United Kingdom Employment Appeal Tribunal

APPEARANCES

 

For the Appellant	MR MATTHEW SMITH (Of Counsel) Instructed by: Messrs Halliwells LLP Solicitors St James's Court Brown Street Manchester M2 2JA
For the First Respondent	MR PETE GOODBODY (Of Counsel) Instructed by: Messrs Ricksons Solicitors 6 Winckley Square Preston Lancashire PR1 3JJ
For the Second Respondent	MR PETER GOODBODY (Of Counsel) Instructed by: Messrs DLA Solicitors India Buildings Water Street Liverpool L2 0NH

SUMMARY

Unfair Dismissal

The Employment Tribunal Chairman erred in holding that the contracts of employment were not illegal when the employee-directors of the Respondent company agreed to set up a scheme whereby 50% of what was properly found to be salary was paid gross to fictitious service providers and not declared for tax and NI. Remitted to the same Chairman to determine whether the Claimants knowingly substantially participated in the illegality disentitling them from enforcement of claims of unfair dismissal, wrongful dismissal and unlawful deductions.


 


HIS HONOUR JUDGE McMULLEN QC

1. This case is about the defence of illegality to claims by two company directors for unfair dismissal, wrongful dismissal and unlawful deductions. I will refer to the parties in this judgment as the Claimants and the Respondent. It is an appeal by the Respondent in those proceedings against a Reserved Judgment of an Employment Tribunal Chairman, sitting alone, Mr M E Coles at Manchester, registered with Reasons on 13 July 2005 following a day's hearing and a day in Chambers.
2. The Claimants and Respondent were respectively represented as here by Mr Matthew Smith and Mr Peter Goodbody of Counsel. The Claimants each claimed unfair dismissal and there were related claims for unlawful deductions from Mr Church and wrongful dismissal from Mr Stuart. The Respondent contended that it dismissed the Claimants lawfully and fairly for gross misconduct, taking the form in Mr Stuart's case of breach of fiduciary duty and, in Mr Church's case, of fraud.

The issues

3. The essential issue as defined by the Chairman at the instance of the parties at pre-hearing review was to determine whether or not the contracts of the Claimants were illegal and, therefore, whether the Tribunal had jurisdiction to hear the claims. The Chairman decided that the Respondent failed in its defence of illegality and listed the substantive claims for a hearing which is pending.
4. The Respondent appeals Directions sending this appeal to a full hearing were given by HHJ Ansell in Chambers on the sift.

The legal provisions

5. No relevant legislation has been cited to me. The Tribunal Chairman directed himself by reference to a number of authorities which had been referred to him and, to the agreed test for illegality set out in Hall v Woolston Hall Leisure Limited [2002] IRLR 578, to which I will return.

The facts

6. I will state the facts tentatively in respect of the substantive issues since there has been no hearing but a number of the facts found by the Chairman can be stated positively. The Claimant, Mr Church, was employed as the Respondent's managing director and Mr Stuart, as its operations director. Each had been employed since 2000 on a remuneration package which I hold to be aptly described as a salary of £60,000 a year. In November 2003 Mr Church's salary increased to £84,000 although there remains a different dispute about his entitlement to the additional £24,000.
7. The leading light in the Respondent's business is Mr Livesey who is the Managing Director of the Livesey Group and I take it he is the principal shareholding in the Respondent company. The way in which the Claimants received their pay changed following an approach by Mr Livesey in the Spring of 2003. Prior to that the Claimants had been paid under PAYE in the normal way. However, in 2003 Mr Livesey spoke to both of the Claimants about a proposal to pay half their salaries ie £30,000 in accordance with a scheme which had been operated for some time in relation to directors and other senior executives within the Livesey Group.
8. The Chairman said this:

"13. …He explained that the system had been set up on the advice of Frank Webster of Guildhall Tax Consultants, a firm then based in Preston City Centre. Mr Webster is apparently some 50 years of age and has taken care of the personal and business tax matters of the Livesey family for a number of years. Although not a qualified accountant, he was previously a senior tax manager within the Inland Revenue where he had worked for some 20 years prior to setting up his own consultancy. Mr Church met with Mr Webster who outlined the scheme and, according to Mr Church, Mr Webster at that time agreed to assist him in completing annual tax returns in respect of remuneration paid to him outside the PAVE system.

