No harm, no foul: Court of appeal analyses the "prohibited purpose" for section 423 claims

The Court of Appeal has found that the operation of a tax avoidance scheme to avoid a tax liability for disguised remuneration was not a transaction defrauding creditors, since the purpose of the scheme was to avoid any liability to HMRC arising, rather than to harm its ability to pursue a creditor claim.

The facts: Purkiss v Kennedy [2025] EWCA Civ 268

Ethos Solutions Limited (the Company) was incorporated in September 2008 to implement a tax avoidance scheme (based on advice received from an offshore tax consultancy) to enable self-employed individuals to reduce their income tax and NIC payable on their remuneration.

The scheme operated as follows:

• Individuals participating in the scheme would enter into contracts of employment with the Company and be paid a modest salary
• The participant would provide services to an end user on a consultancy basis, acting "on behalf" of the Company
• The end user would pay consultancy fees to the Company for those services
• The Company paid the participant their contractual salary and paid the balance (after accounting for its own admin fees and VAT) to a discretionary trust set up for the benefit of each participant
• The trustee of the trust would then loan of all or part of the trust funds to the participant

In 2010, the government published draft legislation to tackle tax avoidance schemes involving employee benefit trusts. The Finance Act 2011 subsequently introduced “disguised remuneration” rules targeting schemes of the nature implemented by the Company.

In 2012, HMRC assessed the Company as liable for £2.3m in income tax and NIC and the Company subsequently entered liquidation. The liquidator instigated proceedings arguing that the above scheme was a transaction defrauding creditors (specifically, HMRC) within the meaning of section 423 of the Insolvency Act 1986 (the Act).

The court was satisfied that each element of the scheme constituted a transaction at an undervalue, and so the relevant question was whether the transaction was entered into for the relevant purpose under section 423 of the Act.

The prohibited purpose

For section 423(3) of the Act to be satisfied, a transaction at an undervalue must have been entered into either:

• for the purpose of putting assets beyond the reach of "a person who is making, or may at some time make, a claim against him"; or
• prejudicing the interests of "such a person in relation to the claim which he is making or may make"

(the Prohibited Purpose)

The liquidator argued that the scheme was designed to secure that no income tax and NIC liability arose in relation to the remuneration received in respect of the participants’ services. The purpose was therefore to avoid HMRC being able to bring a claim, and to prejudice its right to pursue a claim which, absent the scheme, it might be able to make. The primary question before the court was therefore whether an intention to prevent a liability arising at all can amount to a Prohibited Purpose.

The liquidators sought to draw a distinction between “tax mitigation” and “unacceptable tax avoidance” and argued that the Company had sought to disguise remuneration in a “wholly artificial” manner which fell within the scope of section 423. The court was not persuaded, however, that there was any relevance to such a distinction in the context of this case, since the purpose behind both would be the same: namely to prevent a tax liability arising. The court considered it unlikely that parliament intended section 423 to extend to tax mitigation, which is “not generally considered objectionable”.

The decision

The court dismissed the liquidator’s appeal on the basis that an intention to prevent a debt arising cannot be construed as the Prohibited Purpose under section 423.

The policy behind the enactment of section 423 is that “debts must be paid before gifts are made”. The court considered that that policy is not undermined by a transaction which prevents a debt arising; it is consistent with it. Entering into a transaction in order to ensure that a liability does not accrue, therefore, does not involve a section 423(3) purpose. To find otherwise would mean that any legitimate tax avoidance would be made with a Prohibited Purpose and potentially capable of challenge under section 423. The court also rejected the alternative argument that the purpose of the scheme was to make it more difficult for HMRC to recover tax if the scheme was later found to be ineffective.

Comment

The outcome in this case is well-reasoned; however, conceptually it is difficult to reconcile the finding that extinguishing a creditor’s claim does not prejudice that creditor’s interests in pursuing such a claim in the future. The court was likely mindful that an alternative outcome would potentially enable HMRC to target any and all (legitimate) tax planning measures, which (as noted in the judgment) are not generally considered as objectionable. This potential broadening of the scope of section 423 claims would be particularly concerning given there is no insolvency requirement under section 423 and claims could be commenced by HMRC directly as "victim" of the transaction. Against this backdrop, it is easy to understand why the court reached the outcome that it did.