is not a dominant provision, nor is it remedied by the possibility of a departure direction.

Finally, in addressing the matter of whether there had been a violation of the Appellant's human rights Baroness Hale recognised that when two interpretations are possible the interpretation chosen should be that which better complies with the commitment to the welfare of children which this country has made by ratifying the United Nations Convention on the Rights of the Child. Their Lordships observed that where a state prevents a PWC from claiming child support through the ordinary court system it has a positive obligation to provide an effective alternative system but refrained from making any findings in that respect.

Lord Nicholls, in his dissenting judgment, considered that whilst the consequence of the amendments was not fully appreciated the Secretary of State nevertheless clearly intended to refer to figures readily derivable from the NRP's tax return. Similarly Lord Rodger believed the adoption of language used in Box 3.92 of the self-assessment tax return was deliberate. Both Lordships felt the amendment was a change of substance which would not be in doubt were it not for the inconsistency with Paragraph 3. Lord Rodger recognised there may be objections to basing child support assessments on figures used for tax purposes, but that was a policy change the Secretary of State had adopted to make the system more workable.

Statutory Construction
This case is a classic example of the different approaches to statutory construction of ambiguous statutes. The minority of the House adopted the literal approach in placing great emphasis on the correlation between the words 'total taxable profits' in paragraph 2A and the Inland Revenue self-assessment form. However the majority disagreed and adopted a far more purposive construction. Lord Carswell indicated that where a statute is ambiguous the court must have resort to such aids as the mischief which the legislation was intended to meet, the legislative history and the consequences which would ensue from either construction whilst Lord Walker warned of being over-literal and favoured a modern approach to statutory construction. In fact their Lordships, in particular Lord Walker, analysed the contextual background of the regulation in determining Parliament's intention. It was noted that the parliamentary statement introducing the regulations gave no support to the notion it was intended to make substantive changes and the majority emphasised the very striking inconsistency within the regulations. Their Lordships and her Ladyship looked at the effect of both constructions and chose that which accorded with child support principles. What may be of particular interest to family lawyers is that her Ladyship agreed it is permissible to have regard to International Conventions that UK has ratified (despite not being incorporated into domestic law) when adopting a purposive approach. Such an approach will clearly have an important impact throughout all aspects of family and human rights law.

Whilst the case dealt specifically with the interpretation of paragraph 2A of MASC Regulations 1992, which apply to child support cases under the old regime, it is likely that the decision will impact on cases under the new regime. Paragraphs 7(1)(a) and 8 of Part 3 of Schedule 1 to the Child Support (Maintenance Calculations and Special Cases) Regulations 2000 (2001/155) which apply to the new regime, use identical language to that of paragraphs 2A and 3. In the absence of evidence of an intention to make a substantive change in law in 2001 it is undoubted that this decision will provide definitive guidance on the interpretation of paragraph 7(1)(a) in new regime cases.

Departure Direction
The Court of Appeal's choice of Interpretation B was supported by their opinion that the existence of a departure direction under regulation 25 of the Child Support Departure Direction and Consequential Amendments Regulations 1996 (SI 1996/2907) provides Mrs Smith with the means of redressing any unfairness. Such a direction can be made when the Secretary of State is satisfied that the current assessment is based on a level of income substantially lower than the level required to support the overall lifestyle of the NRP. However the House of Lords rejected the Court of Appeal's reasoning by emphasising that the existence of a departure direction would not always alleviate the unfairness of interpretation B. The decision recognises that the possibility of such a direction is too speculative and there is no link between lifestyle and an entitlement to capital allowances. Lord Walker highlighted that if the NRP chooses a monastic, miserly lifestyle regulation 25 would not be engaged yet he would still be entitled to the benefit of capital allowances. The decision highlights the inadequacies of the Child Support system in dealing effectively with cases which result in unfair assessments under the rigid CSA formula. It is a further indication that a return to the discretion of the courts is necessary.

Human Rights
The Appellant submitted that the court should construe the regulations in a way that gives effect to the children's right to receive regular, reasonable maintenance. It is noteworthy that the Secretary of State was prepared to concede that article 8 was engaged and therefore there was no debate as to whether this discussion was relevant. In considering whether Mrs Smith's article 8 rights had been breached Lord Rodger found that despite the failure of the system to provide an appropriate amount of support, the Appellant's entitlement to income support was sufficient to prevent a violation. This supports the contention that the level of basic subsistence, represented by benefits, is considered a reasonable amount upon which to live. Lord Walker took the safer route by concluding it was unnecessary and better not to decide the point in order to dispose of the appeal. Finally Baroness Hale refused to interpret the right to receive regular reasonable maintenance out of the right to respect for family life. Clearly such an interpretation would have opened the CSA Pandora's box given the current state of the child support system. However her Ladyship did impose an obligation to interpret ambiguous legislation in a way that is compatible with the UK's international commitments. Whilst her comments specifically referred to the United Nations Convention on Rights of the Child they will surely extend to all other international human rights instruments to which UK is a signatory.

Baroness Hale and Lord Walker commented (obiter) that where a state prevents a PWC from claiming child support through the ordinary court system it has a positive obligation to provide an effective alternative system. There has been speculation amongst commentators that such a duty will give rise to claims in negligence against the CSA. As the CSA has failed to collect approximately £3.5 billion in maintenance, no doubt at least one PWC will attempt to make a claim based on these comments. However it will be a bold judge who allows it to proceed down this path.

Future of Child Support
Against a backdrop of criticism of the CSA this case further highlights the inherent problems with the current child support system. It is yet another example of how the child support system has failed both the PWC and children. Mrs Smith applied to the CSA in 1997 and was subjected to a total of 33 assessments and 5 years of litigation before achieving an appropriate assessment. Approximately 6% of CSA cases involve self-employed NRPs which can be particularly difficult given the greater scope to be inventive in submitting income figures for assessment. There is clearly a strong argument for allowing the court jurisdiction to determine child support liability especially in such cases where disputes arise and complex issues are involved. This argument is strengthened in cases where the court already has jurisdiction to determine ancillary relief matters. Whilst Lord Hutton has announced his intention to abolish the CSA, any change is likely to be two or more years away; indeed a detailed response from the government will not be available until an autumn White Paper. Therefore this decision is likely to have an important impact in the meantime in assessing the income of self-employed NRPs. However its long term significance will be limited.

Whatever future reform is taken it seems inevitable that there will be a policy decision as to whether capital allowances should be deducted from self-employed earnings for child support purposes. The Secretary of State's support of Mr Smith certainly implies he will support a decision in favour of deduction of capital allowances. However it is hoped that any future reform or policy will take into account Lord Walker's opinion that a parent's obligations should be a first charge on a NRP's income and the objections of the majority that clearly identify a number of valid reasons as to why deducting capital allowances is inappropriate for child support purposes. Even Lord Rodger, in his dissenting judgment, recognised that the resulting figure after deduction of capital allowances may be inappropriate for child support purposes.