Arctic Systems

Arctic Systems Ltd. Case Successful

The Jones succeeded in their three-year struggle to stop the Revenue reinterpreting tax law retrospectively

The House of Lords ruled on the 25th July 2007 in favour of Geoff and Diana Jones of Arctic Systems Ltd in a judgement that has removed a tax threat from thousands of family businesses throughout the UK.

The Jones succeeded in their three-year struggle to stop the Revenue reinterpreting tax law retrospectively. As the case was all about the extent to which Mr and Mrs Jones were able to organise their affairs tax efficiently, it is of widespread significance to companies that are jointly owned by a revenue earning spouse and a non earning spouse.

The company, equally owned by Mr and Mrs Jones, had a turnover of around £90,000 per annum, derived from Mr Jones's activities. Mr Jones drew a salary of £7,000, while his wife drew a salary for administrative work of £4,000, for which she worked approximately four hours per week. After expenses and corporation tax the couple shared the remaining £60,000 equally in dividends. As a consequence, the Jones' 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.

HMRC argued that Mr Jones' 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". That important exception comes from subsection 6 of s660A.

All five Law Lords 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.

Although Diana Jones bought her share in Arctic Systems, rather than being directly given it by Geoff, today's judgment treats this purchase as a gift, on the grounds that it was only possible because Geoff allowed Diana to buy the share. Gifted and purchased shares are therefore both within the scope of the exemption for gifts between spouses.

All five Lords therefore disagreed with the Court of Appeal, which had ruled that no settlement had taken place. Lord Hoffman observes: "I cannot agree that this was a "normal commercial transaction between two adults." It made sense only on the basis that the two adults were married to each other. If Mrs Jones had been a stranger offering her services as a book keeper, it would have been a most abnormal transaction. It was only "natural love and affection" which provided the consideration for the benefit he intended to confer upon his wife. That is sufficient to provide the necessary "element of bounty"." Having established that a settlement had occurred, however, they also established that it was exempted from the settlements legislation.

The judgment also observes that ordinary shares are not "wholly or substantially a right to income" and are therefore within the scope of the exemption. Lord Hoffman notes: "[Diana Jones's share] was an ordinary share conferring a right to vote, to participate in the distribution of assets on a winding up, to block a special resolution, to complain under section 459 of the Companies Act 1985. These are all rights over and above the right to income."

Professional advice should be taken on any situation involving anything not ordinary shares. Arrangements involving preference shares may not be exempted from the settlement legislation.

If your company has paid tax on the basis of being caught by the settlements legislation. You should contact your Accountant for advice on how HMRC will deal with S660a cases that are currently open, and what the Treasury intentions are going forward.
Conclusion

The result of the House of Lords judgment was unanimously in favour of the taxpayers. Accordingly, the very common arrangements, as practised by Mr and Mrs Jones, have been vindicated. That, of itself, removes a huge cloud from the minds of many couples and in turn vindicates the stance taken by practitioners and professional bodies.

It will mean that there is a need to recast HMRC guidance in this area and, of course, many people will be wondering whether HMRC will suggest that the law needs changing.

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