Arctic Systems Section 660 case: first day
Monday (June 14) saw the start of the key section 660A test case involving the two shareholders in Arctic Systems – Geoff and Diana Jones. The case got off to a stunning start when their barrister Malcolm Gammie QC informed the Special Commissioners that as late as Friday last week he had heard from the Revenue that they were dropping their claims in respect of what were known as the ‘discovery assessments’.
These were the assessments in respect of five past years and which accounted for the bulk of the Revenue’s claim of more than £42K.
However, more of this later. First, let’s run through the key players in this thriller. The appellants are Geoff Jones (GJ) and his wife, Diana (DJ). Geoff is the sole director of Arctic Systems Limited (ASL), which he and Diana founded in 1992 after he was made redundant. GJ and DJ hold 50% of the shares each. DJ is company secretary but is not a director.
Representing Geoff is Malcolm Gammie (MG) a well known tax QC. He is supported by Dave Smith of Accountax and by Anne Redston, tax partner from Ernst & Young and one of the tax profession's leading experts in issues like IR35 and Section 660. Also attending today’s hearing were two directors from the PCG who are helping to fund the case for Arctic.
The Revenue is being represented by Rupert Baldry (RB) and he was being assisted by three Revenue officers at the hearing.
Finally we have the Special Commissioners. As MG noted in his opening remarks, this hearing appears to be setting a new precedent as it appears to be the first time ever that the Special Commissioners have been represented by two lady commissioners. The senior commissioner is Dr Nuala Brice (DB) and she is being assisted by Ms J Powell (JP), who looks surprisingly youthful for a special commissioner. Apparently she is better known as a VAT expert.
The discovery assessments
As I commented at the start MG opened his case by stating that the Revenue had cancelled their assessments in respect of prior years leaving just the single year assessment as the matter under appeal. He had been informed of this by the Revenue solicitor only last Friday. Hence his first issue for the Commissioners was the matter of costs.
In his view his clients had been put to considerable extra costs by virtue of the Revenue’s claim regarding earlier years. The Revenue had been told by DJ right at the very start of their investigation that GJ had been the subject of an enquiry (into business expenses) by the local tax office and that the Inspector who raised the Section 660 investigation should check with the local office before going any further. In addition the Revenue had been told in August 2003 that the Jones’ would be appealing against the discovery year assessments. At that stage, in MG’s view, the Revenue were bound to check what evidence they already held regarding the Jones.
This is a vital issue because the Revenue’s right to raise assessments in respect of past years is based on them being able to claim that it was only when they carried out an investigation into the current year that they became aware of information that enabled them to challenge earlier periods. That is – that they did not have sufficient information to raise the assessments at an earlier time.
RB for the Revenue confirmed that the Revenue had dropped the prior year claims at the last moment because, when it was clear in the pre hearing disclosures by each side, that the Jones’ were contesting the right of the Revenue to use the discovery process in this case they became aware that the Revenue did hold information relating to the prior enquiry.
Apparently earlier in the case the Revenue Inspector had asked the local office for their files of their earlier enquiry but these had not been received and the issue was not followed up until recently. RB noted that the Revenue considered that they could have continued with their discovery assessments but the Inspector carrying out the investigation had concluded that had he seen the other file at an earlier stage he probably would not have proceeded with the claims in respect of earlier years. In view of this the Revenue Solicitor had decided to cancel these assessments.
When asked by the Commissioners what the period of his cost claim would be MG confirmed that in his view the Revenue had not done enough to investigate what information they had previously held and that they should have checked this at least from early in 2004 when both sides had discussed what the ‘directions’ would be for this appeal.
DB asked MG to move on to the next issue but agreed that the issue of costs would be re-examined when RB gave the Revenue’s case.
The hearing then moved on to the main issue for consideration – the ‘Settlements’ issue.
‘Settlements Issue’
MG spent the rest of the day outlining the appellant’s case regarding the Revenue’s claim under Section 660A – the settlements legislation. Before lunch MG gave a brief run through of the approach he would take to the case before moving on after lunch to look at the legislation in more detail and to consider specific case law.
