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Analysis of the Court of Appeal’s decision in Arctic Systems

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HMRC’s interpretation of s.660A ICTA 1988 (now s.624 - s.626 ITTOIA 2005) “the Settlement legislation”, and how it may be applied to married couples in business together, was knocked for six yesterday, when the Court of Appeal handed down unanimous verdict in favour of the taxpayer in the case of Jones v. Garnett [2005] EWCA Civ 1553.

In the eagerly awaited judgment, Sir Andrew Morritt and Lord Justices Keene and Carnwath found that Geoff Jones had not created a settlement for tax purposes in favour of his wife Diana when the couple jointly went into business together. In short the decision is a victory for common sense, and a bitter blow for HMRC.

The decision in this extraordinary case backs the finding of the Special Commissioner, Miss Judith Powell in 2004. At that time she had been overruled in a controversial move by the presiding Special Commissioner, Dr Nuala Brice, who had decided to use her vote to count twice to rule in HMRC’s favour.

Describing s.660A(2) ICTA 1988 as “anachronistic”, Sir Andrew said in the judgment: “It is also remarkable that this case could not have arisen after 1990 if Mr and Mrs Jones had lived together without being married”. During the two day hearing back in November, the Lord Justices had seemed incredulous that this piece of tax legislation should effectively discriminate against marriage.

Despite s.660A though, he decided that the court should not “ignore the increasing tendency for married couples to be involved in the business of each other on a commercial non-bounteous basis. Such involvement may take the form of a partnership or a company in which each own shares. Though one spouse may generate the income of the firm or company, the services of the other may be just as commercially important in providing the essential administrative, accounting, support and backup services”.

In summary, the main points to come out of the judgment are:

• There was no arrangement in the nature of a settlement when the Jones subscribed for one share each, and set up their company Arctic Systems Ltd.
• The reason why this case went through the net is that unlike earlier settlement cases (which involved parents settling income for the benefit of their children), there was no contract or mechanism already in place at the outset to either:
• Agree the future income of the business, or
• Decide on what might be done with any future income, in terms of salaries or dividends to be paid out at a later date.

Mrs Jones had what was described earlier at the Special Commissioners hearing “hope value” attaching to her share in the business on day 1. Hope value or intention is not enough to change an arrangement into a settlement for tax purposes.

o HMRC’s had argued that the settlement provisions can “bite” at any time, and claimed that it was necessary to review a business year on year to see if the settlement provisions applied. The Lord Justices totally disagreed, and Sir Andrew Morritt said: “the fact that the structure being set up might lend itself in the future to some tax mitigation is irrelevant”.

o HMRC’s interpretation of the settlement provisions in terms of a commercial venture between a married couple was an unjustified extension to the scope of the rules.

o There was no gift in this case - Diana Jones subscribed to her share.

o If there had been a gift of a share, an ordinary share is not substantially a right to income in any case.

The court refused HMRC leave to appeal to the House of Lords. This does not mean that HMRC may not apply for leave to appeal, and so we must wait and see on this point.

As a result of this verdict all existing guidance on the settlement provisions must be substantially re-written. I am not placing any bets on HMRC admitting total defeat, and fully expect their revised guidance to indicate that it will still be possible to have a settlement in certain circumstances, for instance:

1. In cases where there are contracts in place at the outset/formation of the company - this might conceivably apply where a company is set up to develop a specific property, or take over some pre-existing contracts, or even take over an existing business of a sole trader.
2. Where the non-fee earning spouse plays absolutely no part whatsoever in the business.
3. Where exemption for gifts cannot be claimed, because the settlor spouse still benefits from the income - for instance dividends paid into joint bank accounts.

There is clearly a need for a re-write for this part of the legislation, until that day, advisors are best off recommending outright gifts of ordinary shares in cases where there are non-fee earning spouse who is not going to play any part whatsoever in the business, but still want to share their spouse’s income. This will avoid any problems associated with this sort of spouse subscribing to shares in their own right.

Article kindly provided by Nichola Ross Martin - Ross Martin Consultancy

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Posted December 16, 2005