Part two: Section 660's High Court battle begins

This week sees the start of a landmark case which could have significant financial implications for hundreds of thousands of small businesses owned by husbands and wives 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 Diane 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 be 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 Diane 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 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. It is quite usual to have hearings before three Commissioners - and the absence of a third opinion proved to be a critical factor later on.

The Jones's case hearing started on a positive note for small businesses. 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 what hope was there for any degree of certainty for small businesses.

The High Court

Progress up the legal chain seemed inevitable and, this week, the Jones's will have their day - or two - at an appeal in the High Court.

But the stakes also rise. The Special Commissioners' verdict does 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 will have much wider-reaching implications for all husband and wife businesses.

What happens after the High Court...

Although the case is scheduled to be heard this week, a decision is unlikely for some time.

If the decision goes in favour of Arctic Systems, it is likely 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.

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.