14. On Mr Webster's advice, Mr Church and Mr Stuart devised "service providers" using the initials of their girlfriends, this being KB Services in the case of Mr Church and CLC Services in the case of Mr Stuart. CLC are the initials of Clare Chaplin, who was, and in fact still is, employed in the respondent organisation and was at the material time a Finance Manager within the respondent company. She, in fact, administered the scheme, apparently on the instructions of Mr Alan Livesey. When Mr Church's salary increased in November 2003, the additional payments were stated within the company books to be in respect of services provided by LK Services, the initials of Mr Church's new girlfriend.

15. Although the payments were shown within the respondents payroll documentation as going to these "service providers, in fact the cheques themselves were made payable to the claimants personally or the BACS payments made into their personal bank accounts.

16. No invoices were ever supplied by these "service providers" in respect of the sums paid in this way, although there was one invoice from CLC Services dated 13^th May 2004 for £300 in respect of a personal computer and printer which was apparently sold by Mr Stuart to the respondent.

17. The Tribunal is satisfied, and the claimants accept, that no separate services were provided by these "service providers" to the respondent. The payments did, however, represent remuneration (in gross terms) to which the claimants were contractually entitled, certainly in relation to £30,000 per annum and, depending on whether the increase in November 2003 of £24,000 to Mr Church was agreed, in respect of that sum also. The remuneration in excess of £30,000 was made by way of gross monthly payments of £2,500 and a further £2,000 from November 2003 in the case of Mr Church. For the purposes of this Pre-Hearing Review, although making no finding of fact, it is assumed that Mr Church was contractually entitled in gross terms to the additional £2,000 per month."

9. The outcome was that the Claimants never returned an account for tax of the payments exceeding £30,000. In other words Mr Church failed to disclose sixty five per cent of his earnings and Mr Stuart, fifty per cent.
10. The Skeleton Argument of Mr Goodbody shows that there was broad agreement to the facts for the Respondent's contention that these contracts were tainted by illegality, that is that there was no dispute that a substantial portion of the Claimant's salary was paid gross. The description of the remuneration package as salary is entirely correct. This is because Mr Goodbody's succinct summary is based upon the witness statement of his client, Mr Church which indicates that the arrangements made were for the payment of his salary, see page T331, paragraph 29 and the evidence of Mr Stott who is a chartered accountant employed by the Respondent who says that effectively the Claimants were earning a salary of £60,000 before Mr Church's increase.
11. In the light of the findings the Chairman made he came to the conclusion that there was no fraud by the Claimants against the Respondent; since the money which they had agreed they would be paid was paid and nothing more. And he noted the concession as follows;

"12. It should finally be added that it is not maintained that these contracts of employment were illegal from the outset but only became illegal in performance once the claimants entered into the arrangements identified above. The respondent also conceded that, not only were these arrangements entered into with the full agreement of the controlling directors of the company (essentially being members of the Livesey family) but actually at the suggestion (the claimants would say the insistence) of those directors, having advised the claimants that other, if not all, of the directors and senior executives of the group were operating similar schemes in respect of their remuneration."

12. The Chairman further considered the way in which tax returns had been made for the year ending 2004. At this stage Mr Church used an accountant from Robin Oatridge & Co who had also been spoken to by Mr Stuart. The returns disclosed income of £30,000 but it was the Claimants' case that because of the dispute about the legality of the payments they had been advised not to declare or pay tax on the additional remuneration until it was resolved.
13. The Chairman had before him the advice of the chartered accountant. It is plain to me, see page T243 that the accountant was advising in respect of Mr Church's disputed payment of the pay increase in November 2003. He was not advising in respect of the initial £30,000 upon which tax had not been and was paid gross into his service company. Thus, reliance upon the accountant's advice by Mr Church for failure to disclose the £30,000 was wrong.
14. So was it in the case of Mr Stuart as to whom no claim was made by the Respondent, as there had been against Mr Church, for repayment of the £24,000. Mr Stuart had not been given an increase. There was no dispute about his total package of £60,000 and thus he could not rely for failing to declare any part of his £60,000 on the existence of a dispute or claim for repayment. The position remained therefore that for earnings very substantially above £30,000 no return was made, no tax was paid.
15. The Chairman concluded that the defence made by the Respondent had been put very high: it was the Claimants' intention, in acceding to the arrangements for the payment of their salary in the way described, that they had deliberately intended not to pay the tax. The Chairman treated that submission as one which was the critical issue for him to decide. He held that the Respondent had not proved to the high standard required for an allegation of fraud like this that the Claimants had so intended and thus denied the Respondent's defence of illegality.
16. In his conclusions the Chairman recited ten arguments put by Mr Smith on behalf of the Respondent pointing towards illegality, and then said this:

