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Date of Issue: 31 July 2007
On 25 July, the House of Lords announced its verdict in the long
running case of Jones v Garnett, often referred to as the Arctic
Systems case. The result was a victory for the taxpayers (Mr and
Mrs Jones) but for different reasons than in the Court of Appeal.
For the history it is necessary to go back to 1990 when independent
taxation was first introduced. Prior to that time a wife’s
income was taxed on her husband (although it was possible to choose
for a wife’s earned income to be taxed separately). Since
then it has always been considered acceptable for income producing
assets (e.g. let properties or bank deposit accounts) to be transferred
between spouses to reduce tax. A higher rate taxpaying spouse
could transfer assets to a non or basic rate tax paying spouse.
However, it was considered unacceptable to transfer income without
transferring the asset. So a gift of an asset that was “substantially
a right to income” was ignored for income tax purposes.
Mr Jones is a computer consultant. In common with many other computer
consultants, a number of years ago he set up a company to provide
his services to clients. However, if he had received all the income,
he would have paid higher rate tax. So the shares in the company
were split with his wife. He received a small salary and the rest
was paid to them both as dividends on their shares. As a result
no higher rate tax was paid.
In the eyes of H M Revenue & Customs, the shares were no more
than substantially a right to income, that is the income derived
by the supply of Mr Jones’ services, and so Mrs Jones’
dividends should be taxed on Mr Jones. If Mr Jones did not work
the company would receive no income and there would be no dividends.
The Special Commissioners of Income Tax and the High Court agreed
with the Revenue. However, the Court of Appeal overturned these
decisions and said that essentially there was no gift of a right
to income in the first place. The House of Lords has said that
there was such a gift but that the shares are more than substantially
a right to income.
The result brings relief to many small businesses in similar circumstances
to this case. However, the relief is likely to be short lived.
As is normally the case when the Government lose a tax case, an
announcement has been made that the legislation will be changed.
Quite what form the changes will take has yet to be seen. It is
common with small businesses for profits to be extracted by dividend
with small salaries. This saves substantial national insurance
costs (the Government does not like this either but that is another
story!). Are small companies to be forced to pay their owners
full salaries? This approach would deal with the national insurance
problem as well as the income splitting issue. If so, how does
one determine what would be a full salary? Should the same rule
apply to a one-man company as to a bigger company with other employees?
The one certainty is that small businesses will continue to live
with uncertainty over their tax affairs for a while longer. Business
structures or their ownership may need changing. Watch
this space!
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