Family Business and the Arctic Systems Ruling - Your Questions Answered

Following the recent controversial High Court case of Jones –v- Garnett (Inspector of Taxes) known as the Arctic Systems case, Nicola Zoumidou, and Susanna Heley of Sykes Anderson LLP Solicitors discuss the implications of the ruling with the husband and wife owners of a family business.

Nicola is a Private Client solicitor at Sykes Anderson LLP, a member of STEP and an elected member of the Executive Committee of the Law Society's Probate Section; Susanna is a trainee solicitor in our Litigation and Dispute Resolution Department. They can be contacted by email by clicking on the links above or by telephone on 020 7398 4700

Q. We have heard that there has been a recent case on the taxation of family businesses. We are concerned about what this might mean for our business.

You have heard correctly about the case. It is a very controversial and important ruling concerning the tax treatment of income which HM Revenue and Customs (‘HMRC’) believe to be artificially apportioned in order to reduce the overall tax liability of the people concerned.

Q. That sounds complicated! What does it mean?

Although the rules are fairly complex, the basic premise as it relates to family businesses is straightforward. The essential issue for small businesses – and particularly family businesses - is that HMRC can look at the structure of the business and the amount of work done by each party and check whether the income that they get from the business is proportionate to the amount of work that they do. If it is not, HMRC can apply certain provisions (‘the settlements legislation’) to tax the income of the less active party as the income of the more active party and adjust their tax liabilities accordingly. This will defeat the planning implemented by many family businesses over the years.

Q. Who will be caught by the new rules?

The rules are not really new, HMRC (or the Inland Revenue as was) have been trying to enforce these rules for some time and the legislation has been around in various forms since the 1930s. It was not thought to apply to family businesses. However, following this ruling, HMRC now have judicial sanction for their interpretation of the rules and it is anticipated that they will now seek to enforce their interpretation as much as possible. HMRC have published a number of scenarios which they consider are caught by the settlements legislation including where a married couple own a company and one party runs the company but the other party has been given shares in the company with, for example, preferential rights to receive dividends.

Q. So how does this affect us? I run the company and my wife is a shareholder. How will HMRC treat this arrangement?

It depends on a number of factors, including how your wife came to be a shareholder and the contribution she put in initially. Although the type of company may also be a significant factor.

Q. How is my wife’s initial contribution important?

If she paid the face value for the shares and there are no preferential rights attached to them, HMRC will not usually apply the settlements legislation as your wife would merely be a shareholder in a private company with the same rights as any other shareholder. If the injection of capital from your wife’s shares was necessary to provide start-up capital for the company, the guidance states that the settlements legislation will not apply. There may however be problems in any event if your company is a personal service company.

Q. What happens if she did not pay for the shares to begin with?

If you gifted the shares to your wife and she made no contribution to the company at all, HMRC may apply the settlements legislation and claim that what you have given your wife is a right to income in the form of dividends. They will take the view that she has done nothing to earn this and that it is therefore a ‘bounteous arrangement’. This is what the Settlements legislation is designed to prevent. HMRC will apply the Settlements legislation and deem the dividend income to be your income and tax you accordingly. Since these arrangements are usually put into place to take into account the less active party’s tax allowances, the overall tax liability as between you and your wife is likely to be increased.

Q. What is a personal service company?

Personal service companies are basically private limited companies which are set up to provide the services of one person. They are usually set up by consultants and people who would otherwise be independent contractors to take advantage of the beneficial corporation tax regime. The ‘employee’ usually also the director/shareholder draws a small salary from the company and takes the remaining profits as dividends, usually at an effective tax rate of 10%, rather than the 22% they would otherwise be paying.

Q. Why does it make a difference if my company is a personal service company?

If the company is a personal service company – as Arctic Systems was in the case you mentioned – HMRC are much more likely to treat dividend income paid to anyone else as accruing to (and therefore taxable on) you.

Q. So does this only apply if it is my wife getting the money – what about if my children own the shares?

The Settlements legislation applies to everyone, including children and strangers where HMRC believe that there is a ‘bounteous element’ to the transaction. They will ask whether the transaction would have been made in the same form if the parties had been at arm’s length. If the answer to this question is ‘yes’, the arrangement will be commercial and will fall outside the Settlements legislation however if the answer is ‘no’, HMRC will usually seek to apply the Settlements legislation.

Q. That shouldn’t be a problem though, should it? Surely the tax liability can’t be that much?

Each case depends on the specific circumstances of the settlement in question. In the case of Arctic Systems, this led to a back tax bill of £42,000, on which HMRC are likely to be able to claim penalties and interest. It is therefore vitally important that the arrangements you have in place are not deemed to be settlements.

Q. So what can I do to minimise my liability?

Unfortunately, in the light of the Arctic Systems ruling, there is nothing you can do about the back taxes owed if you are caught by the Settlements legislation. If you are concerned that you will be affected, you should take legal advice from a properly qualified adviser. It may be the case that you need to tell HMRC about your liability so that you are seen to be co-operating with them. If you co-operate fully, you may be rewarded by a reduction in the penalty which may otherwise be payable. Interest is likely to be payable in any event.

Q. What about future liability?

You should consult a professional who will be able to give you advice tailored to your specific circumstances. In general, you should ensure that there is no bounteous element to transactions you make. You can ask yourself whether you would offer the same transaction to a stranger in order to decide how HMRC would view it although bear in mind that they may view matters differently to you and your answer is unlikely to definitive.

Q. Any other ideas?

Effective tax planning is key and there are a number of ways your affairs can be structured to minimise your tax liability. Effective schemes cannot be discussed properly in general terms and you should take advice on your own circumstances.

Sykes Anderson LLP can offer proven tax advice and expert assistance in dealing with HMRC. Please contact Nicola Zoumidou for further details.

Please note that the information herein is of a general nature and you should not act or refrain from acting on it without professional advice on the specific facts of your case. Taxation is a complex subject and the above is a basic outline only and is intended only as a general guide.