"24. Whilst the Tribunal acknowledged the force of those arguments, the "subterfuge" could in fact be attributable to a desire on the part of the claimants, at the instigation of the controlling directors and advice from Mr Webster, simply to avoid "highlighting" the fact that these payments in reality represented remuneration of employees which would normally be paid under the PAVE system but could be "buried" in documentary systems which the Inland Revenue would simply not investigate, overburdened as it is with the impossible task of collecting revenue from often reluctant tax payers and having to rely very much on people's honesty so far as disclosure is concerned. There are, of course, benefits to be derived from declaring income to the Inland Revenue on a schedule D basis, including deferral of tax payment giving rise to a cash flow advantage and claiming allowances which the Inland Revenue would not have the time or resources to challenge."

17. The approach to that paragraph has caused me some difficulty to which I will return (para 40 below). If it is a finding, then I can easily understand how the Chairman could form a view that this was illegality. If it is not a finding then it ought to be identified as some other matter. The outcome was that the Chairman found that there was no illegal contract and thus it was not necessary for him to decide whether there had been participation in it.

The Respondent's case

18. On behalf of the Respondent it is submitted that the Chairman erred in law, first in his approach to what I will describe as its primary contention. I have examined the way in which the case was put in the response and the way it was dealt with by the Claimant as illustrated by the Claimants' Skeleton Argument today. It was contended that the Chairman had misunderstood the nature of the submission made because what was being sought was a finding that the Claimants had intended to evade taxation; whereas the primary issue was the application of the test in Hall which invokes a consideration of illegality and participation by an employee in the illegality.
19. Secondly, it was contended that the Chairman had made a judgment which was perverse, effectively holding that the contract was not illegal. Amongst the submissions accepted by the Chairman as being forceful was what Mr Smith described as the legal nonsense of a person working as an employee for a company and, at the same time working under a contract for services on a self-employed basis where there is no division of the duties in respect of the employed and self-employed status.
20. It was further submitted that these two claims call for a consideration of the precise relationship between the Claimants' conduct and the claim sought to be enforced. Mr Smith acknowledged the force of the authority I invited him to consider and which neither he nor the Chairman had seen: the Court of Appeal in Vakante v Abbey & Stanhope School [2004] EWCA Civ 1065. It is contended that the Chairman misdirected himself in his approach to the evaluation of factors relevant to his judgment. He failed to apply the test in Hall and should have asked himself whether the payment of sums in excess of £30,000 to the Claimants directly without reference to the PAYE and NI constituted illegal performance and had he done so he would have concluded that the contract was illegal.
21. Mr Smith further contended that the Chairman misdirected himself in his approach to the way in which the Revenue had apparently not picked up such treatment of compensation packages by the Respondent or the Livesey Group for other directors. The Chairman's abstention from making a judgment on this matter on the grounds that it would have been improper to do so could not be supported.

The Claimants' case

22. On behalf of the Claimants it is contended that the point put before the Chairman was the one which was actually to be decided and that a new point was sought to be advanced in the Employment Appeal Tribunal for the first time and should not be allowed. In response to the claims made by Mr Smith in his Skeleton Argument which reflect those put and found to be forceful before the Chairman, the scheme was imposed upon the Claimants by a powerful Mr Livesey and that the Respondent had not had identified to the cmts the specific form of illegality which it was sought to raise to defeat their claims.
23. Secondly, Mr Goodbody contended that his clients' involvement in the scheme was entirely passive. He accepted that there was an element of acquiescence in that fictitious service providers had been set up who never did provide a service. Details of that fiction had been provided by the Claimants. Mr Goodbody resisted, however, the contention that the Claimants had participated beyond that limited form of involvement. It was contended that the Grounds of Appeal and the arguments supporting it had failed to cross the threshold placed high, as accepted by Mr Smith, before those who seek to claim perversity in a Tribunal decision. See Yeboah v Crofton [2002] EWCA Civ 794 paragraph 93.