MG’s first point was that it was essential to consider what the legislative framework was like when the settlements legislation was amended in 1989 to take account of the introduction of separate assessment for spouses. He would show that the Revenue’s approach to Section 660 was totally at odds with what the Government had intended.
As MG pointed out Section 660A could potentially affect millions of family owned businesses. In his view it was inconceivable that the Government would modify the settlements legislation in the light of separate assessment without making it clear that it would be applied in the way the Revenue was now seeking to apply it. As MG put it “why would Parliament leave such a vast area open to interpretation”
As MG also pointed out between 1989 and 1995 there was a tremendous amount of consultation in process regarding the introduction of self-assessment, regarding trust taxation and regarding the rewriting of this settlement legislation. But there had been virtually no debate or discussion concerning the Revenue’s current approach to Section 660.
MG went on to question why Parliament would have introduced a specific exemption from the settlements legislation for outright gifts between spouses – even when the value of the gift arises from the efforts of one spouse - while leaving a wife who enters into a joint business enterprise with her husband exposed to the settlements legislation?
The Jones’s
Having set out his general plan of attack MG then presented his case in detail. He started by calling GJ to give evidence. Having confirmed that he had nothing to add to his witness statement GJ was questioned by RB for the Revenue. RB queried how GJ came to start a company and why he and his wife drew the low salaries that they did. He was clearly trying to force GJ to confirm that the reason he worked via a company and drew a low salary was purely for tax avoidance. He made the point that the 50:50 share split was not an arrangement that GJ would have offered to anyone other than his wife.
RB drew attention to the company’s memorandum and articles, which had a clause that gave GJ the right to veto a transfer of the company shares. As GJ admitted he might not let his wife transfer her shares to just anyone. RB is clearly trying to show that the company is really an extension of GJ and that he controls how it is managed.
RB also drew attention to the fact that salaries remained low until the accounts to 31/10/2000 when GJ’s salary increased from around £7K to about £42K while DJ drew no salary in this period. GJ admitted that this arose as a result of IR35 when they were advised that they would be caught by IR35 and he believed, wrongly, that he could no longer pay a salary to his wife.
MG responded by getting GJ to confirm that he was not particularly familiar with the company articles – they were not something he needed to refer to very often. GJ also stressed that it had always been their intention that GJ and DJ would set up the company together and that DJ would work with GJ – handling the company administration. GJ confirmed that DJ was not a director although he could not recall the reason why that was the case and confirmed that she participated in all the main decisions. Salaries had been based upon the advice of their accountants.
Diana Jones also gave evidence. Again it was left mainly to the Revenue to cross-question her. RB probed again at the decision to set up the company and DJ’s statement that they had considered the advantages of operating as a company. Again RB was clearly trying to elicit the response that they had used a company purely for tax advantages.
He established that DJ had had no training as a company secretary and tried to get DJ to agree that the company was really just GJ and his skills. Again his thrust was to establish that ASL and GJ were really one and the same. He also queried DJ’s input into the management of the business stating that her involvement in informal business decisions was really no different to the involvement of any wife in her husband’s career.
It was noticeable how, when DJ explained how she and Geoff had considered all the options when Geoff had been made redundant and were taking into account the needs of their young family, that DB appeared particularly sympathetic to their situation. We shall see.
Settlements
After lunch MG started by referring to the case of Esso Petroleum vs Ministry of Defence, which is unrelated to settlements law, but where the point was made that ‘interest’ received in a claim against the Government was not a ‘public revenue dividend’ merely because the definition of a public revenue dividend included interest. This he argued was exactly the same as the settlements legislation. Just because a settlement included an ‘arrangement’, did not mean that all arrangements were also settlements.
MG stated that the Revenue would have the Commissioners believe that when a couple decide to set up a company, with both as shareholders and both contributing to the business enterprise and that when they decided what to take as salary and what to leave as a profit – that this was an arrangement and hence a settlement. But MG argued that there is nothing in the taxes acts that says that a company must be owned in any proportion much less that that proportion should mirror their relative contributions to the enterprise.
