The case of Jones v Garnett finally reached its end on 25 July, when the House of Lords gave a judgement unanimously in favour of the taxpayers.
This marathon of a case concerned Mr and Mrs Jones, who owned one each of the two shares in Arctic Systems Ltd, their family company. Mr Jones was the fee-earner, as an IT consultant, and Mrs Jones dealt with the admin work.
As is normal in such companies (if they have a competent tax adviser!), the Jones took very little out of the company in the way of salaries, and instead paid out the profits as dividends. This is the most tax-efficient way to extract cash from such a company and is normal, basic tax planning.
HMRC, however, had a change of heart in 2003 and decided that this strategy was unacceptable tax avoidance. They said that by allowing his wife to have one of the shares in a company for which he earned all the income, and by taking a low salary so that there were more profits to distribute as dividends, Mr Jones had made a “settlement” on his wife, and that therefore her income should be taxed as if it were his. This would have meant a significantly higher tax bill because Mr Jones paid income tax at 40%, whereas his wife paid at the basic rate, so (broadly speaking) an extra 25% tax was due on the dividends paid to Mrs Jones.
There is an exemption from the “settlements” rules for “outright gifts” between spouses, but HMRC said it did not apply here because the exemption does not extend to gifts that are “wholly or substantially a right to income”, and they said that because Arctic Systems Ltd had no fixed assets (such as buildings or plant and machinery), a share in the company was “substantially a right to income”.
The Lords agreed with HMRC that by allowing his wife to subscribe for a share in the company for a nominal £1, when there was an expectation that the company would earn significant income, Mr Jones had made a “settlement” on her, but they absolutely rejected HMRC’s contention that this share was merely a “right to income” and confirmed that the exemption did apply.
The judgement has some unexpected ramifications – largely because HMRC had previously said that in their view the same logic applied to husband and wife partnerships and they cannot easily back out of that view now. Rather than go through the highly technical arguments in the case, here is a summary of how it affects the taxation of married couples:
Allowing your spouse to have a share in the family company on terms you would not extend to a stranger “at arm’s length” is a “settlement”, BUT
Provided the share is an ordinary one (that is, it is not for example a “preference share” which is arguably only a “right to income”), the exemption for outright gifts will apply so that your spouse’s income will not be taxed on you.
It is not necessary for either of you to be paid a “market rate” of salary – you can take all the profits out as dividends if you wish.
It is not necessary for both spouses to work in the business – and this applies to partnerships as well as companies. This is perhaps the most interesting consequence of HMRC’s losing this case. Previously, we advisers were nervous where a businessman took his wife into partnership if she did little or no work for the business, but following Jones v Garnett, this is no longer a worry.
Now the bad news……………
HMRC have always been bad losers, and the day after the judgement was announced, there was a ministerial statement issued:
“The Government acknowledges the judgement given by the House of Lords in the Jones v Garnett (Arctic Systems) case.
The Government is committed to maintaining fairness in the tax system. The case has brought to light the need for the Government to ensure that there is greater clarity in the law regarding its position on the tax treatment of ‘income splitting’.
Some individuals use non commercial arrangements (arrangements that they would not reasonably enter into with an arms-length third party) to divert income (which would, in the absence of those arrangements have flowed to them) to others. That minimises their tax liability, and results in an unfair outcome, increasing the tax burden on other tax payers and putting businesses that compete with these individuals at a competitive disadvantage.
It is the Government’s view that individuals involved in these arrangements should pay tax on what is, in substance, their own income and that the legislation should clearly provide for this. The Government will therefore bring forward proposals for changes to legislation to ensure this is the case. In the meantime, HMRC will apply the law as elucidated by the House of Lords and will be providing guidance in due course.
The Government would not want commercial arrangements to be caught by any change to legislation. Consultation should help to ensure this.”
In other words, if you lose the game, change the rules! It is too early to say how or when the threatened changes will take place, but my guess is an announcement in the 2007 Pre - Budget Statement (rumoured to be in September or October this year), with a couple of months of “consultation” (that is, we tax advisers will protest and be ignored), followed by legislation in the Finance Bill in March 2008.
Whatever form the new legislation takes do not be fooled by the “spin” it will inevitably be given to present it as “correcting” an “unfairness”. It will just be yet another tax increase!