The legal principles

24. The legal principles appear to me to be enunciated in the following authorities. As I have said it was common ground before the Chairman that the test to be applied from Hall is as follows:

"in cases where the contract of employment is neither entered into for an illegal purpose nor prohibited by statute, the illegal performance of the contract will not render the contract unenforceable unless in addition to knowledge of the facts which make performance the illegal the employee actively participates In the illegal performance. It is a question of fact in each case whether there has been a sufficient degree of participation by the employee".

25. That passage in the judgment of Peter Gibson LJ followed a close analysis of the relevant authorities on illegality as applied in a case of sex discrimination. The central question in this case is whether there was not simply knowledge but also participation. See Ashmore Benson Ltd v Dawson [1973] 1 WLR 828 at 836 per Scarman LJ. In Newland v Simons & Willer (Hairdressers) Ltd [1981] IRLR 359 May J on behalf of the EAT said this:

"We have no doubt that Parliament never intended to give the statutory rights provided by the relevant employment legislation to those who are knowingly breaking the law by committing or participating in a fraud on the Revenue."

26. Returning to the judgment of Peter Gibson LJ in Hall, he said this at paragraph 42:

"It therefore follows that the correct approach of the tribunal in a sex discrimination case should be to consider whether the applicants claim arises out of or is so clearly connected or inextricably bound up or linked with the illegal conduct of the applicant that the court could not permit the applicant to recover compensation without appearing to condone that conduct."

27. It is to be noted that in that case the Court of Appeal found that the Claimant had received no benefit from the mode of payment of her salary to her without deductions for tax and National Insurance and she was thus allowed to proceed with her claim of sex discrimination.
28. The judgment in Hall was also followed and applied with gratitude by the Court of Appeal in Vakante above where Mummery LJ giving the judgment with which Lord Slynn and Brooke LJ agree said this:

"…the defence of illegality is an appeal to a self-evident legal principle or policy that justice, and access to it, does not require courts and tribunals to assist litigants to benefit from their illegal conduct, if it is inextricably bound up in their claim."

29. Mummery LJ went on to say in respect of the Hall case

"8. The strength of the Hall approach is that it is flexible. It enables the tribunal to avoid arbitrary and disproportionate outcomes and to reach sensible and just decisions in most cases. The proper application of the test should produce reasonably consistent and predictable results, more so, I am inclined to think, than would be the case if, in cases of illegal conduct involving the applicant, the tribunal were given a general statutory discretion, constrained by specific limiting factors.

9. Although Hall uses some of the familiar language of legal and factual causation ("connection", "link"), the test does not restrict the tribunal to a causation question. Matters of fact and degree have to be considered: the circumstances surrounding the applicant's claim and the illegal conduct, the nature and seriousness of the illegal conduct, the extent of the applicant's involvement in it and the character of the applicant's claim are all matters relevant to determining whether the claim is so "inextricably bound up with" the applicant's illegal conduct that, by permitting the applicant to recover compensation, the tribunal might appear to condone the illegality."

30. It seems to me that a simple and helpful approach to the issue of illegality in the case where it is contended that a contract in its performance has become illegal was given by Carnwath LJ in Colen v Cebrian [2003] EWCA 1675 where he said:

"31. ... There are three issues:

a) What was the contract?

b) Did it involve illegality?

c) If so, how does this affect the jurisdiction of the Employment Tribunal?"

31. I also drew the attention of Counsel to a judgment given by the Court of Appeal in Wheeler v Quality Deep Ltd t/a Thai Royal Restaurant [2004] EWCA Civ 1085. In that case, which was heard on the same day as Vakante by a different division without reference of either Court to the other, the Court of Appeal overturned unanimous judgments of the Employment Tribunal and EAT. Mr Smith, however, invited my attention to paragraph 71 which he contends radically restricts the scope of the judgment, for Hooper LJ, giving a judgment with which Ward LJ agreed, said this:

"71. I add this final comment. This is a very unusual case concerning as it does a foreign national working in this country in that language with limited knowledge of the English language and of the tax and national insurance provisions of this country. Had she not had that limited knowledge, she may well not have succeeded."

