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Arctic Chill

FRANCESCA LAGERBERG considers the Government reaction to the Jones v Garnett decision in the House of Lords


  • A review of the case.
  • The Government's commitment to 'fairness'.
  • Legislating to ensure that the 'right amount' is paid.
  • Will consultation be serious and effective?
  • What happened to the original plans for independent taxation?
  • How is small business taxation served by such cases?

Imagine you are 5-0 up in the biggest and you believe last football game of your life. The referee is just about to blow the whistle for the end of match and all that remains for you to do is to pick up the cup, do the victory circuit and then hang up your boots and retire gracefully.

Suddenly, someone steps on to the pitch, moves the goalposts ten feet to the left and rules that the last 90 minutes really weren't the right way to play the game and from now it will be played under different conditions. That is how Mr and Mrs Jones must be feeling.

After all their perseverance in fighting on for over four years in a case that affects thousands, what was their reward for winning in the House of Lords with a unanimous verdict? The very next day a Ministerial statement was released stating that legislation is being considered to reverse aspects of the final judgment. But what does this really mean for businesses and where does this case leave us when we are advising those in a similar position to Mr and Mrs Jones?

A recap on the case

The House of Lords decision in the case of Jones v Garnett, which is perhaps better known as Arctic Systems, was covered in depth in last week's issue of Taxation by Mike Truman. That set out the key facts, namely that the husband and wife team of Mr and Mrs Jones worked through a limited company in which they both owned one share. They each drew small salaries, but for the years in question distributed the majority of their income in the form of a dividend, which they shared equally, reflecting their holding in the company. This reflects a company holding structure that is mirrored in many thousands of other small businesses around the UK.

Mr Jones was a higher-rate taxpayer, but his wife paid tax at a lower rate. As Mr Jones did the majority of the work in the business, HMRC argued that the dividend being received by Mrs Jones was, in reality, income that should have been taxed on her husband and sought to claim the tax difference.

HMRC used legislation known as the settlement provisions which used to be found in TA 1988, s 660A and is now in ITTOIA 2005, s 619 et seq. The tax authority sought to reallocate the dividend from Mrs Jones to Mr Jones and recover the extra tax due. All five Law Lords hearing the case found in favour of the taxpayer and rejected the appeal by HMRC.

The judges' approaches

Each took a slightly different approach in reaching their decision. They were unusually keen to put down in words exactly what their view on the case was. There was none of the more short and simple 'I agree' statements from the concurring judges backing up the main opinion. It seems in this case everyone wanted to get on the record with their view.

Broadly, the House of Lords did accept that in this case there was a settlement within the meaning of the legislation, but that Mr and Mrs Jones were exempt from the charging provisions due to the specific exemption available for certain transfers between married couples (and civil partnerships) as found in what used to be TA 1988, s 660A(6).

This decision in itself means that most of the existing HMRC guidance, as outlined in its booklet, A guide to the settlements legislation for the small business adviser, becomes defunct. This guidance was issued in 2004 and never updated for subsequent decisions in the Jones v Garnett case.

The only evidence that it might not be the whole story is a caveat on the front of the guidance about the case still not being final.
However, what seemed on 25 July 2007 like the conclusion to a long and difficult chapter in tax history looks as though it will be just a staging point in the taxation of small businesses. On 26 July 2007, the Exchequer Secretary to the Treasury, Angela Eagle, who has taken over the responsibilities formerly undertaken by Dawn Primarolo MP, announced the intention to legislate to reverse the effect of the decision.

The Government view

Now of course it is entirely right and proper for Government to decide policy and to make changes when they are appropriate. It has every right to look at tax cases and take a view that they have highlighted the need for change in the legislation. We also knew that the Treasury was keeping a close eye on this case. The Budget 'Red Book' included a clear reference to how it would take action on 'tax-motivation incorporation' if required (see paragraph 5.113).

However, the statement issued by the Minister was one of those which, if you weren't an animal loving character, might make you want to kick the cat. It was so full of spin that a washing machine manufacturer could only observe it with envy.

