Part two: Arctic's road to the Court of Appeal

November 29 sees the start of a landmark case which could have significant financial implications for hundreds of thousands of small businesses owned by husband and wife or close partners. UKTECH reviews why the eyes of the small business community are now focused on a small West Sussex IT consultancy called Arctic Systems.

Not unusual

When Geoff and Diana Jones set up their small IT consultancy little could they have imagined that they would become the legal champions for married couples in business together all over the country.

The structure for Arctic Systems is not unusual - and, in fact, is one which was often recommended by financial advisers and accountants. The scenario is quite common. While both parties have shares and responsibilities in the company; one is the major fee earner while the other offers administrative, management and other support. Dividends are paid according to share holding.

Then the Revenue stepped in...

All was fine until the Inland Revenue chose to apply a new interpretation to Section 660, a long-standing tax legislation that had been on the statute books for 70 years but not applied in the manner that the taxman now proposed.

The result was a tax demand, backdated for six years, for £42,000.

In short, the Revenue claimed that the dividends paid to Mrs Jones should really belong to Mr Jones and therefore taxed at the higher rate.

Spotlight

Small businesses, their representative bodies, opposition politicians, accountants and advisers shuddered at the wider implications for all such businesses. Political rows ensued as one side argued the unfairness of this new interpretation; while the other side, the Revenue and their political masters in the Treasury, dug in their heels and said that there was nothing new and this was a legitimate approach.

With a political stalemate and small businesses left in a limbo land of uncertainty, the stage was set for a legal battle to resolve the issue - and Geoff and Diana Jones found themselves centre stage in the row over the so-called married couple's business tax.

Special Commissioners - the hearing

The case was taken up by the Professional Contractors Group (PCG) and supported by donations from individuals and organisations with an interest in the issue.

The first step on the journey was a three day hearing before the Special Commissioners in June 2004. While this would not establish case law, it would provide some guidance and clarification for similar cases.

At least, that was the theory.

The reality of the situation in the Arctic Systems case was that the decision of the Special Commissioners sent the entire Section 660 issue into a farcical state.

The case lasted three days at a hearing before two Special Commissioners.

The Jones's case started on a positive note. Initially the Revenue sought to apply this measure retrospectively and back-dated the tax demand for six years, amounting to a claim for £42,000 in unpaid tax from the Jones.

However, the specific circumstances of the Arctic case led to this retrospective element being dropped during the Commissioners' hearing when it became clear that the Revenue had information relating to the prior enquiry. This does not set a precedent that it would be dropped in all future cases.

Special Commissioners - the decision

The two Commissioners were entering previously uncharted waters and it wasn't until three months later in September 2004 that their decision was known. And few would have bet on the outcome!

Just as the Revenue and the professionals had been unable to reach a common view, the two Commissioners, after hearing the same evidence, came to opposing views. One supported the Revenue, the other supported Arctic Systems.

A split decision - with what appeared to be a legal stalemate as well as a political one.

However, that wasn't the end of the matter as the saga took an unusual turn - against the small business. The view of the senior of the two Commissioners was given more weight than that of the junior - and the senior Commissioner had supported the Revenue's argument. So the Revenue won.

The normally reserved comments of the accountancy and professional world went into hyperbole-overload at the situation with some suggesting that the whole decision-making process could be incorrect and others pointing out if two Commissioners couldn't agree with each other, what hope was there for any degree of certainty for small businesses.

The practical outcome was that the small business community had no clearer understanding than before and had now suffered a defeat in the Commissioners.

Revenue 1 - 0 Small business

The High Court

Arctic Systems and their advisers and supporters decided to appeal to the next stage: the High Court.

But the stakes also rose. The Special Commissioners' verdict did not set case law, so a loss or win at that stage was only applicable to these particular circumstances and could only be used as guidance. A victory or defeat in the High Court could have much wider-reaching implications for all husband and wife businesses.

The High Court hearing took place in March 2005 and Mr Justice Park delivered his verdict on April 27 2005. It was another defeat for Arctic and a victory for the Revenue. But still the issue was not clear cut.

The small business community was shaken by this defeat. The PCG, who had supported the case, described it as 'a bitter blow', tax expert, Anne Redston, called it 'a black day for small business'.

However when the dust settled, it became clear that it had left as many questions unanswered as it had solved.

For example, the judge made reference to a belief that the Revenue might have taken a different approach if Mr Jones had paid himself 'a market salary'. But what is a 'market salary' and where is it defined and by whom?

The judge also said that this ruling was unlikely to affect many small businesses. He cited the example of this not being the same as a husband and wife running a shop. Why? At what point does a partner make 'an acceptable contribution to the business'?

Nevertheless it was now Revenue 2 - 0 Small Business and the stage was set for the next act.

Court of Appeal

Arctic Systems, their supporters and advisers decided to appeal to the next court up the chain - the Court of Appeal.

Initially, the case was scheduled for hearing in January 2006 which brought new groans from the accountants and small businesses who then faced the prospect of filing end of year tax returns without the benefit of a decision or guidance from this case.

However, the date was moved forward and the case is due to be heard in the Court of Appeal on November 29 and 30, 2005.

What happens after the Court of Appeal

Although the case is scheduled to be heard this week, a decision is not expected immediately, although it is hoped that it will be available before the tax filing deadline of January 31, 2006.

A victory here for Arctic Systems will 'wipe out' the previous two defeats. A victory for the Revenue could signal the end of the road for the small business community on this issue.

If the decision goes in favour of Arctic Systems, it is possible that the Revenue will appeal it further up the legal chain. They could even agree to fund the case themselves.

If a decision goes in favour of the Revenue, it is questionable whether the freelance community could support an ongoing and increasingly costly series of appeals, with three defeats behind them.

Law makers

It is also worth remembering that one of the parties has the ability to change the law or introduce new legislation - while the other has the obligation to comply with it.