Arctic Systems case - No tax certainty for family businesses

The final arguments of a landmark tax case, heard earlier this month in the House of Lords, will have a major impact on the future taxation of family businesses whether the taxman wins or loses, according to leading accountants and business advisers PKF.

If, as expected, HM Revenue & Customs (HMRC) loses the case, PKF predicts that it will push the Government into a change to the relevant tax law - clamping down on a widely-used and accepted business practice.

The case, an appeal by HMRC against an earlier ruling at the Court of Appeal in favour of a company called Arctic Systems, relates to the taxation of the profits of the husband and wife-owned company.

Geoff and Diana Jones established their jointly owned company, Arctic Systems Limited, and each purchased one share in the company, drew a salary and distributed profits equally as dividends.

HMRC argued that the Joneses avoided tax by under paying Mr Jones’ salary whilst paying more in tax-efficient dividends to both Mr and Mrs Jones. However this is a well established business model and, if HMRC wins, then thousands of similarly operated businesses will be affected. HMRC claims that it started to pursue cases on this issue in the mid-1990s.

Peter Penneycard, National Director of Tax at PKF, explained: “What the Joneses did in establishing their business in this way was common practice. It is only since HMRC published its re-interpretation of the law in 2003 on how jointly owned family businesses should be taxed that such businesses have been aware of the tax risk.

“HMRC stated that if there was a co-owning spouse whose contribution to the earnings of the business was low then, if they received dividends, the dividends should be taxed as the income of the spouse who is the main earner.

“However what this means is that a widely used business structure has been undermined by HMRC - shifting the goalposts and making many business owners liable, not just for higher current and future tax, but also backdated tax.

“Their Lordships’ questions and comments during the hearing suggest that they feel HMRC’s interpretation pushes the meaning of the law to the limit, if not beyond. Therefore, I am hopeful that sense will prevail and, on the facts of this case, they will rule in favour of the Joneses.

“However, if HMRC loses, I fear it will either marshal a more cogent argument to attack this business structure or simply move the goalposts again by asking the Government to change the relevant tax law. It has already started to attack small companies in this year’s Budget by proposing increases in the rate of corporation tax that they pay. Family businesses will continue to face uncertainty on their tax bills for some time to come.”