Taxman loses battle, will change the rules

For a while there was potential for a back-tax nightmare. Would the Law Lords rule in favour of HM Revenue & Customs (HMRC) in its battle against a married couple who owned a small business? The implications of such a decision could have resulted in an estimated 30,000 business couples collectively facing a £1 billion tax bill. In the event, the Lords sided with Arctic Systems, owned and run by Geoff and Diana Jones, effectively leaving HMRC out in the fiscal cold.

So, celebration time for husband and wife partnerships (gratingly known also as 'mom and pop' companies) who utilise a long-recognised tax-saving arrangement Alas, no. Just the one cheer perhaps; it would seem that a financial cold spell is just around the corner. Within 24 hours of the Law Lords ruling last month, the Treasury announced a wholesale re-evaluation of the common practice whereby business couples pay themselves low salaries and draw higher dividends in order to maximise tax efficiencies.

Accusations of taxman mean-spiritedness and condemnation of HMRC as sorry rule-changing losers wont cut any ice, although Mr Jones predicted that subsequent changes to tax laws would not negate Arctics success. "If the law changes and it starts from a particular date in the future, that is preferable to the arbitrary, back-dated decision the Revenue made in our case."

New tax rules are unlikely to apply retrospectively. In the Jones' case HMRC attempted to seek some £10,000 in back taxes, revised down from an initial demand for £42,000 sent to the West Sussex couple in 2003.

Thousands of businesses structured in the Arctic mould should now feel safe from a sudden back-tax chill, but can expect, according to tax experts, future testing by the Revenue of the legitimacy of their business arrangements.

It is likely that circumstances will be compared to non-family companies and the exemption that applies to married couples will be removed.

The taxman loses out

The Joneses set up Arctic Systems, an IT consultancy, with equal shares. Annual turnover was around £100,000. Following a long-established tax-reduction method, Mrs Jones was paid a low salary enabling her to become a basic rate taxpayer. Thus there was more money left in the business to distribute as profits or dividends to shareholders each year. Mr Jones didnt enjoy an extravagant salary either. In fact, counsel for HMRC argued that it was "inadequate" given that he was "solely responsible" for the income generated by the company.

In one particular year Mr Jones drew a salary of £6,250, along with dividend payment of £25,700. His wife, who handled the admin side, took £3,600 in salary, but also received £25,700 in dividends.

The Revenue's argument was that, as Mr Jones did the majority of the work the dividends represented income he had earned and thus were taxable at his higher rate. Effectively, he was giving his wife a chunk of his own earnings, paid as dividends which attract a lower rate of tax and are not subject to National Insurance.

02 August 2007 © Moneyextra.com

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