August 2007

Victory for Taxpayer!

Arctic Systems result sends a chill through HMRC
Many businesses will be breathing a sigh of relief following the landmark decision by the House of Lords in the Arctic Systems case.

You have no doubt heard of the case. It has been in the press for almost four years now as it has proceeded through the various courts. A decision was made on 25 July, by the House of Lords, that the Appeal by HM Revenue and Customs has been unanimously dismissed and the taxpayers (the Joneses) have emerged victorious.

The case revolves around husband and wife companies and whether the shareholding of ordinary shares can be structured in such a way to ensure that dividends can be paid to both spouses to avoid national insurance and ensure tax efficiency by utilising both basic rate bands.

HMRC argued that there was a "Settlement" by Mr Jones to Mrs Jones which consisted of "wholly or substantially a right to income". Furthermore, because Mrs Jones paid £1 for her share on the formation of the company, HMRC argued that there was no "outright gift", merely an acquisition at under market value and, therefore, any dividends paid to Mrs should be taxed on Mr.

Five Lords presiding over the case all dismissed HMRC's appeal on the basis that a gift of "ordinary" shares carries far more rights than income, such as:

As ordinary shares are not "wholly or substantially a right to income", the gift is specifically exempt from the Settlements Legislation and, therefore, the dividends should remain taxed on Mrs Jones.

On the point of whether there had been a gift, Lord Neuberger commented that "a purchase at an undervalue involves..., an element of gift... Once one accepts that there is a gift, it seems to me that the word "outright" is of no assistance in connection with this point."

In other words, if there is any element of gift (for example, transfer at undervalue), it is sufficient to trigger the exemption for inter-spouse transfer.

Since the start of the Arctic Systems case, there has been a concern that, if HMRC were successful, they could seek to apply the Settlements Legislation to all husband and wife companies. The decision, however, has shown that HMRC were wrong in their interpretation of an old piece of legislation.

As a firm, we have always considered the risk to be lower where there is a substantial capital asset base to the company, for example, freehold property or retained profits, as this clearly shows that there is more than just a right to income attached to the ordinary shares.

Until this Judgement, there has been more concern as regards personal service companies, where one spouse may generate the income, whilst the other performs ancillary services, such as bookkeeping, payment of bills, tax, etc. However, there are two key quotes within the Judgement that indicate that, like Arctic Systems, personal service companies are also outside the Revenue's clutches.

Lord Hope of Craighead stated that "the question whether the property given to Mrs Jones was wholly or substantially a right to income cannot depend on the state of the affairs of the company at time of the gift". In other words, a strong capital base at the date of gift is not necessary to become exempt.

He further comments that "so long as the shares from which that income arises are ordinary shares, and not shares carrying contractual rights which are restricted wholly or substantially to a right to income, the settlement with fall within the exemption....."

HMRC will not be able to appeal this decision within the UK courts, and we have no reason to believe that they will take it to Europe. The more likely consequence is a reconsideration of small company taxation!

In the meantime, however, husband and wife companies can sleep easy in the knowledge that they will not be faced with a Revenue enquiry into their company's shareholding structure. Although it is clear that HMRC are not happy with the decision and changes to the legislation are expected, perhaps in the Pre-Budget Statement.

Mr and Mrs Jones should receive a huge amount of credit for their services to small businesses in the UK. Four years, two decisions for the Revenue along the way, astronomic costs (although a fighting fund was set up by various professional bodies) and a great deal of strain, but the result has ultimately proved worth it.

Whilst the decision is clear, any changes to shareholding through a transfer between husband and wife should not take place without professional advice. Although it appears such gifts are outside the Settlements Legislation, further tax issues can arise.

For further information contact Nick Haines on 01242 237661 or e-mail nmh@hazlewoods.co.uk