That is a useful insight into the facts in that case and I would prefer to base my judgment upon the Court of Appeal's contemporaneous judgment in Vakante.

32. As to the issue of perversity, it is clear that the threshold is high for making a successful claim. There must be overwhelming case on the facts or some internal inconsistency in order for this argument to work. See Yeboah above.

Conclusions

33. In my judgment Mr Smith is correct in his submissions that this contract was illegal. I find his arguments persuasive that the real issue for the Tribunal Chairman was to determine those points set out by Carnwath LJ in Colen (see para 30 above): was there an illegal contract, and had the Claimant participated to a substantial degree such as to disentitle him from being able to rely upon it? That Counsel for the Respondent was seeking a finding of fact that the purpose behind the arrangement for payment was to evade tax does not destroy the essential issue which was to determine whether there was illegality in which each Claimant substantially participated. Thus, I do not accept that a new point is being argued on appeal and I do accept that the Chairman focused too narrowly on what was essentially one finding of fact he was invited to make on his way to an overall conclusion based on the Hall test. That may explain part of his approach. In my judgment there is no other answer to this case but that there was an illegal contract.
34. The starting point is the evidence given by Mr Stott, the chartered accountant who said this:

"The payments of £30,000 as in the case of Mr Stuart or £54,000 a year in the case of Mr Church would in all likelihood be challenged by the Inland Revenue as unlawful."

The Chairman had that evidence in mind when he made his comments (recorded at paragraph 16 above). What Mr Smith describes as a legal nonsense is in my judgment a fitting characterisation . Only two examples were given to me of a situation where an employee can also be self-employed. In the first, given by Mr Smith, an employee also in his spare time conducts a business repairing computers. His employer who has a problem with a computer invites him to do the repairs. The employee submits an invoice, is paid separately and accounts separately under Schedule D to the tax authorities for that part-time business which he conducts, as it happens for this employer and maybe for other parties as well. Thus, it would be possible in any given month to see him being paid net under PAYE for his duties as an employee and with a gross payment for his services as an engineer. There is no illegality.