The statement talked about the Government being 'committed to maintaining fairness in the tax system', a comment which is becoming synonymous with leading to yet more complex and impenetrable legislation.

The statement went on to note that the Arctic Systems 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”'.

Clarity and certainty is exactly what small businesses have been requesting for many years. Back in 2004, a small business review was launched by the Treasury and there was an optimistic hope that this would give rise to a thorough review of some of the anomalies in the way smaller businesses are taxed; e.g. the differences in the treatment between unincorporated entities and companies.

However, the review seems to have produced nothing of marked significance except of course the increase in the small companies taxation rate which took effect this April and will hit again in April 2008.

The right amount of pay

The Government statement on Arctic Systems then does try to separate out the 'sheep' from the 'goats' by seeking to differentiate between situations where income splitting is based on nothing but tax-saving objectives and those that are more 'commercial'. Presumably it is trying to differentiate the person who just passes shares to, say, his basic rate taxpaying wife who does nothing in the business, from those who are more engaged in the company. It says:

'Some individuals use non-commercial arrangements (arrangements that they would not reasonably enter into with an arm's length third party) to divert income (which would, in the absence of those arrangements have flowed to them) to others. That minimises their tax liability, and results in an unfair outcome, increasing the tax burden on other taxpayers and putting businesses that compete with these individuals at a competitive disadvantage.

'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 difficulty here is: how do you manage to phrase legislation to achieve this end? Is it ever practical to make this kind of divide? Is it the right policy to pursue? Let's take some examples that highlight how hard this could be. Assume in all of these examples that you have a family business which is set up like that of Mr and Mrs Jones.

Scenario 1

Scenario one is that the wife is never going to be involved in the business. She has neither the interest nor the time to get involved, but is taking half the dividends out of the business at a lower tax rate than her husband. This on the face of it seems like it might be the type of situation the Government wants to catch.

However, is life ever that simple? What if she does take telephone calls at the house when the husband is out that help the business? What if she and her husband do sit at the kitchen table and discuss business matters from time to time that shape its future? Is she making any significant contribution to the business? A divorce court might argue that she was and a number of recent high profile family law cases have given a wife 50% of the total available on similar grounds. Divorce cases, of course, go further and can take into account the fact that one spouse looking after children enables another spouse to run a successful business.

Scenario 2

Scenario two is that the wife begins by being very actively involved in the business start-up. She then becomes pregnant and will not be working for six months but hopes to return to a more active role afterwards. Would this be caught or not caught by the legislation the Government is contemplating? Is the decision about whether there is a 'settlement' to be determined when a business is first formed (which does accord with some existing case law) or would you have to revise it for important situation altering events? Worst still (as one part of the Arctic Systems judgment has suggested) should you think about revisiting this issue each year at both huge cost and considerable complexity?

Scenario 3

Scenario three involves trying to find some kind of acceptable 'market salary' to use as a base for taxing the more active spouse in the business. This was a concept mooted in the High Court decision in Arctic Systems. Finding a workable methodology to apply would present many challenges, given that each case would have different facts.

There are no easy answers, although later in this article I consider some of the solutions that might be floated.


The Ministerial statement goes on to say: 'The Government will therefore bring forward proposals for changes to legislation …. In the meantime, HMRC will apply the law as elucidated by the House of Lords and will be providing guidance in due course. The Government would not want commercial arrangements to be caught by any change to legislation. Consultation should help to ensure this.'

Let us hope that someone has learned some lessons of the recent past and takes the consultation issue seriously. Since March 1999, small businesses have been ill-served by the consultative process. The personal service or IR35 rules were brought in with no consultation allowed on the underlying policy. Discussion was only allowed on the implementation of the rules. No statistics have ever been produced that can show how much revenue has been raised by IR35. Many cases have been heard and many lost by HMRC. The rules remain complex and yet arguably have failed to meet the policy objectives of the Government.

The non-corporate distribution rate was introduced for a short period and thankfully abolished. It was thought to be a way of tackling the issue of small companies extracting funds in the form of a tax-efficient dividend. It was shown to be overly complex and again ineffective and its passing was mourned by few. Although its removal was praised by the Government as the reduction in administrative burdens for small business, most commentators saw it as correcting a fundamental policy mistake.

