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Lords Rules In Favour Of Arctic Systems

by Robert Lee, Tax-News.com, London

27 July 2007


Thousands of small family-run business across the UK breathed a sigh of relief yesterday after a panel of Law Lords came down on the side of Arctic Systems in a long-running tax dispute, leaving HM Revenue and Customs with no recourse to appeal.

The House of Lords ruling brings an end to a seven-year ordeal for Geoff and Diana Jones, the husband and wife team behind the small IT consulting firm Arctic Systems Ltd, who have been fighting a GBP42,000 tax bill imposed on them by the then Inland Revenue, after tax inspectors called into question the way in which the Jones remunerated themselves through the company to save tax.

HMRC had been defeated in the Court of Appeal late last year and was not granted leave to appeal to the House of Lords, yet the tax department successfully petitioned the Lords to contest the Court of Appeal's ruling.

At issue was HMRC's interpretation of the S660A settlements legislation. HMRC argued that Mr Jones’s actions in setting up the company allowing his wife to subscribe for a share and the general arrangements all constituted a settlement. Under S660A Taxes Act 1988 the income of a settlement can be treated as that of the settlor (i.e. Mr Jones) in some cases, though not if the settlement was an outright gift to a spouse, unless the property given is “wholly or substantially a right to income".

While HMRC pointed out that this could not be classed as a test case since the S660A legislation had been in effect since the 1930s, tax advisors have countered that the husband/wife issue only became relevant in the 1990s with independent taxation of a wife’s income, and have expressed the belief that S660A has not been used in this way before.

The company, equally owned by Mr and Mrs Jones, had a turnover of GBP91,000 for the year, derived from Mr Jones’s activities. Mr Jones drew a salary of GBP7,000, while his wife drew a salary for administrative work of GBP4,000, for which she worked approximately four hours per week. After expenses and corporation tax, the couple shared the remaining GBP60,000 equally in dividends. As a consequence, the couple paid less tax and national insurance contributions on their income because they took dividends rather than salaries, and a significant portion went to Mrs Jones to use up her lower tax rates.

Although all five Law Lords disagreed with the Court of Appeal, which ruled that no settlement had taken place, they nonetheless rejected HMRC's appeal on the basis that, although there was a “settlement” for the purposes of S660, it fell within the exemption provided for an outright gift between spouses. The settlements legislation therefore does not apply to companies jointly owned by married couples and civil partners and structured in this way.

According to Lord Hope of Craighead: "An arrangement by which one spouse uses a private company as a tax-efficient vehicle for distributing to the other income which its business generates is likely to constitute a "settlement" on the other spouse within the meaning of section 660G(1) of the 1988 Act. But so long as the shares from which that income arises are ordinary shares, and not shares carrying contractual rights which are restricted wholly or substantially to a right to income, the settlement will fall within the exception created by section 660A(6).”

The case has ramifications for tens of thousands of businesses structured in a similar way to Arctic Systems, which were bracing themselves for higher tax bills had the Law Lords ruled in favour of HMRC.

"The spectre of horrendous tax bills has disappeared," announced David Kilshaw, head of private client advisory at KPMG. "Thousands of businesses have literally been saved from bankruptcy by the House of Lords."

However, Kilshaw also pointed out that Mr and Mrs Jones won because of the particular way that they had structured their company – ie because Mrs Jones had an actual share in Arctic Systems with real rights. "Couples running businesses together need to check that they have appropriate arrangements in place or they may find that they still have high tax bills," he cautioned.

“In addition it is important to note that, the Arctic Systems case looked at the situation where a husband and wife were running an actual company but many couples run businesses in a partnership structure," Kilshaw added. "The judgment is far less helpful to them and HMRC may now turn their attention to family partnerships. It is vital that each partner has an interest in the capital of the partnership and not just a share in the profits.”

Dividends are taxed at an effective rate of 25%, whereas the top rate of income tax is 40% plus a one percent national insurance charge. Thus, receiving dividend payments rather than salary can result in a 16% tax saving.

However, there remains the danger that the government will skirt the ruling by simply changing the legislation in this area. "If so, it needs full and careful consultation and the result should be clear legislation that is simple to use so that small businesses of this type are able to plan and manage their tax affairs correctly and effectively," observed Leonie Kerswill, tax partner at PricewaterhouseCoopers LLP.

KPMG's Kilshaw also noted that the ruling may prompt the government to introduce national insurance contribution payments on dividends from family companies. "If this were to happen, it would affect all dividend payments, not just those in examples similar to Mr and Mrs Jones’ case,” he warned.

The Jones' have been supported for the last three years by the Professional Contractors Group, a body established to help freelancers and small businesses fight injustices in the UK tax laws. Commenting on the judgment, its Chairman, David Ramsden stated: “This is an enormous relief for family businesses throughout the UK, who had been facing a tax rise from a previously obscure bit of law. We will now be working to ensure that HMRC respects this decision and does not attempt to penalise family businesses unfairly."


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