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Just When You Thought it was Safe to Have a Family Business … The Chancellor’s Revenge for Arctic Systems

Just When You Thought it was Safe to Have a Family Business … The Chancellor’s Revenge for Arctic Systems
There was a chilling announcement in the Pre Budget Report, warning us that legislation would be introduced in the next Finance Act to counter “income splitting”, with effect from April 2008.

 

This was not exactly unexpected. Ever since HMRC’s humiliation in the House of Lords in the summer, when the Arctic Systems case was decided in favour of the taxpayers, we have been waiting for the backlash from the taxman.

 

The Arctic Systems case involved a standard type of tax planning that has been used for many years by family businesses. Mr Jones was an IT consultant and he set up Arctic Systems Ltd as the vehicle to run his business. He and his wife owned 50% of the share capital each and most of the business profits were extracted by way of dividends.

 

This makes sense, because for a 40% taxpayer the effective rate of income tax on a dividend is 25%, compared to the 41% tax (that is 40% income tax and 1% NIC) payable on a salary from the company, and the 12.8% employers NIC the company has to pay. For a company with profits of less than £300,000, significant tax savings could be made.

 

HMRC decided in 2003 that what had previously been regarded as normal tax planning was in fact unacceptably sophisticated tax avoidance, and tried to use the “settlements” legislation to charge Mr Jones to tax on the dividends paid to his wife (she was a basic rate taxpayer and so had no income tax to pay on her dividends).

 

After a battle through the courts, the Joneses were finally victorious in the House of Lords and the very next day the Treasury announced that they were going to look at ways of changing the law to nullify that victory. If you can’t win, change the rules!

 

This is not the place to look at the technicalities of the Arctic Systems case, particularly as they are presumably going to become irrelevant as a result of the proposed legislation. It is also not the time to look at that new legislation because it has not yet been published. I want to focus on the injustice and inconsistency of this attack on the family business, and I want to make four simple points:

 

The use of dividends as in Arctic Systems was not “tax avoidance”. It was normal routine tax planning and was encouraged by Gordon Brown in 2002 when he slashed the rates of corporation tax for small companies.
 

The House of Lords in their judgement described the way the current “settlement” rules work as “workable and fair”. I very much fear that whatever anti-avoidance legislation is introduced will be so complex as to be unworkable – I already know it will be unfair!
 

We are told there will be “consultation” on the new legislation. If that is the case, why has it not been published yet? It is over three months since the Treasury made the threat and if they can rewrite the rules for IHT in a week in response to the Conservative Party’s announcement, then surely they can draft this legislation in time for the Pre-Budget Report? I fear that any “consultation” will be meaningless, given the short time available before the Budget in March
 

It is vital to remember that this will be an attack on small family businesses – the use of dividends does not benefit a company or its shareholders if the company’s profits are over £300,000, because then a salary is (just) more tax efficient than a dividend. Big business gets its corporation tax rate cut to 28% and the small family company is going to get hammered.
 

If there are two words that send a chill down my neck when used by a Chancellor, they are “simplicity” and “fairness”.

 

“Simplicity” (as you will see in my article about capital gains tax) is another word for taking away tax reliefs, and “fairness” usually means creating an unworkably complex set of rules to counter something that used to be tax planning, but which the spin doctors have decided is now tax avoidance.

 

The Chancellor is desperate for more money, but it is politically impossible to do the obvious and increase rates of tax. Instead, as with pensions in the late nineties, he hides a tax increase behind a smokescreen of “reform”.