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The “Arctic Systems” Case – Good news for family businesses!

The “Arctic Systems” Case – Good news for family businesses!
In November 2005, the Court of Appeal heard a tax appeal that was of vital importance to family businesses in the UK. They found against the Inland Revenue and in favour of Mr & Mrs Jones, the proprietors of Arctic Systems Ltd.

 

At the time of writing, it is not clear if this case will go on to the House of Lords, or whether it is now settled, but for the time being at least, it has been a victory for the family business against what most tax advisers considered to be an unjust attack by the Inland Revenue.

 

To understand the importance of the case, we first need to understand the tax legislation about “settlements”. Essentially, this says that if I try to transfer some of my income to my wife or to my children under 18, for tax purposes it will still be treated as my income. This legislation is designed to frustrate schemes to use all the family’s annual allowances and lower rates of tax against what is in reality only the income of one member of the family.

 

There is however an important exception to this rule, which says that it does not apply to an outright gift from one spouse (or Civil Partner) to another, provided that all the income produced by the property goes with it to the spouse, and provided that the property given is not “wholly or substantially a right to income”.

 

This used to be taken to mean that if, for example, a wife was given shares in the family company by her husband, the income from them was hers, and the “settlements” rules would not apply to treat it as still being his.

 

The only exception to this was thought to be “funny” shares that tried to exploit the legislation by transferring income without giving any real ownership of the company itself. For example if the husband gave his wife shares which had no voting rights, and no right to any of the proceeds if the company was sold, but just received an annual dividend of a fixed amount (often, surprisingly, exactly equal to her annual tax-free allowance and lower rate band of income tax!), then this was “wholly or substantially a right to income” and the legislation treated it as still taxable on the husband.

 

As a result, it was standard advice to a husband and wife setting up a company to divide the shares between them, so that the profits could be paid out to them as dividends and both their lower rate bands for income tax could be set against the income.

 

Recently, the Inland Revenue has been arguing that in many cases this arrangement is caught by the “settlements” legislation after all. They have used a variety of more or less ingenious arguments to justify this – for example, they have said that if the husband is the main earner for the business, and if he does not take a “realistic” salary for his efforts (on which he would have to pay National Insurance Contributions and Income Tax), then by doing without this salary he was effectively giving his wife a “right to income” because the company could now afford to pay her larger dividends.

 

Mr and Mrs Jones were the unlucky couple whose company, Arctic Systems Ltd, became the test case for this new attitude of the Inland Revenue. It became clear that not only did the Revenue believe that the income for the current year could be treated this way, but Mrs Jones’ dividends for the last six years could be taxed on Mr Jones as well, on the basis that the “settlements” legislation had been there all the time. In the Jones’ case the six years were dropped early on, but only because of a technicality that would not have helped other companies if the Revenue’s view of the situation proved to be correct.

 

The case went to the Special Commissioners (an independent body who adjudicate on disputes with the Inland Revenue), where the Revenue won their case. Mr & Mrs Jones appealed to the High Court, where once again the Revenue won.

 

At this stage, many couples who owned companies could have been facing potentially crippling tax liabilities for the previous six years, even though all they had done was take the advice of their accountants on what was generally thought to be a normal and completely innocent form of tax planning.

 

The Inland Revenue published “guidance” demanding that either their tax returns were prepared on the basis of this new view of the law (thus in many cases treating dividends paid to one spouse as being taxable on the other), or that they at least notify the inspector that they had not done so, and thus made themselves liable to a tax investigation.

 

The Revenue was even insisting that the same principle applied to family partnerships where only one spouse was the main earner.

 

Fortunately, when the case reached the court of appeal in November 2005, the Revenue’s case was thrown out. The report of the case makes enjoyable reading as an example of a demolition job on what I always thought were very spurious arguments on the Revenue’s part, but for those readers with better things to do than study tax cases, the essential points were:

 

? An ordinary share in a company is not “wholly or substantially a right to income” so a gift of such shares to a spouse is not caught by the “settlements” legislation

? The fact that one shareholder spouse chooses not to take a commercial rate of salary from the company is not a “settlement” on the other shareholder spouse, except in the very rare case where there is a legal agreement in place to fix his salary before the shares are given to the other spouse.

 

The Court also refused the Revenue leave to appeal to the House of Lords, but the way the process works means that at the time of writing it is not certain whether they will be able to get round this. If the case does go to the Lords, we must hope that they will agree with the Court of Appeal.

 

For the time being, however, it looks as if we tax advisers have been right to tell couples to arrange their family businesses in this way, and that the Inland Revenue’s attempt to pretend that the law worked in a different way has been a resounding failure for them.

 

There is of course another possible cloud on the horizon – there have been cases in the past where the Inland Revenue have responded to defeats in the Courts by getting the government to change the law to suit their view of the matter, and the next Budget is due to be delivered in March 2006…….watch this space!