Part one: Section 660 - Court of Appeal looms

Next week, the curtain again rises on the on-going legal saga of Section 660 - the so-called 'married couple's business tax'. Section 660 faces its biggest test yet as it moves up the judicial chain to the Court of Appeal, having already appeared in the Special Commissioners and the High Court.

On one side, Arctic Systems, a small IT consultancy owned by husband and wife, Geoff and Diana Jones. On the other, the Inland Revenue, (now HMRC).

The audience: tens - possibly hundreds - of thousands of similarly owned businesses whose financial futures could be significantly affected by this ruling - one way or another.

At stake: Clarification of a controversial and old piece of legislation, Section 660 or 'the settlements' legislation.

A victory for Arctic Systems could bring a sigh of relief from small family owned businesses. A victory for the Revenue could leave husband and wife businesses facing tax bills of up to £42,000.

In a two part series, UKTECH takes a detailed look at this issue, starting with an examination of 'how we arrived here'. In Part Two, we look at the circumstances surrounding the Arctic case.

The Prince and the Showgirl

Married couples in business together can 'blame' their current predicament on a piece of legislation which was aimed at 'the Prince and the Showgirl' syndrome of nearly a century ago.

The 'offending' piece of legislation is now known as Section 660 and relates to Sections 660a to 660g of the Income and Corporation Taxes Act 1988. It originally dates back to the 1920s when it was known as the 'settlements legislation' and it had something of a rather romantic origin.

The purpose of the settlements provision is to give somebody a right to income but not to the underlying capital. This was not that unusual in the days when heirs to nobility married showgirls. His family would want to ensure that, while the new bride would be kept in a status worthy of her new position, she couldn't get her hands on the 'family silver'.

The Inland Revenue's weapon against this has been the so-called married couple's business tax or Section 660, a Revenue-deemed form of anti-avoidance legislation. It is this new interpretation which is causing so much concern for small family businesses nearly a century later.

The case for the Inland Revenue

The Inland Revenue says this isn't new - which has a further disadvantage for small business in that it means that the Revenue can seek back taxes up to six years.

The political position was summarised by Paymaster General, Dawn Primarolo, who wrote to her Conservative opposite number: "First let me reassure you there is neither a new policy nor any change in policy in the application of the settlements legislation. The Inland Revenue has been applying the legislation in this way for a number of years.

"The settlements legislation is intended to prevent an individual from gaining a tax advantage by making arrangements which divert his or her income to another person who is liable at a lower rate or is not liable to income tax".

Nevertheless, advisers were more than surprised when, a few years ago, the Revenue blew the dust off this old Statute and decided it could be used to target husband and wife businesses.

Dividends

For decades, accountants and advisers have been recommending small businesses arrange their affairs in this manner, with the shareholding - and therefore entitlement to dividends - divided between partners.

In a nutshell, the Revenue takes as an example the case of a business owned by a husband and wife where the shares are divided. One of the parties is the major fee earner who receives a salary from the business. The profits are then paid out as dividends between the shareholders - the husband and wife or close partners.

The Revenue claimed this is a transfer of earnings from the higher tax payer to the lower tax payer in order to avoid tax and cried 'foul' or to be more precise cried 'settlements legislation' - and attempted to charge the fee-earning partner as if he or she had received the income (at a higher rate of tax) rather than his or her partner.

The issue is complicated further by the 'retrospective' element of the case as the Revenue believed it could push for payment dating back six years - which would amount to tax bills of up to £42,000. This proved not to be the case in the Arctic hearing as there had been a prior review which did not raise this. However, this ruling, at the moment, is not applicable across the board.

The case against

Advisers, representative groups, professional bodies, accountants and small businesses have seldom been so united in their opposition to an issue.

Official letters, Parliamentary Questions and formal representations have been made to the Inland Revenue and their political masters arguing that this was not the intention of the legislation and citing the unfairness of the Revenue's approach.

The Revenue and the politicians remained entrenched.

They responded by issuing a further Tax Bulletin in April 2003 and then a guidance note for professionals in November 2004.

But accountants and advisers felt this guidance fell well short of the mark and it was roundly condemned. Rather than clarifying the situation, it still left significant room for confusion and uncertainty.

At the time, Kevin Miller from Ernst & Young described it as disappointing being long on pages and short on new information. John Beattie, President of the Chartered Institute of Taxation likened it to a sun-burnt zebra. He said: "We have read it from cover to cover, but it deals only with the black and white and not with the important grey areas, which remain just as murky as before. After all this time, we hoped for more than a sunburnt zebra."

Subsequent guidance from professional bodies and continued entrenchment from the Revenue merely resulted in a confused stale-mate.

Stale-mate

So both sides - the Revenue and advisers - were left in a position of having to agree to disagree, with small businesses trapped in a no-man's land somewhere in the middle.

Tens of thousands of small businesses owned by husband and wife or close partners were facing a taxation uncertainty, not knowing if a tax bill for up to £42,000 could land on their door mat for doing something they had been advised to do and everyone believed was acceptable practice at the time.

While they couldn't change the past, there was still uncertainty about what they should be doing now and how they should arrange their business in the future.

Legal issues

Resolution of this issue seemed to lie in the hands of the legal rather than the political system.

Arctic Systems became the 'test case', which - supported by professional bodies, corporate groups and individuals - has been slowly climbing the legal ladder for the past few years.

At the moment, the 'score' is 2-0 to the Revenue with victories in the Special Commissioners and the High Court. A 'hat-trick' result in the Court of Appeal could kill off further challenge from small business. A victory in the Court of Appeal for Arctic could give the advantage - for the present - to the small firms.

In part two, UKTECH will look at the detail and implications of the Arctic Systems case.