Breaking finance and business news, tax information, jobs and more for finance directors and senior finance professionals.

Economy

Split-income tax verdict prompts Government clamp down

Thursday, 26 July 2007

The government has announced plans to change the law after the House of Lords dismissed HM Revenue and Customs’ appeal in the so-called “Arctic Systems” case, which centred on a split-income tax structure commonly used by married business couples.

Married couples and civil partners who run a business together had barely finished celebrating Wednesday's landmark ruling by the House of Lords on their tax-saving arrangements, when the Exchequer Secretary, Angela Eagle, announced that the Government plans to change the law.

In a ministerial statement issued on Thursday, Eagle announced that the Government was to "bring forward proposals for changes to legislation" which will clamp down on the tax-saving arrangement used by thousands of husband and wife businesses.

The legal battle, which has run since 2004, was won by HMRC at the Special Commissioners and High Court, but by the taxpayers on appeal to the Court of Appeal. It finally concluded at the House of Lords, who ruled 5-0 in favour of the Jones's.

In the Jones v Garnett case (also referred to as the "Artic Systems" case) HMRC had challenged husband and wife, Geoff and Diana Jones’ remuneration structure (commonly used by spouses) in which they formed a family company - called Artic Systems - and paid themselves a low salary and a relatively higher dividend payment in order to maximise tax efficiencies.

The particular element on which the case was dismissed was that, while the court agreed that if a husband made a “gift of income” to his wife, he should be taxed on it in full; if there was a transfer of an actual share in the company (which there was in Mr and Mrs Jones’ case), the dividend income associated with that share is taxable only on the wife.

According to Thursday's ministerial statement the Government intends to change the law to ensure there is "greater clarity in the law regarding its position on the tax treatment of 'income-splitting'". It said that in the future, such arrangements should result in the "true earner" being taxed on the income.

"Some individuals use non commercial arrangements (arrangements that they would not reasonably enter into with an arms-length third party) to divert income (which would, in the absence of those arrangements have flowed to them) to others." she said. "That minimises their tax liability, and results in an unfair outcome, increasing the tax burden on other tax payers 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 government will therefore bring forward proposals for changes to legislation to ensure this is the case. 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".

The Chartered Institute of Taxation (CIOT) and ICAEW Tax Faculty are asking the Government to take their time and reflect on the decision before rushing to legislate.

Andrew Hubbard, CIOT Vice-President, says: "It is entirely right and proper for Government to decide who pays tax and how it is paid. However, the Ministerial statement published today will almost certainly lead to yet more complex tax legislation to deal with the situation that Mr and Mrs Jones faced. Given the new Chancellor's stated commitment to making the tax system simpler, this would be a backward step and one which we would like to avoid."

Both professional bodies are hoping that HM Treasury and HM Revenue & Customs will fully consult and listen to all interested parties before creating tax law that increases uncertainty further and puts yet more obstacles in the way of small businesses. The Government announced a review of small business taxation in 2004 and it would be much better to await the outcome of this review rather than rush through legislation. The professional bodies believe that there have been too many cases in the recent past where legislation introduced without proper consideration and consultation has ended up creating more problems than it solves.

Francesca Lagerberg, Chairman of the Technical Committee of the ICAEW Tax Faculty, says: "The Government is looking to review situations where family members are involved together in a business. It appears that the tax authorities will seek to separate out 'commercial' situations from those where it believes dividends are being passed to lower rate taxpayers primarily to keep down the tax bill. The reality is that most businesses do not fall into such neat categories. There is a danger that rushed legislation will result in unworkable legislation, plunging thousands of taxpayers into yet more uncertainty about their tax position. There is no ‘quick fix’ formula that we think could work. There is now an urgent need for full and detailed consideration of the small business tax regime, which should include a detailed understanding of the businesses and the issues involved and full consultation, which should be completed before any measures are announced.”

Andrew Hubbard adds: "We can understand why the Government would want to review the structural basis of small business taxation. There are anomalies in the current system and we would support reforms that more closely linked taxation with the underlying economic activity rather than with the legal form of that activity. But it is difficult to see how there can be a proper and open debate and consultation if the outcome has been pre-determined.”

Francesca Lagerberg concludes: "A clear signal should be sent to owner managed businesses that they are a valued part of the economy and that the tax goalposts will not shift every time a tax case goes against the tax authority. A full and open debate is required about how small businesses should be taxed and we would welcome a review that covered all aspects of this area without leaving hardworking individuals like Mr and Mrs Jones with years of concern about their future tax liabilities."