The long-running tax case known as Arctic Systems has finally reached its conclusion with a decision by the House of Lords in favour of the taxpayer: Mr Jones. This means that Mr Jones will not have to pay higher rate tax on the dividends paid out of his company (Arctic Systems Ltd) to his wife. More importantly, thousands of other couples who set up their companies in a similar fashion to Mr and Mrs Jones should no longer be pursued by the Taxman for additional tax on their dividend income.
Mr Jones set up Arctic Systems in 1992 through which to offer his services as an IT contractor. He was the only director and held one of the two ordinary shares issued by the company. Mrs Jones purchased the other ordinary share from the company formation agents, and also became the company secretary.
They acted on advice from their accountant to take minimal salaries from the company, and pay out most of excess profits as dividends. As Mr and Mrs Jones held the shares equally, the dividends were paid to them equally and were mostly covered by their basic rate tax bands, meaning little higher rate tax was paid. If Mr Jones had paid himself a higher salary, or had been the only person receiving a dividend, he would have paid far more tax as much of his income would then have been taxed at the higher tax rate of 40%.
This type of arrangement has been standard tax planning for many husband and wife companies since the introduction of independent taxation for spouses in 1990. It was even recommended on the Business Link website! However, the Taxman decided to attack the arrangement, saying Mrs Jones only received her share, and the dividends paid on that share, because of Mr Jones work and the decisions he took as a director. The argument was that Mr Jones had effectively made a gift of half the earning capacity of the company to Mrs Jones, and because she is his spouse, the tax law says he automatically benefits from the gift, and thus Mr Jones should be taxed on all of the dividends.
The House of Lords actually agreed with the Taxman that the shareholdings in the company had been set up to minimise the tax paid by Mr and Mrs Jones. However, because the gift by Mr Jones had been made to his wife, and the gift was not restricted to the earning capacity of the company, but included future rights to capital on liquidation, and the voting rights associated with the ordinary share, there was a get-out clause. This get-out clause only applies to married couples and civil partnerships, and says that if you make a gift to your spouse/civil partner (which comprises more than just income), and there are no strings attached, you should not be taxed on the income arising from that gift.
Mr Jones had allowed Mrs Jones to buy half of the company (the other ordinary share) for a very small sum. This did amount to a gift, but the gift was covered by what is known as the "spouse exemption", so Mr Jones could not be taxed on the dividends arising from Mrs Jones' share. The Taxman went away red-faced, and the taxpayer was victorious!
The Taxman is a bad loser, and after a big defeat like Arctic Systems it is quite likely the tax law will be changed. In fact the Treasury has already announced that they will be looking to change the law to prevent people splitting income between themselves in an unfair way. However, the Treasury spokesperson has also said that they do not want to disturb commercial arrangements.