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Roy Maugham from UHY Hacker Young writes:
The Arctic Systems case
The case in question involved Arctic Systems, a computer consultancy business jointly set up and run by Geoff and Diana Jones, with two £1 ordinary shares.
Geoff Jones provided the company’s services to clients whilst Diana Jones provided the administration. Initially, Mr Jones took a moderate salary while his wife drew a figure close to the personal allowance for her few hours work. This left significant profits in the company which were then paid out as a dividend; 50 per cent to each of them. In more recent years, concerned that ‘IR35’ rules could catch the company, Mr Jones increased his salary and consequently, there were little or no remaining profits
for distribution.HMRC challenged the dividend to Mrs Jones by arguing that the reduced salary drawn by Mr Jones was not commercial remuneration, but a settlement. HMRC argued that Mr Jones should therefore be taxed on the entire dividend income irrespective of a proportion being in his wife’s name.
A controversial decision
HMRC have met with heavy criticism over this issue, being accused of ‘moving the goal posts’ as the legislation had existed for many years without being invoked in such a way. Others have argued different interpretations of the detail of the law
of settlement.
The argument
Legally, for a settlement to exist, there must be a provision of funds with an element of ‘bounty’, and for income tax to be charged there must be income. As Mrs Jones subscribed for her share in the company the former would not seem to apply. Curiously, the Chairman of the Commissioners hearing the case at an earlier stage, took the view that the property given away was her share.
This is questionable; Mrs Jones’ share was only worth £1 at the time, the amount she paid for it, and so appears to be without that element of reward. So, HMRC argued that it is Mr Jones’ reduced salary that provides the element of bounty, and whilst it may provide the funds, there still has to be a further legal step to create the taxable income; ie. the declaration of the dividend. Mr Jones, being the sole director, had to make that declaration and so clearly had a hand in providing the income to his wife. Arguably, if she had also been a director, making the commercial decision to pay a dividend, the element of bounty may not have applied.
Are there any exceptions?
If you are a husband and wife business you should be aware that an exception to the rules invoked by HMRC does exist and could be of help in your situation:
If the settlement relates to an outright gift from one spouse to another, of property from which income arises, it is not a settlement unless the gift carries the right to the whole income, or the property given is wholly or ‘substantially’ a right to income. This has led to much debate and some have argued that a preference share is caught by the new rules, whilst the rights and interest of an ordinary share take it outside of the second aspect of the above test.
Irrespective of which view is correct, in the Arctic Systems case Mrs Jones paid for the share, and so there was no gift. Interpreting ‘substantially’ as regards this exception may be crucial to you. It is understood to mean at least 75 per cent. Therefore, if there are substantial assets in your company, including goodwill, a gifted share could be excluded entirely on the basis that your spouse may receive substantial sums upon a sale or liquidation.
By contrast, if your business has little or no capital base, and only a single employee generating revenue or running the company, the view is that this is really a means by which the income of one person is being carved up between two.If you and your spouse have a genuine ‘joint venture’; both providing valuable input, although possibly from different skill sets, then your company profits can be attributable to both of your efforts and so can be enjoyed, and taxed, between you.
Roy Maugham — Tax partner, London
UHY Hacker Young
Further information
For more information about Section 660 and the Arctic Systems case, see Shout99's Section 660 news section
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Susie Hughes © Shout99.com 2005
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