MG also stated that the Revenue were trying to make much of the fact that ASL was a personal service company and that the turnover was due solely to GJ’s efforts. As MG pointed out the Jones do not deny that ASL sells GJ’s services. But as GJ had made it clear they had had to set up a company, as he could not obtain contracts through an agent without one. And as MG stated, if there is a ‘vice’ in the legislation it cannot be confined just to personal service companies. No one denied that the capital needs of a personal service company were small compared to some other businesses. But that should not make any difference.
Human capital
MG went on to state that what the Revenue was trying to argue was that people must value their human capital. In particular that GJ should draw a commercial salary and that DJ should only receive a commercial reward for her services. In MG’s view there was nothing in the taxes acts that supported this view. Had this been the intention of Parliament then it would have introduced it when it changed the legislation for separate assessment.
In MG’s view setting up the company was a commercial arrangement. Both the Jones contributed to the business. Merely distributing profit to a shareholder cannot turn something that is not a settlement into something that is. There was an arrangement – a structure for earning their living. Mr and Mrs Jones paid salaries on the basis of their accountant’s recommendations. Whether salaries were low or high did not make any difference. DJ was not paid market rates. They did not know what the market rates might be. It was not relevant.
Legislation and case law
MG then settled into a detailed analysis of the legislation and case law. In particular he analysed the situation as at 1989 when separate assessment was being introduced.
MG made the point at some length that Section 660 was not a ‘charging provision’ – that is a provision that established tax charges. It is merely a tax switching provision – one that switches the tax burden from one taxpayer to another. The Revenue would argue that DJ’s dividend income exceeded the fair value of her services and that it should therefore be taxed as GJ’s income. But the Revenue could not in MG’s opinion assess income on the basis of what they thought GJ should have been paid as a salary.
MG made the interesting point that he was representing the Jones largely on a pro bono basis. As such he was conferring a bounty on the Jones. However it was not for the Revenue to say that his income should have been higher. There was nothing in the Taxes Acts that could require him to declare a higher income than he had actually received. Similarly there was nothing in the legislation to force the Jones to pay themselves a commercial salary, whatever that was. To the extent that they had taken low salaries so ASL had made a greater company profit on which it had paid corporation tax.
Just as not every ‘arrangement’ is a ‘settlement’ so not every ‘bounty’ sinks a commercial enterprise. Human Capital is not recognised in the Taxes Acts. The exception that Parliament created in 1989 dealt with outright gifts because that was included in the Taxes acts whereas this form of settlement was not contemplated and was therefore not provided for in the legislation.
Up to that time the settlements legislation had evolved over many years from 1914. It dealt with issues such as dispositions of income over short periods and dispositions to children. Where Parliament had seen the need for measures to prevent the transfer of employment income – such as via benefits in kind – it had dealt with it through the Taxes Acts.
MG then looked at two settlement cases in detail. It seems that the Jones’s are destined to join the heady ranks of film stars as both the cases MG cited relate to movie stars. One was a case involving Jack Hawkins in the mid 1950’s and the other an early 1960’s case involving Hayley Mills. Both cases had gone to the Appeal Court and in both cases the Courts had found that there was a settlement that took the income earned from films and placed it into a settlement. These clearly were settlements as envisaged by the legislation.
However as MG pointed out these cases differ from the current case because it was quite clear that there was a settlement involved – one which was arranged in anticipation of the income from the film sources and which switched the income from one tax payer to another. As MG stated for the settlements legislation to apply you first need a settlement then you need a bounteous payment. You cannot create a settlement by creating a bounty. In the case of the Jones’s and ASL the company was set up for valid commercial reasons to effect a joint business enterprise between GJ and DJ. It was a commercial arrangement.
The hearing concluded on this note with MG confirming that he would probably need the whole of Tuesday morning to complete his case.
Kevin Miller will be continuing to follow the events in the Commissioners and the latest developments will be reported here