Effective consultation?

For consultation to be effective on the Jones v Garnett issues a number of factors are required. First and foremost it will need an open mind — a willingness on all sides to look at the taxation of small businesses from a wide perspective. It would be a tragic waste if decisions were made by Government on how to proceed and then a 'rubber-stamping' consultation process occurred which allowed for no revision.

There needs to be a much more thoughtful, practical and pragmatic approach to resolving this question. We as advisers will also need to play a part here, accepting that changes may well be needed in the small company arena and that there will inevitably be some winners and some losers.

The second factor that is needed is proper time for consultation. A rushed agenda pushed through for the Finance Bill 2008 is unlikely to give rise to satisfactory legislation. It will not be good enough to have poorly thought through primary legislation that relies on regulation or, worse still, unlegislated HMRC guidance to provide the ground rules for significant numbers of businesses.

Possible ways forward

So what are the next possible steps forward? In the short term if you have clients akin to Mr and Mrs Jones you can follow the House of Lords judgment and safely assume that the settlements legislation does not apply. You will need to keep a close eye out for the HMRC's interpretation of the case which we now know is coming shortly.

But looking further ahead, what might HMRC be considering as ideas for Ministers to consider? Will we see some alteration to the independent taxation rules which treats each partner in a marriage to have separate income? Given that the tax credit rules already amalgamate the income of a 'family unit' to work out total income levels, such a step might be possible but would go completely against the concept of independent taxation.

Could the Government just remove the exemption in what was s 660A that helps spouses? This would be a narrower change and targeted, but clearly go against the purpose of the original legislation. It was made clear during the debates on the introduction of independent taxation, during the passage of the 1989 Finance Bill, that the settlements legislation would be applied in future where there were effectively transfers only of income between husbands and wives. However the Minister, Norman Lamont, also said:

'Independent taxation is bound to mean that some couples will transfer assets between them with the result that their total tax bill 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.'

He also noted:'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.'

Dividend taxation

Will we see a change to the way dividends are taxed? This must be a tempting target for policy advisers given that it is the absence of National Insurance contributions on dividends that is the prime driver behind the incorporation of businesses, such as that which Mr and Mrs Jones set up. Could we get National Insurance contributions just on dividends from close companies?

The honest answer at this stage is that we do not know what proposals will be brought forward. When the non-corporate distribution rate was being considered, there were seven potential options on the table. The fact that the option that was chosen proved to be so short-lived and ineffectual does not bode well for a satisfactory solution to this decision.

Real world view

One thing that often gets forgotten in the section numbers and permutations of important tax cases is the people. Mr and Mrs Jones have fought for well over four years against the tax authority. They lost at the Special Commissioners and High Court and many believed they should have given up then. However, they carried on with quiet dignity and determination. Huge credit must go to them for their courage and willingness to fight on when many would have opted for a quieter life. Grateful thanks should also go to the Professional Contractors Group who helped fund the case, the legal team (Malcolm Gammie QC and Keith Gordon) and others who kept the issue going when funds were low and prospects were not high.

I met Mr and Mrs Jones for the first time on the steps of the House of Lords as they emerged quietly victorious and rather embarrassed by the awaiting photographers and journalists. These are ordinary, decent people wanting to get on with their lives. They would never have chosen to become the cause celebre of the tax world. These are the sort of people who couldn't capture a personal photo of the day because they had left the data card for the digital camera at home. These are people I can relate to. These are people you would like. These are people like our clients.

I think they deserve a better tax system than the one we seem to have at the moment, which appears mired in complexity and distortions, with a critical lack of certainty and which does not appear interested in supporting their business endeavours. I hope that, in the aftermath of a case they never sought and never wanted to happen, everyone involved in the coming debates over the next steps for small business taxation will seek to ensure that the people are not forgotten.

Francesca Lagerberg is head of the National Tax Office at Grant Thornton UK LLP and chairman of the ICAEW's Tax Faculty Technical Committee. The views expressed in this article are her own.

Sections - corporation tax

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