Section 660 Arctic Systems test case background

As UKTECH reported last week the Revenue are using Section 660A to attack a wide range of businesses in the hope of raising an average of around £40,000 a company. A key battle in this, the Revenue's latest war on small businesses, will take place next week. Between 14th and 16th June the Section 660 test case involving Arctic Systems is due to be heard by Special Commissioner Dr Nuala Brice sitting in London. Here we take a look at the background and events leading up to this case which is being followed with considerable interest by freelancers and small businesses.

Background

To briefly recap, it was the Arctic Systems case that first brought to light the Revenue's new approach to applying the Section 660 settlements legislation. Geoff Jones and his wife Diana had set up their IT consulting company in 1992 following the classic formula that most accountants were recommending for such family businesses of splitting the share capital 50:50 between themselves.

As Geoff Jones reported in an on-line discussion about his case:

" Our company was formed in '92 with a 50:50 share split between me and my wife who is company secretary, does the books etc. She draws a token salary, I a larger one. The shares are ordinary, equal dividends are paid by individual cheque.

The Section 660A tax demand was for the six years prior to IR35 start and was for £42,000, incl. £10+K interest. The total is about £2K higher now.

The IR had received returns from me for nine years with no comment about S660a. Neither of my two previous accountants commented either. To my knowledge no professional was aware of the applicability of S660A nor has anyone with ordinary shares been caught by this."

The Revenue's view

The Revenue are contending that Diana Jones' ordinary shares are wholly or substantially a right to income and that by taking a salary that is below the 'commercial rate' Geoff Jones created a larger profit in the company – in effect a bounty – that he then settled on his wife by way of a dividend. Also inherent in their argument is the claim that the dividend and salary that Diana Jones received represented an un-commercial reward for the investment she made in the company or the services she rendered to the company.

The Professionals' response

This use of Section 660A took most accountants and tax experts by surprise. Anne Redston, one of the profession's leading tax experts in the areas of IR35 and Section 660, was reported as saying:

"One of the worrisome things about this attack is that it appears to contradict earlier advice given by the Inland Revenue to practitioners. If the Inland Revenue now wish to take a different approach then it would have been appropriate for them (as a minimum) to inform practitioners and taxpayers before they did so."

Such was the concern of the professional tax and accounting bodies that they asked the Revenue to issue clear guidance on their approach to Section 660A – which the Revenue did in April 2003 in the form of tax bulletin 64. However, this did little to reassure the professionals and in the autumn of 2003 there was an unprecedented move when the combined tax and accountancy professional bodies issued two formal letters to the Revenue setting out their concerns as to their view of the Revenue's perceived new approach.

Key Issues

Amongst the key issues they raised were:

• How could the Revenue argue that ordinary shares or a share in a partnership could be wholly or substantially a right to income when they involved a package of rights and responsibilities?
  
• How could such subjective issues as 'commercial' salary or a 'reasonable rate of return' on an investment be determined?
  
• How could the Revenue justify backdating their approach up to six years when their view of the legislation had not been made clear before April 2003 and when they usually had had sufficient information from the tax payer to raise any queries much earlier?
  
• How could the Revenue justify their approach when it was clear from discussions in Parliament, at the time that separate taxation of couples was introduced, that this would result in couples taking advantage of the new rules to shift income earning assets from one to the other and that this was accepted by the Government as being a logical consequence of separate taxation?

The Revenue responded by issuing further guidance early in 2004 in the form of another tax bulletin – number 69. In this they basically reaffirmed their belief that their approach was correct, that it was not a new application of the legislation and that they were entirely justified in backdating its application up to six years.

Hence there has been an impasse between the Revenue and the Professional bodies with both agreeing to differ in their views. Only case law will determine who is right.

Consequences of the case?

The Arctic Systems case will therefore be the opening shot in this battle of wills. It is hard to know what exactly the impact of the case will be. Experience of decisions in IR35 cases suggests that most are greatly affected by the individual circumstances of each case, which makes it hard to apply the decision more widely. Cases that appear to have similar circumstances have resulted in different decisions because of particular aspects of each case that only become apparent when the full details are known.

On the face of it Arctic Systems seems to be a typical set up for many knowledge based consultancies, with one spouse providing the technical input and fee generating work and the other providing some degree of administrative assistance and some general degree of practical and emotional 'support'.

This means that the decision could be crucial in determining whether thousands of similar businesses will be exposed to similar attacks if the Revenue are successful, or can breathe a big sigh of relief if the Jones' win. Or it may end in a result that applies to this case but very few others because of some particular point of detail that is not yet apparent. We shall see as the details unfold next week.