BACKGROUND TO THE CASE

The Jones v Garnett (Arctic Systems Ltd) case concerns the tax treatment of a husband and wife owned company - the alleged 'married couples business tax'. It has been a controversial and important case concerning the way small business income is taxed, with HM Revenue & Customs (HMRC) believing that unacceptable arrangements had been made in order to reduce the overall tax liability of the husband and wife concerned.

The company, equally owned by Geoff and Diana Jones, had a turnover of £91,000 for one particular year, 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.

This sort of arrangement has been very common and indeed all but routine advice for couples running a business. No doubt many readers will recognise aspects of it; why then did HMRC object?

WHAT'S WRONG WITH IT: THE TECHNICAL ARGUMENT

Clearly Mr and Mrs Jones were saving tax by their way of managing their business affairs. Most would say they were just taking advantage of the opportunity to run their affairs tax efficiently: not a loophole but something that followed from some key principles - that husbands and wives are taxed separately; and businesses are taxed differently from employees.

HMRC's technical argument was that Mr Jones' actions in setting up the company, allowing his wife to subscribe for an ordinary share and the general arrangements, all constituted a 'settlement'. Under anti-avoidance rules, the income of a settlement can be treated as that of the settlor (i.e. Mr Jones) in some cases; this is the source of the rule that stops parents putting taxable income into the hands of their young children apart from £100.

As far as husband and wife (or civil partners) are concerned, the settlement rules don't operate unless the property given is “wholly or substantially a right to income”.

HMRC ASSESS

HMRC assessed Mr Jones on six years' worth of dividends paid to his wife by Arctic Systems Ltd, producing a tax bill of around £42,000 once interest had been added. Note that there was never any dispute about the salary paid to Mrs Jones - it has always been perfectly acceptable (and sensible) for small businesses to pay all those involved at appropriate rates. Mrs Jones did work for the company, supported Mr Jones, and deserved reward for her efforts. What was at issue was the amount paid to Mr Jones: HMRC would have been happy if he had been paid a substantial salary (whatever that was) by the company, leaving just a small profit to be paid out as dividends to the co-owners.

One point worth noting at this stage is that companies that had significant assets - perhaps a shop owned by husband and wife - wouldn't be caught by this new approach. That's because when the shares in the company were allocated, even if the husband was making a settlement, it wouldn't be just a gift of income but would involve the assets owned by the company as well.

PROGRESS THROUGH THE COURTS

The Jones's first appeal to the Special Commissioners produced a finding in favour of HMRC and this was upheld at the High Court. However, the Court of Appeal found for Mr and Mrs Jones, saying that although there may have been an arrangement between the taxpayers (in setting up the company in the way they did) the arrangements didn't confer a 'bounty' at that stage, so there could be no settlement. Even if there was a settlement, it wasn't something that was 'wholly or substantially a right to income' as the share gave other rights.

The House of Lords has now upheld the Court of Appeal, albeit on slightly different grounds. They did think there was a settlement - there was that element of bounty - but they agreed that it wasn't just about income. The arrangement fell into the exception in the settlement rules and Mr and Mrs Jones were vindicated. So were many advisers and professional bodies: there has been a virtually unanimous chorus from the tax profession that HMRC were wrong in their contention.

The view of bodies such as the Chartered Institute of Taxation (CIOT) has all along been that there were three broad issues with the HMRC stance:

• Technical - that as what was involved was an ordinary share, conferring a right to vote, participate in the distribution of assets etc., then it could not be just a right to income
• Practical - if what they expected was the right amount of income to be paid to the Mr Jones of this world, how could one accurately assess that?
• Retrospection - this case seemed to represent a change of stance from the taxman, challenging an arrangement that had been used for many years. Although at times HMRC justified their argument by saying that the settlements rules had been around since 1936, this was rather specious in that they didn't become relevant to couples until the 1990s and separate taxation of husband and wife!

HMRC have said they will accept the decision and issue new guidance. There have been a number of statements and notes from HMRC and professional bodies alike in terms of how to handle the issue.

There may be couples who are due a repayment. One of HMRC's contentions has been that they have regularly taken cases similar to Arctic Systems and settled with taxpayers - though many advisers were unaware of this being the case. Those taxpayers may well be due a repayment, depending on their circumstances and anyone in that situation should undoubtedly be talking to their tax adviser.

This doesn't signal a free-for-all in tax planning. There was a case a few years ago where an established, profitable company, owned and run by two men, arranged to give their respective wives a block of preference shares. Those shares didn't carry votes or any other rights other than a right to the preference dividend. It was held that that arrangement was a settlement and it was simply of a right to income - so the preference dividends fell to be taxed on the husbands. That case wasn't overturned in any way by Arctic Systems.

But this new case does reiterate that couples can make use of what the tax system allows to minimise their tax bills. That is as it should be: whilst people faced with PAYE operating on their salaries may feel that there is an unfair advantage here, the fact is that the tax system operates differently between employees (who have lots of support and rights from their employers) as against small businesses (who are fundamentally on their own and usually end up paying various other taxes such as VAT and business rates).

THE FUTURE

Any euphoria for taxpayers and their advisers was short lived. The government has already announced it will change the law to reverse the effect of the House of Lords' decision. That is not entirely unexpected but the immediacy of announcement is disappointing; any changes need careful consultation. Changes need to have regard to those principles set out earlier - including the freedom of married couples to arrange things tax efficiently. Would there, for instance, suddenly become a block on transferring assets tax-free to help plan for capital gains tax or inheritance tax? Or might we see national insurance imposed on dividends? Those would be major changes that would have wide ramifications. It's not clear when changes will be made from - probably next April.

In the meantime, Mr and Mrs Jones will hopefully be able to recover their costs, tear up their tax bill and get back to their real job of running an IT consultancy.

John Whiting is a member of the Chartered Institute of Taxation. The Chartered Institute of Taxation is the main professional body concerned solely with taxation. www.tax.org.uk.

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