The Arctic Battle

David Nash reviews the recent case heard by the House of Lords regarding the taxation of the husband and wife company, Arctic Systems Limited.

In 2004 the case of the husband and wife company, Arctic Systems Limited was heard at the Special Commissioners and after progressing through the courts, the House of Lords on 25 July 2007 found in favour of the taxpayers Mr and Mrs Jones.  On Tuesday 26 July 2007 the Treasury issued the following statement in response to the decision. 

“The case has brought to light the need for the Government to ensure that there is greater clarity in the Law regarding its position and the tax treatment of “income splitting”.  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 that this is the case.”

The issue is likely to create uncertainty going forward for many family businesses.

The Facts

To recap, Arctic Systems is an IT Consultancy company set up by Mr and Mrs Jones who each owned one share.  Mr Jones provided IT consultancy advice and Mrs Jones’ role was as secretary.  She received a reasonable pay for her work, whilst he was paid a salary below market rate.  The remainder of profits were paid out via Dividend and as the only Director, Mr Jones could decide when this would be paid and how much.  HMRC’s argument was that dividends arising in the name of Mrs Jones should be taxed as Mr Jones’ income and that he had effectively created a settlement in favour of his wife.

Judgements

HMRC won the case at the Special Commissioners and again at the High Court.  As the case progressed, the Court of Appeal found in favour of the taxpayers, as was the case at the final hearing at the House of Lords.

The House of Lords agreed that the arrangement did constitute a settlement.  The point of law on which the taxpayer relied on was the spouse exclusion in Section 660A (6) ICTA 1988.  Whilst the House of Lords agreed the acquisition of Mrs Jones’ share in Arctic Systems did constitute an outright gift by Mr Jones, they ruled this exclusion applied due to the ordinary shares constituting more than simply a right to income as they carry voting rights, assets on winding up etc.

Longer term, the Income Tax and NIC benefits which have been enjoyed when operating a business through a private Limited company are likely to be adjusted and ultimately, the benefits may reduce.  Owners of current and future small businesses should take the time to consider the most appropriate business structure for their circumstances.

DAVID NASH