Family unfriendly

When the Lords threw out HMRC’s appeal against an income-splitting family business, the Government announced a change to the law. By James Johnston

In July this year the long-running saga of the family business ‘Arctic Systems’ tax case (known officially as Jones v Garnett (2007)) came to a close, with the House of Lords unanimously dismissing HM Revenue & Customs’ (HMRC) appeal. However, the Government’s immediate announcement to legislate as a result of losing this case means that the case’s impact for small owner-managed businesses structured in a similar way to Geoff and Diana Jones’s will be short-lived.

The facts of the case
Having been made redundant in 1992, Geoff Jones set up his own IT consultancy business. As IT agencies and other clients would deal only with limited companies, he needed to form a company to offer these services. Geoff and his wife each paid £1 for one share in Arctic Systems Ltd, which they acquired ‘off the shelf’ from company formation agents. Geoff was the sole director. Diana had prior experience of managing a company, so she acted as the company secretary and dealt with all the book-keeping and day-to-day administration, working around four or five hours a week. The company entered into contracts with customers to provide Geoff’s services as an IT contractor and the fees received constituted the company’s source of income. From the outset the couple was paid comparatively low salaries, with the balance of the company’s profit being extracted by way of dividends.

HMRC assessed Geoff to income tax in respect of the dividends paid to his wife on the basis that the dividends constituted ‘income arising under a settlement’ created by him. Income arising under a settlement in which the settlor retains an interest (and a settlor is treated as having an interest where their spouse benefits under the settlement) is treated as income of the settlor and taxed accordingly.

The definition of settlement for these purposes included “any disposition, trust, covenant, agreement, arrangement or transfer of assets”. HMRC’s case was that the acquisition of the company and the transfer of the share to Diana, enabling her to receive dividends that were expected to be paid, was an “arrangement”. It was not a transaction at arm’s length because the taxpayer would never have agreed to transfer half the issued share capital to a stranger who merely undertook to provide the paid services that his wife provided. This provided the necessary “element of bounty”. The arrangement meant that the entire income from the company was kept within the family, but gained the benefit of using Diana’s lower rate of income tax.

The Lords’ view
Having failed in his appeal against the assessments before the Special Commissioners and in the High Court, Geoff appealed to the Court of Appeal, which found against HMRC.

HMRC’s appeal to the House of Lords was dismissed in an unanimous decision by the five Law Lords who heard the case, although for reasons slightly different from those given by the Court of Appeal.

Their Lordships held that the arrangement entered into by Geoff and Diana constituted a settlement within the meaning of the tax legislation. It was not a normal commercial transaction between two adults and the arrangement entered into had the necessary element of bounty. The Court of Appeal had found that the issuing of the share to Diana was not a settlement because she had paid the par value of £1 for it.

However, their Lordships considered that, even though a settlement existed, it was covered by an exemption that excludes income from property which is the subject of an outright gift between spouses or civil partners. While the transfer of a share with expectations of dividends gave the transfer the element of bounty, it also made the transfer a gift for the purposes of this exemption. There was no dispute that, if it was a gift, it was an outright one. Diana subscribed for her share and had all the rights attributed to that share.

Geoff and Diana will clearly be able to celebrate the fact that their tax position for the years under review has finally been resolved, as will many owners of small businesses who have structured their companies in this way and whose tax positions for earlier years had also been uncertain while the case progressed.

However, any sense of victory was tempered by the fact that, on 26 July 2007, the day after the House of Lords delivered its judgment, a written ministerial statement was issued announcing the Government’s intention to legislate in this area.

“The Government is committed to maintaining fairness in the tax system. The case has brought to light the need for the Government to ensure that there is greater clarity in the law regarding its position on the tax treatment of ‘income-splitting’. It is the Government’s view that individuals involved in these arrangements should be taxed on what is, in substance, their own income and that the legislation should clearly provide for this.”

If you don’t like it, change it
It is interesting to compare the present Government’s view of what constitutes ‘substance’ against the attitude of the courts in areas such as divorce and bankruptcy.

In October 2003, in response to earlier criticism from professional bodies, including the Chartered Institute of Taxation (CIOT) and the Society of Trust and Estate Practitioners (Step), HMRC issued a note concerning the settlements legislation and small businesses in light of the case. In formulating their replies, the professional bodies reviewed the Hansard Debates on the introduction of the independent taxation of spouses during the passage of the 1989 Finance Bill.

In the debates, Norman Lamont had stated that the settlements legislation would be applied when there were transfers only of income between husbands and wives. He also acknowledged that “independent taxation is bound to mean that some couples will transfer assets between them, with the result that their total tax bill will be reduced. This is an inevitable and acceptable consequence of taxing husbands and wives separately… We have made it clear that we expect income-splitting will occur” and “provided that a gift of assets between husband and wife is free from conditions and is a complete and irrevocable transfer of the underlying capital as well as the income, we see absolutely no case for imposing a tax penalty on the income from those assets”.

More generally, the case highlights the difficulties faced by individuals and small businesses in navigating the complexities of the UK tax system. The legislation considered in the case is now contained in the Income Tax (Trading and Other Income) Act 2005, being part of the Tax Law Rewrite project, the primary aim of which is to rewrite UK primary legislation to make it clearer and easier to use. It often feels a forlorn hope. Advisers in this area can now look forward to another consultation exercise and further amendments to the settlements legislation.

It is difficult enough for specialists in this field to interpret and keep up to date with continual changes in the legislation. How can individuals who spend their time and energy running their businesses be expected to understand how the tax legislation applies to them without engaging expensive professional advisers at every turn? And when, one wonders, will the Government’s appetite for introducing new tax legislation ever be satisfied?

James Johnston is head of private client at Bircham Dyson Bell