If HMRC wins, thousands of couples in similar situations could face tax bills of up to £42,000. The irony of this case is that it is a highly common practice to establish companies in this manner. It was widely recommended by accountants and financial advisers and, in fact, at the time of the court case it was even advised by the Government's Business Links service which said: If desired, family-members' remuneration can be topped up by other means - through regular share dividends, for example.
Hardhatter's sister site, Shout99 has updated its two-part series which looks in detail at the background to this case and the Jones' road to the House of Lords.
Section 660 - the Prince and the Showgirl
Married couples in business together can 'blame' their current predicament on a piece of legislation which was aimed at 'the Prince and the Showgirl' syndrome of nearly a century ago.
The 'offending' piece of legislation is now known as Section660 and relates to Sections 660a to 660g of the Income and Corporation Taxes Act 1988. It originally dates back to the 1920s when it was known as the 'settlements legislation' and it had something of a rather romantic origin.
The purpose of the settlements provision is to give somebody a right to income but not to the underlying capital. This was not that unusual in the days when heirs to nobility married showgirls. His family would want to ensure that, while the new bride would be kept in a status worthy of her new position, she couldn't get her hands on the 'family silver'.
The HMRC's weapon against this has been the so-called married couple's business tax or Section 660, a Government-deemed form anti-avoidance legislation. It is this new interpretation which is causing so much concern for small family businesses nearly a century later.
The case for the HMRC
The HMRC says this isn't new - which has a further disadvantage for small business in that it means that they can seek back taxes up to six years.
The political position was summarised by Paymaster General, Dawn Primarolo, who wrote to her Conservative opposite number: "First let me reassure you there is neither a new policy nor any change in policy in the application of the settlements legislation. The Inland Revenue has been applying the legislation in this way for a number of years.
"The settlements legislation is intended to prevent an individual from gaining a tax advantage by making arrangements which divert his or her income to another person who is liable at a lower rate or is not liable to income tax".
Nevertheless, advisers have been a little more than surprised when, a few years ago, the Revenue blew the dust off this old Statute and decided it could be used to target husband and wife businesses.
For decades, accountants and advisers have been recommending small businesses arrange their affairs in this manner, with the shareholding - and therefore entitlement to dividends - divided between partners.
In a nutshell, the HMRC takes as an example the case of a business owned by a husband and wife where the shares are divided. One of the parties is the major fee earner who receives a salary from the business. The profits are then paid out as dividends between the shareholders - the husband and wife or close partners.
The HMRC claimed this is a transfer of earnings from the higher tax payer to the lower tax payer in order to avoid tax and cried 'foul' or to be more precise cried 'settlements legislation' - and attempted to charge the fee-earning partner as if he or she had received the income (at a higher rate of tax) rather than his or her partner.
The issue is complicated further by the 'retrospective' element of the case as the Revenue believed it could push for payment dating back six year - which would amount to tax bills of up to £42,000. This proved not to be the case in the Arctic hearing as there had been a prior review which did not raise this. But the retrospective element could still exist in other cases.
The case against
Advisers, representative groups, professional bodies, accountants and small businesses have seldom been so united in their opposition to an issue.
Official letters, Parliamentary Questions and formal representations have been made to the HMRC and their political masters arguing that this was not the intention of the legislation and citing the unfairness of the HMRC's approach.
They responded by issuing a further Tax Bulletin in April 2003 and then a guidance note for professionals in November 2004.
But accountants and advisers felt this guidance fell well short of the mark and it was roundly condemned. Rather than clarifying the situation, it still left significant room for confusion and uncertainty.
At the time, Kevin Miller from Ernst & Young described it as disappointing being long on pages and short on new information. John Beattie, President of the Chartered Institute of Taxation likened it to a sun-burnt zebra. He said: "We have read it from cover to cover, but it deals only with the black and white and not with the important grey areas, which remain just as murky as before. After all this time, we hoped for more than a sunburnt zebra."
So both sides - the HMRC and advisers - were left in a position of having to agree to disagree, with small businesses trapped in a no-man's land somewhere in the middle.
Tens of thousands of small businesses owned by husband and wife or close partners were facing a taxation uncertainty, not knowing if a tax bill for up to £42,000 could land on their door mat for doing something they had been advised to do and everyone believed was acceptable practise at the time.
While they couldn't change the past, there was still uncertainty about what they should be doing now and how they should arrange their business in the future.
Resolution of this issue seemed to lie in the hands of the legal rather than the political system.
Arctic Systems, a husband and wife owned IT consultancy, became the test case - and will now appear in the highest court in the UK, the House of Lords, after a three year journey via the Special Commissioners, the High Court and the Court of Appeal.
On Monday, in part two, Hardhatter will look at the details of that legal journey.
Hardhatter's sister site, Shout99 has followed this case closely and all the developments relating to Section 660. You can read more about the background and the issues at stake in Shout99's Section 660 resource centre
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The Editor © Hardhatter 2007