Life After Arctic

On 25 July 2007 the House of Lords ruled unanimously in favour of the taxpayer in the long-running saga of Jones v Garnett, better known as the Arctic Systems Ltd case. However, almost before the bubbles were flat on the champagne of this great victory for commonsense the Government announced it would look to legislate. So where exactly does that leave taxpayers and what advice can we sensibly give to them?

The case in brief

Unless you have been away from a tax for a very long time, you are probably pretty familiar with the facts of Jones v Garnett so here is just a very brief recap. The husband and wife team of Mr and Mrs Jones decided to set up a business together. After taking advice from their accountant they decided to operate through a limited company and both purchased one ordinary one pound share in an off-the-shelf company called Arctic Systems Ltd. They each drew small salaries but for the years in question distributed the majority of their income in the form of a dividend, which they shared equally, reflecting their holding in the company. This behaviour mirrors that of many thousands of other businesses across the UK, which explains the huge interest in the outcome of this case.

Mr Jones was a higher rate taxpayer but his wife paid tax at a lower rate. As Mr Jones did the majority of the work in the business Her Majesty's Revenue & Customs (HMRC) argued that the dividend being received by Mrs Jones was in reality income that should have been taxed on her husband and sought to claim the tax difference. In order to achieve this, HMRC relied on the settlement provisions, which used to be found in s 660A, ICTA 1988 and are now in s 619 onwards of ITTOIA 2005. It argued that Mr Jones had ineffectively tried to divert income to his wife and sought to reallocate the dividend from Mrs Jones to Mr Jones and recover the extra tax due.

The taxpayer lost at the Special Commissioner and High Court. The tide turned at the Court of Appeal and now in the House of Lords all five Law Lords hearing the case found in favour of the taxpayer and rejected the appeal by HMRC.

Each took a slightly different approach in reaching their decision. but broadly the House of Lords did accept that in this case there was a settlement within the meaning of the legislation. This means that dividend reallocation was possible in theory. However, the judgement showed that Mr and Mrs Jones were exempt from the charging provisions due to the specific exemption available for certain transfers between married couples (and civil partnerships) as found in the former s 660A(6), ICTA 1988.

Current position

The House of Lords decision is now the applicable law to follow. This means that for those clients whose facts are akin to Mr and Mrs Jones the settlements legislation does not apply to them and they do not need to take any action.

It also means that most of the existing HMRC guidance, as outlined in its booklet 'A guide to the settlements legislation for the small business adviser', is no long valid. This guidance was issued in 2004 and never updated for subsequent decisions in the Jones v Garnett case. The only evidence that it might not be the whole story is a caveat on the front of the guidance about the case still not being final. The guidance includes a number of examples with a HMRC interpretation. Many of those interpretations do not accord with the House of Lords judgment and thus should not be followed. HMRC is expected to issue new guidance although no date has been given for when this will be published.

However, this is not the end of the story. The day after the Court hearing the Government, in the form of the Exchequer Secretary to the Treasury, Angela Eagle, announced an intention to legislate to change the effect of the House of Lords decision. The statement goes as follows:

'The Government acknowledges the judgment given by the House of Lords in the Jones v Garnett (Arctic Systems) case. The Government is committed to maintaining fairness in the tax system. The case has brought to light the need for the Government to ensure that there is greater clarity in the law regarding its position on the tax treatment of "income splitting".

Some individuals use non commercial arrangements (arrangements that they would not reasonably enter into with an arms-length third party) to divert income (which would, in the absence of those arrangements have flowed to them) to others. That minimises their tax liability, and results in an unfair outcome, increasing the tax burden on other tax payers and putting businesses that compete with these individuals at a competitive disadvantage.

It is the Government's view that individuals involved in these arrangements should pay tax on what is, in substance, their own income and that the legislation should clearly provide for this. The Government will therefore bring forward proposals for changes to legislation to ensure this is the case. In the meantime, HMRC will apply the law as elucidated by the House of Lords and will be providing guidance in due course.

The Government would not want commercial arrangements to be caught by any change to legislation. Consultation should help to ensure this.'

Putting aside the spin, this Statement is probably no surprise to those who have followed the case and always assumed that if the taxpayer won, action would be taken to change the ground rules for owner managed businesses. What it does provide is some pointers to be aware of in this area as follows:

We still remain in a state of flux when advising in this area. There is sadly still no certainty or clarity for small businesses when determining how to incorporate. We have been promised some HMRC guidance post-Arctic and Government will offer some form of consultation process before it makes any changes. This will at least provide pointers for future change. Where possible it seems sensible to wait and see what the next few months offer before taking any action on existing situations. However, you should be aware that change is likely.

The current state of the law is as set out in the House of Lords decision. Nevertheless, if your circumstances differ from the facts of Jones v Garnett (eg it doesn't involve a husband and wife) the Court did find that a settlement existed and you might therefore be subject to attack by HMRC under the settlements legislation, if relevant.

For those whose facts differ sufficiently from Mr and Mrs Jones, it may be worth considering the available options. For example, is the salary/dividend split too provocative? Is there a way of restructuring the entity to leave it more robust in light of any future enquiries? Whether any decisions are required will depend on the facts of each case.

A business looking to incorporate now would want to think carefully about the salary/dividend structure but equally would not want to make itself uncompetitive. There is no simple solution here as we need to know what the Government has in mind for future legislation. Clearly careful thought will be required where there is a non-active spouse who may be offered shares in a business.

The future

It is more than disappointing that the House of Lords decision has not proved to be the end of the saga for those many thousands of husband and wife businesses that have been waiting with bated breath for its conclusion. The various tax representative bodies, such as the Tax Faculty of the ICAEW, are already in touch with the Treasury to see if a sensible way forward can be found but it looks like yet more months of uncertainty for small businesses that would much prefer to be able to spend their time on their enterprises rather than worry about their tax position.

The only positive aspect is that it might lead to a renewal of the small business review which was launched in 2004 and so far has done no more than raise the small companies rate of tax. There are anomalies and oddities in the taxation of these entities and a sensible review, with full consultation, discussion and time to consider the practicalities could be of great use as opposed to any quick knee-jerk reactions to the Arctic decision.