Mutiny over the Bounty

There has been a setback for consultants practising as companies following the Inland Revenue's victory in a landmark tax case.

The decision of the Special Commissioners at a tax tribunal in the Arctic Systems case, made public last month, was only decided by the casting vote of the senior member after a split decision.

One commentator dubbed this as the equivalent of deciding the World Cup by a penalty shoot-out.

The case centred on the interpretation by the courts of controversial anti-avoidance rules known as the 'settlements legislation' - in particular, its effect on husband-and-wife companies.

Settlements legislation has been around since the 1930s, but up to now has not been used by the Inland Revenue to
attack small companies. It is wide-ranging and deals with situations where income from a source such as company shares is gifted by one person to another. This is called a settlement, and the aim of the legislation is to stop people 'settling' their income on another person who pays tax at a lower rate.

The case was considered to be significant, as it is typical of the situation in thousands of small companies in the UK, including hospital specialists.

So what were the facts in this case?

A husband and wife set up a company and subscribed equally to the shares. He generated most of the income
but he had only a small salary - the profits were mainly extracted by way of dividend.

The Inland Revenue argued that the settlements legislation applied, so the wife's dividend earnings should be treated as the husband's income, and subject to tax at higher rates.

The Commissioners felt that the situation as a whole, from incorporation of the company through to the payment of dividends, plus the husband's low income, constituted a settlement.

An important factor appears to have been that the husband was the sole director and thus controlled the whole exercise.

Why are husband-and-wife companies being targeted?

The Inland Revenue believes too many small businesses, particularly those of husbands and wives, are making dividend arrangements to divert income to the lower-earning spouse with the sole purpose of saving tax.

I've got a company for my private practice and my spouse receives dividends. Should I panic?

Undoubtedly, this result will put wind in the sails of the taxman, but, to provide some perspective, the number of investigations using the settlements legislation is currently very low, and even these are predominantly targeted at the IT sector.

Also, despite the fact that many small businesses could be affected by this decision, the Inland Revenue simply does not have the resources to mount a widespread attack.

Restructuring your business in response to this judgement could create greater problems later if not properly thought through. The best advice is to speak to your accountant.

But isn't there anything I should be doing now to reduce the risk of attack from the Inland Revenue?

Only consultants practising through limited companies and partnerships are at risk from an attack under the settlements legislation. Even in advance of this decision, there were certain steps that good accountants were advising clients to take to minimise the risk of attack.

Practices at the highest risk are those where funds are provided by the husband and wholly flushed through the company as dividends - some or all of which go to his wife.

Undoubtedly, there will have to be some soulsearching in the light of this case to see if a more effective remuneration strategy can be developed. But it is important to understand that, for the settlements legislation to apply, there has to be an element of 'bounty' - money for nothing.

To advance the argument that there is no bounty, you have to produce supporting documentation and evidence.
This should be prepared before the event, rather than after, when it is generally too late.

So where do I go from here?

It is not possible to comment in any detail at this stage until the full facts become available and are fully considered by advisers.

The main issue arising from this case is that, far from clearing the air, the result adds to the uncertainty and confusion surrounding the taxation of small businesses.

Pronouncements from the Inland Revenue will follow in due course, but an appeal in the Arctic Systems case looks to be inevitable and it could be more than a year before the issue is resolved.

Mr MacKenzie is a chartered accountant specialising in the tax affairs of consultants. Contact him by phone on 01483 419922, by email at wtm@accmac.plus.com or visit www.wesaveutax.co.uk