Husband and Wife companies - The Arctic Systems Case

The HM Revenue & Customs are challenging the tax planning of setting up companies in which both husband and wife are shareholders. This is applicable where income has been split between the partners to ensure that both have sufficient income to use their basic rate band

The HMRC have been successful in the courts in challenging one arrangement in the case of Jones v Garnett. They are using this victory to push back the boundaries beyond those shown in the case itself. The taxpayer has gone to the Court of Appeal so all the information below may be overturned in the future

The HMRC are arguing that there was effectively a gift of income (called a "settlement") and that this is not effective for tax purposes. The income is still taxed on the person who made the gift. The settlement legislation was introduced to prevent a person being able to transfer income to another person in order to avoid higher rates of tax.

A settlement can include "any arrangement" to transfer income and the HMRC are using this wide definition to include the circumstances where an individual reduces their normal commercial salary in order to allow a company to pay larger dividends part of which will be paid to another person.

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What is definitely acceptable?
The HMRC have issued a 49-page booklet which sets out the interpretation they are applying which makes excellent light reading and is available on their website. The HMRC make it clear that if the facts show that the business is a commercially run joint venture and the income flows reflect that, it is unlikely that any income will have arisen under a settlement. If both partners are fully involved in the business then there is clearly no problem.

What happens if we are caught?
The effect of the settlement legislation is to treat the income arising to the non- working partner as if it arose to the working partner. Generally this will remove the tax benefits and so the structure is ineffective.

What if we are in between the two extremes?
The difficult area will be for businesses where both partners are involved but one is clearly more active than the other. The HMRC says that the diverting of income will be challenged if there is an arrangement, which is "bounteous" and "not commercial". The HMRC "helpfully" explain these terms - which have been defined in the courts - by saying that an arrangement is blocked if it is one that would not have been undertaken with a third party. This seems too sweeping, since so many business decisions in a husband and wife company are made on the basis of a trust that does not exist between people acting at arms length. None the less it is clearly going to be important to establish that all arrangements can be supported by justification as being the equivalent to those transactions that would have been taken at arms length.

How do we get out of it if we are caught?
In most cases where someone accepts that they are caught, it will be advantageous to wind-up the company and to substitute some alternative structure to maximise the tax benefits going forward. Since the settlement legislation does not apply to capital, we might take out spare cash from the company as a capital gain rather than income as a dividend. If you are worried then please contact us to discuss your particular circumstances.

What alternatives might we consider?
Suggesting alternatives is very much a case of fitting a plan to suit someone's particular circumstances. No one solution will fit all clients. However some options which might be helpful in some circumstances would be taking a higher salary for the working partner and only distributing the excess, forming a partnership instead of a company, forming a new company in which only one partner was a shareholder, purchasing assets within the company so that there is a more than just an income stream.

What should go on the tax return?
The HMRCs advice suggests that if your circumstances are at all problematic you should make a note of this on the tax return. This should only be done with great care. If you are concerned then please discuss this with us, before the tax return is completed.

What can I do to strengthen my argument?
If you are comfortable that your arrangement is commercial then it is good practice to make a record of this so that there is evidence if the Revenue challenge. Minutes of directors meetings at which both parties take an active part are essential. Document the hours and the tasks which the less active party takes in the business. We will continue to avoid using dividend waivers. We will only set up companies with different classes of shares where there is a commercial reason.

Are husband and wife companies now a bad idea?
There is no doubt that much greater care will now be necessary before recommending that a husband and wife should both be involved in a company. There are many occasions when the arrangement is both tax efficient and commercially appropriate, indeed these are likely to be the majority of husband and wife businesses. Personally we think it is significant that there was a very particular professional expertise in the Court case and this was always exercised on the client's premises - one client at a time.

However, it is undoubtedly true that the HMRC are seeking to push the boundary beyond the point established in the case. The HMRC have insisted that there will not be large numbers of family companies caught by this change, therefore it seems clear that they accept that in most cases, it is perfectly acceptable tax planning and not avoidance caught by the settlement legislation.

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If you feel you are affected by the Settlement Legislation or wish to know about the implications of the Arctic Systems Case, please get in touch with one of our consultants at Andrew Webster Limited by calling 01223 507080 or e-mailing info@tax.uk.com

Important: This note on the Settlement Legislation is for the purpose of guidance only and further professional advice should be obtained from your Account Manager before acting on any information contained herein. Andrew Webster Limited will not accept any responsibility for loss caused to any person(s) whatsoever as a result of action taken or refrained from based on the content of this note.