35. The second example, given by Mr Goodbody, is of a director and company secretary who is paid a fee for discharging her company law duties and is at the same time an employee or even a director in the non-technical sense. Provided there is a sufficient distinction between the duties, I accept the argument that there would be no illegality in accounting on the one hand to the Revenue herself under Schedule D for her duties under the statutory office, and PAYE being deducted in respect of her employee duties.
36. However, neither of those examples touches the situation in this case. Each employee agreed that a very substantial part of his salary would not be treated as Schedule E remuneration as an employee. There has been no division of the responsibilities which were said to be discharged through the service provider. No service provider existed. No services were provided by the fictional company nor did that fictional provider receive any money. Although on the documents of the Respondent payments were said to be made to the service providers in fact cheques and direct payments into the bank were made to Mr Church and to Mr Stuart respectively in their own names. Indeed. Mr Church signed some cheques to himself.
37. In my judgment, apart from the two examples I have given, it is legal nonsense for an employee to be at the same time a self-employed contractor rendering services. In the circumstances of this case, no attempt has been made to divide the payment as between any different duties performed by these two men. Since my analysis of the evidence and the findings is that it was all salary for the respective positions they held as employees, it was unlawful for no tax or National Insurance to be deducted in respect of £30,000, or £54,000 in Mr Church's case.
38. With respect, had the Chairman focused on the correct question, he should have come to the conclusion that these were illegal contracts and, then have turned to the second question which involves examination of the Claimants' role in that illegality. Both Counsel accept that the Chairman did not directly answer that question. Mr Smith contends that the answer is obvious. From the points which the Chairman regarded as forceful, there is ample evidence of the Claimants' participation in a contract which they were seeking to enforce and which was illegal. I have no doubt Mr Smith is correct when he says applying Vakante that public policy in this case militates against entitling the Claimants to enforce the contracts.
39. The claims for unfair dismissal seek remedies of compensation. The claims for unlawful deductions and wrongful dismissal are self-evidently claims based on the contract and what is properly payable under the contract and losses flowing from breaches. These cases are different from the example given to me of a claim of sexual harassment involving a one-off act and causing a female claimant to seek only an award of a declaration and compensation for njury to feelings. The claims made in the present proceedings are inextricably wound up with the contract, and if the contract is illegal the Claimant should not be in a position to enforce it if he has substantially participated in it knowing it was illegal.
40. As I indicated (at para 17), I was concerned with the language used by the Chairman in his paragraph 24 (para 16 above). If this is a finding, and it seems to me more likely than not that it is, since it is put as a counterweight to Mr Smith's argument, then all the material is there for a finding that the Claimants substantially participated. The Chairman notes that there were benefits to the Claimants from this method. In Hall there was no benefit. It would be easy to make a finding against the Claimants if paragraph 24 represented the facts found by the Chairman.
41. Further, it seems to me that the Chairman wrongly decided that it was improper to pre-empt any further findings. (See Reasons paragraph 26 which I do not cite). The task was to decide the issue in this case and not to be concerned with others. But I do accept, and therefore reject the submission made by Mr Smith, that it was relevant to consider the Claimants' view of other people engaged in this activity. These are the other directors for whom it is said a similar scheme was in place. The role of Mr Webster is also relevant, who was, it will be recalled, a consultant with 20 years service as a senior tax manager of the Inland Revenue who apparently approved these schemes. It is also to be noted that the evidence was that Mr Webster would assist Mr Church in drawing up an annual tax return in respect of the remuneration which was not subject to PAYE. There is no evidence that there was such assistance or of the advice given by Mr Webster about that.
42. The disposal of this case was the subject of argument before me. Mr Smith contended that I have sufficient material myself to make the decision having detected an error in the Chairman's approach and, to substitute a judgment that this was illegal and the Claimants, because of their substantial participation, would not be able to enforce the contracts. Mr Goodbody indicated that I did not have sufficient material to do that. The appropriate response would therefore be to remit and although he was relaxed about the Chairman to whom it should go, he submitted it was logical to go to the same Chairman. On that issue Mr Smith contended that, his clients having alleged perversity, they would have lost faith in the Chairman and it should not go back to him.
43. I have decided that these claims should be returned to the Chairman. I have considered how high the stakes are. There can be no area more fact-sensitive than deciding whether there has been knowing participation in an illegal scheme, the effect of which is that half of a person's salary escapes taxation. I am not prepared to come to a judgment on this matter for the Chairman himself saw the Claimants and heard their evidence. I note, as did the Chairman, that Mr Church put forward a distinguished education and that might indicate the way in which his knowledge and understanding of illegality might be dealt with. But again I did not have the advantage which the Chairman did.
44. Since it is common ground that the Chairman did not make a positive finding on the participation point, he should now be invited to do so in the light of my judgment (which it must be said includes reference to Vakante which was not placed before the Chairman) that this was indeed an illegal contract and my direction to answer the single question pursuant to Hall. Standing back from it, the Respondent has succeeded in two of its arguments. Applying the factors in Sinclair Roche & Temperley v Heard [2004] IRLR 763 I have decided that it is proportionate for this matter to go back to the Chairman, since two days has been spent on it and that the Claimants will not have lost faith in his professionalism to determine this issue in accordance with the judgment I have given.
45. I doubt whether it will be necessary for further evidence to be heard. It may not be necessary for there to be another hearing because I am acutely conscious of the expenditure in this case which is simply at a preliminary stage. If both parties and the Chairman agree, it would seem to me to be practicable for written submissions to be made and for the Chairman to determine it without a hearing but that I will leave to the parties and to the Chairman to decide.
46. I would very much like to thank both Counsel for their very helpful submissions completed well within the time allowed for this case.

Directions not part of judgment

47. The order will be: Appeal allowed, remitted to the Chairman to decide in accordance with the principles in Hall whether the Claimants knowingly participated substantially in the illegality. The parties will have 14 days following the sending of a transcript in which to make any applications. Any such application should be copied to the other side and the other side will have 7 days thereafter to respond to it and then it will come back in front of me if there is such an application.