The long-running case of Arctic Systems has finally come to a close. The House of Lords' decision in favour of the taxpayer will bring a sigh of relief to around 200,000 small businesses. HMRC had imposed legislation dating back to the early 20th century to impose tax on dividends paid to Mrs Jones as though it were paid to Mr Jones.

The legislation was never intended to apply to husband and wife, as it dates back to the time (before 1990) when a wife's income was taxable on her husband. It is contained in section 624 Income Tax (Trading and Other Income) Act 2005 (when the case was brought, it was section 660A ICTA 1988) and was originally designed to prevent a taxpayer avoiding liability to income tax and surtax by transferring assets to his family.

The case
The facts of the case are well known: Mr and Mrs Jones set up an IT consultancy company in 1992. Each subscribed for one share, Mr Jones became director and Mrs Jones was company secretary. Mrs Jones dealt with the administration of the company and Mr Jones worked as an IT consultant; both drew a modest salary. Profits were distributed by dividend in accordance with the shareholdings, i.e. equally.

HMRC claimed that Mr Jones had made a settlement on his wife by taking a modest salary and distributing the profits by way of dividend. Mr and Mrs Jones appealed to the Special Commissioners and lost (although of the two commissioners sitting, they disagreed with each other). They also lost in the High Court, but the Appeal Court judges found in their favour. The House of Lords unanimously upheld the Appeal Court judgement.

Central to the case was the fact that Mrs Jones had subscribed for her share and had contributed to the business, drawing £3,000 in salary. Mr Jones also drew a moderate salary (£6,250), below his potential earning power, and HMRC considered that drawing such low salary from year to year (he had no service agreement) was an arrangement containing an element of bounty and therefore taxable on Mr Jones under the settlements legislation.

The taxpayer argued that Mrs Jones also contributed to the business and that it was only prudent to draw a low salary in the early years of a business. HMRC's assertion brought into question a private business owner's right to determine salaries, and indeed, sought to take us back to the period before 1990 when a husband was taxed on his wife's income.

Lord Carnwath pointed out that this the first time HMRC had sought to apply the settlements legislation to a normal commercial transaction between two adults, to which each is making a substantial commercial contribution, albeit not of the same economic value.

What happens now?
This was a decision in favour of Mr and Mrs Jones, based upon the circumstances of this case and businesses in this situation can celebrate. However, it should not be relied upon in the other circumstances outlined by HMRC.

It is unrealistic to believe that HMRC will become any more comfortable with the above situations than before. It is entirely possible that they may try to differentiate other cases. Indeed, they may seek legislation to bring what is generally regarded as acceptable tax planning into charge to tax.

This situation is not the only one potentially affected by the settlements legislation. HMRC have published a list of circumstances (in Tax Bulletin 64) where they would look at the situation with a few to invoking the legislation. These are:

• A main earner drawing a low salary leading to enhanced profits from which dividends can be paid to shareholders who are friends or other family members. The Arctic Systems case was a victory for the taxpayer, but similar cases may have different circumstances
• Disproportionately large returns on capital investments e.g. excessive rates of interest paid on loans
• Differing classes of shares enabling dividends to be paid only to shareholders paying lower rates of tax e.g. A, B, C, D etc. shares, some carrying higher dividend rights than others;
• Dividends being waived so that higher dividends can be paid to shareholders paying lower rates of tax. Waivers have to be made before a dividend is declared, so that leaves a higher profit available for future distribution;
• Income transferred from the person making most of the profit to a friend or family member who pays tax at the lower rates. (There is already legislation in place regarding diverting income to minor children).

Exemptions
There are exemptions from the legislation:

• Section 624 exempts situation where the property passed to a spouse is an outright gift, unless

1. the gift does not carry the right to the whole of the income arising, or
2. the property given is wholly or substantially a right to income.

It is important to remember that this legislation does not relate only to companies; it also relates to partnerships and trusts.

Action required
Review cases where there is a potential charge under the settlements legislation and make businesses that are potentially affected aware of the danger. Many of the situations outlined above have long been accepted as legitimate tax planning, but now taxpayers ignore them at their peril.

Contact businesses and make them aware of the victory, but ensure that they are aware of the details and specific circumstances.

Not all husband and wife, family or civil partnership companies will be affected. If a husband and wife set up a company and run it together, it does not follow that the husband will be taxed on the wife's dividends. It should be pointed out that this case was brought because of the fact that Geoff Jones had drawn a low salary. In similar situations, it would be wise to pay attention to the warnings set out above and keep family business transactions within the realms of what HMRC would class as commercial reality.

If you have filed tax returns on the basis that the settlements legislation did apply, the return should be amended by 31 January.

Further guidance
The case report is available here; you may find paragraphs 30, 31, 33 and 34 of particular interest.

The above paragraphs represent a summary of the case and you are recommded to seek further professional advice regarding the actual circumstances of your client's or your personal situation. CPD Resource Limited cannot accept responsibilty for your reliance on the summary as set out above.