Arctic Systems: Lords rule for the Joneses and end HMRC's Section 660 campaign

The House of Lords has ruled unanimously for Geoff and Diana Jones in the Arctic Systems case, ending a dispute that began with a tax bill of a few thousand pounds and became the most important small business tax decision in a decade.

The judgment, handed down this morning, upholds the Court of Appeal's decision of December 2005 but on different reasoning. The Law Lords accepted HMRC's central argument that the arrangement was a settlement: Mr Jones, an IT consultant, worked for the company at a low salary and the profits were paid out as dividends on shares held equally with his wife, and the expectation that he would do so gave the arrangement the element of bounty the settlements legislation requires. They then held that the exemption for outright gifts between spouses applied, because the share Mrs Jones held was an ordinary share carrying full rights and not wholly or substantially a right to income. That exemption, in Section 660A(6) of the Taxes Act, defeats the charge.

What it means

The practical result is that the structure used by tens of thousands of husband-and-wife companies, in which each spouse holds shares and dividends are paid to both, does not give rise to a tax charge on the higher earner under the settlements rules. HMRC had argued that it did, had been pursuing cases on that basis since 2003, and had said publicly that the Arctic case would decide the matter. It has.

The reasoning leaves a narrower point open. The exemption applies to outright gifts of property that is not wholly or substantially a right to income. A share with full voting and capital rights qualifies. Arrangements involving preference shares, dividend waivers or share classes designed to carry income to one spouse and nothing else may not, and HMRC will read the speeches for what they leave standing.

The cost of the fight

The Joneses were supported throughout by the Professional Contractors Group, which raised a fighting fund from members after the couple lost before the Special Commissioners in 2004 and again in the High Court in 2005. The Court of Appeal found for them at the end of that year, and HMRC, having said the case was a test, appealed.

Attention now turns to the open enquiries HMRC has held in suspense pending the outcome, and to the guidance the department must issue on what the speeches leave standing.

The Treasury's response

The decision may not be the end. Treasury ministers have indicated in the past that if the courts found the settlements legislation did not reach income splitting between spouses, they would consider legislating. A statement is expected. The industry, which has spent four years and a great deal of money establishing what the law is, will now find out whether the law is to be changed.

For today, the Joneses have won, and the company that gave the case its name, a small IT consultancy run from the family home, has done more to define the tax position of the family business than any Budget of the last ten years.