Arctic Systems – and how to move on

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The Revenue have lost what has been called the Arctic Systems case in the House of Lords.

This case dealt with a husband and wife who co-own a company. They paid themselves very modest salaries and then split the remaining net income of the company (which was high in relation to salaries and also in relation to sales since this was a consulting business) between them as dividends. The problems were twofold:

1) As the House of Lords found, the Jones arranged their company in this way with the intent of saving tax. They said part of the income Mrs Jones received was gifted to her by her husband. It just so happened that the Revenue lost the case because there was an exemption in the law that allowed this to happen.

2) As a result of tis gift, and the fact that dividends rather salaries were paid, less tax was received by the Revenue from this company than might otherwise have been the case.

Now, as a matter of fact I think the House of Lords made the right decision in this case based on current legislation. It had been stated in parliament that the settlement legislation which was the basis of the Revenue's claim would not be used for this purpose. As I believe in purposive legislation applied in accordance with the stated will of parliament it has to be right that litigation in contravention of the will of parliament should fail.

But, let's move on. The government has announced that now it has lost it will introduce legislation to ensure that "income splitting" as they call the practice undertaken by the Jones (and several hundred thousand other couples, I suspect) is outlawed. This is going to be immensely unpopular. It's also the right thing to do. They are quite right: this can be a straightforward abuse of the tax system. That happens when there really is a gift and low salaries exacerbate its value. I know it will make me unpopular, but since I believe in tax compliance, which means that the right amount of tax is paid at the right time in the right place, then this comment has to follow.

But, and I stress this very strongly, when the economic reality is that the partners do really contribute to the company, even if unequally, then they should be entitled to the return it generates, having allowed for reasonable (and no more) compensation for the time each has expended. If this is not the basis of new legislation then the law will not tax the economic substance of the transaction. That would be wrong. The economic substance of a transaction must match the taxation charge raised on it if tax is to be fair, which the Revenue say is their objective. This will challenge the Revenue, but anything less than this will harm small business in the UK. And that makes no sense.

Serious consultation, clear guidelines and ways of determining what is, and is not acceptable which are binding on all parties (assuming the truth is told) will be essential to make this work. The Revenue are trying to work in partnership with large business: they have to now show they can do the same with small business as well. Will they rise to the challenge? I hope so.