New CIS' to be Delayed a Year

Geoff Jones of Arctic Systems has won his landmark Section 660A appeal in what may well go down as the Tax Case of the Century. The case had previously been won by HMRC at the Special Commissioners and the Court of Appeal but on appeal to the High Court in November, Sir Andrew Morritt, with Lord Justices Keene and Carnwath delivered judgement on 15th December in favour of the taxpayer.

This is the fantastic news for the UK's small family businesses as the facts of the case are not that dissimilar to many husband and wife set ups where one is the main earner but income is diverted to the other, so avoiding higher rate tax.

HMRC estimates that up to 30,000 family-run companies could have similar arrangements to that of Mr & Mrs Jones and that the ruling will cost £240million in lost revenue. However, the Professional Contractors Group, which funded the text case, thinks more companies will benefit and estimates that the amount of tax at stake at £1billion.

Facts of the case
Mrs Jones was a catering manager with skills in financial and business management and Mr Jones was an IT specialist.
They decided to start an IT business together, and were advised by their accountant set up Arctic Systems Limited and for them to have half of the shares each in the company. Mr Jones was made director and Mrs Jones secretary.
Mr Jones worked as an IT contractor, and Mrs Jones did the office side of things. They took minimal salaries and the balance in dividends.

The Revenue argued that the setting up of the company, the payment of less than market salaries, and the payment of dividends, enabled Mrs Jones to share earnings which were solely those of her husband, and so was caught by the settlements legislation. The arrangement enabled Mr Jones to save tax by diverting a share of his income to his wife thus avoiding higher rate tax by using up her basic rate tax band. HMRC believe that Mrs Jones's salary (which works out at about £5 per hour) was commensurate with her duties and skills (she worked 4 to 5 hours per week), and Mr Jones' salary, was not at "market rate"and by not taking a "market rate" salary, there is evidence of him foregoing income for the benefit of his spouse.

In a nutshell the relevant part of the settlements legislation says if you give something to your spouse that is not wholly or substantially a right to income, any income that does arise will be treated as their income for tax purposes.

The taxpayers argument goes that giving your wife a share in your partnership or some ordinary shares in your company as with Mr & Mrs Jones is not just a right to income but also to capital because they now become entitled to a proportion of the assets when the business is closed down or would be on a divorce. Therefore it is not just a right to income. HMRC have of course been arguing otherwise.

The Judgement & Reaction
The court found that HMRC was attempting a clear extension of the scope of the legislation and concluded that the law simply does not say what the Revenue was claiming it did. The court also acknowledged that the formation of Arctic Systems was a bone fide commercial arrangement.

The Chancellor of the High Court found that "the dividends paid to Mrs Jones on her share in the Company were not income arising under a settlement". Even if the share had been property comprised in a settlement, Section 660A did not apply because "there was no outright gift of the share from Mr Jones to Mrs Jones" and even if there had been, "the share was not substantially a right to income".

Lord Justice Keene observed that the fluctuating fortunes of Arctic Systems over time meant that the argument about a settlement existing because bounty had been anticipated at the time of the company's formation was not persuasive. He noted that the salaries drawn by Geoff and Diana varied from year to year, depending on how the company
performed and concluded that "it is difficult to regard such a protean state of affairs as capable of being part of an arrangement in the sense used in the legislation". He added that for a commercial venture such as Arctic Systems to be brought within the provisions of the settlements legislation "would represent an unjustified extension of their scope".

The third judge, Lord Justice Carnwath, also agreed that HMRC's position was not supported by statute. He said, "For the first time, they seek to apply the concepts to what has been found to be a normal commercial transaction between two adults to which each is making a substantial commercial contribution, albeit not of the same economic value."

There was not a settlement, and this case is distinguished from the leading case authorities on settlements by the lack of any contractual agreements on the set up of the company, Arctic Systems Ltd. Mr and Mrs Jones were found to have set up a company jointly, and at that time Mrs Jones received no bounty. There were no service agreements and the payment of dividends was not agreed in advance, it was dependent upon the future trading fortunes of the company. There was no certainty as to the outcome or even that income might be derived from the venture. Nothing in the structure guaranteed profits.

Payment of modest salaries was not accepted as part of any arrangement, as there was no service contract or employment contract. Geoff Jones as director had not decided in advance as to what level of salary or dividends might be paid at some time in the future.

These factors distinguish this case from the other authorities relied on by HMRC.

Jones, who was at the Royal Courts of Justice with his wife Diana, said, "This is the end of three years of uncertainty for us -- at one point we thought we'd lose our home. It's been extremely stressful and we've been made to feel like criminals, just for running our own business. What's more, by organising our affairs in this way, we were simply following government advice and that of our accountants."

Lord Justice Carnwath's said 'if the legislature wishes [a setup like Arctic] to be brought within a special regime for tax
purposes, clearer language is necessary to achieve it.

What happens now?
The court refused HMRC permission to appeal, which means that should they decide to appeal, they will have to approach the House of Lords directly. We will have to wait to see what the Revenue so next. This is something that they may well consider in the next few weeks as they analyse the judgment.

Until the dust settles and more is known of how the Revenue intend to react our guidance to businesses in a similar situation to that of the Joneses should is...

Taxpayers will of course want to take advice in the context of their individual circumstances, and this advice is provided for
general guidance only. Please contact us for advice in your own situation.

Click here to read a full copy of the judgement.

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