In the second part of a series, Hardhatter looks at the legal journey which has brought this case to the highest court in the UK - and the ups and downs which have accompanied it. (The first part of this series looked in detail at the background to the Section 660 attack - see The case of the husband, the wife...and the taxman (1) - Hardhatter, June 2007).

Not unusual
When Geoff and Diana Jones set up their small IT consultancy little could they have imagined that they would become the legal champions for married couples in business together all over the country.

The structure for Arctic Systems is not unusual - and, in fact, is one which was often recommended by financial advisers and accountants - and at one point even a Government agency. The scenario is quite common. While both parties have shares and responsibilities in the company; one is the major fee earner while the other offers administrative, management and other support. Dividends are paid according to shareholding.

Then the Revenue stepped in...

All was fine until HMRC chose to apply a new interpretation to Section 660, a long-standing tax legislation that had been on the statutes books for 70 years but not applied in the manner that the taxman now proposed.

The result was a tax demand, backdated for six years, for £42,000.

In short, the Revenue claimed that the dividends paid to Mrs Jones should really belong to Mr Jones and therefore taxed at the higher rate.

Spotlight
Small businesses, their representative bodies, opposition politicians, accountants and advisers shuddered at the wider implications for all such businesses. Political rows ensued as one side argued the unfairness of this new interpretation; while the other side, the HMRC and their political masters in the Treasury, dug in their heels and said that there was nothing new and this was a legitimate approach.

With a political stalemate and small businesses left in a limbo land of uncertainty, the stage was set for a legal battle to resolve the issue - and Geoff and Diana Jones found themselves centre stage in the row over the so-called married couple's business tax.

Special Commissioners - the hearing
The case was taken up by the Professional Contractors Group (PCG) and supported by donations from individuals and organisations with an interest in the issue.

The first step on the journey was a three day hearing before the Special Commissioners in June 2004. While this would not established case law, it would provide some guidance and clarification for similar cases.

At least, that was the theory.

The reality of the situation in the Arctic Systems case was that the decision of the Special Commissioners sent the entire Section 660 issue into a farcical state.

The case lasted three days at a hearing before two Special Commissioners.

The Jones's case started on a positive note. Initially the Revenue sought to apply this measure retropectively and back-dated the tax demand for six years, amounting to a claim for £42,000 in unpaid tax from the Jones.

However, the specific circumstances of the Arctic case led to this retrospective element being dropped during the Commissioners hearing when it became clear that the Revenue had information relating to the prior enquiry. This does not set a precedent that it would be dropped in all future cases.

Special Commissioners - the decision
The two Commisoners were entering previously unchartered waters and it wasn't until three months later in September 2004 that their decision was known. And few would have bet on the outcome!

Just as HMRC and the professionals had been unable to reach a common view, the two Commissioners, after hearing the same evidence, came to opposing views. One supported HMRC, the other supported Arctic Systems.

A split decision - with what appeared to be a legal stalemate as well as a political one.

However, that wasn't the end of the matter as the saga took an unusual turn - against the small business. The view of senior of the two Commissioners was given more weight than that of the junior - and the senior Commissioner had supported HMRC's argument. So the Revenue won.

The normally reserved comments of the accountancy and professional world went into overdrive at the situation with some suggesting that the whole decision-making process could be incorrect and others pointing out if two Commissioners couldn't agree with other, what hope was there for any degree of certainty for small businesses.

The practical outcome was that the small business community had no clearer understanding than before and had now suffered a defeat in the Commissioners.

HMRC 1 - 0 Small Business.

The High Court
Arctic Systems, their advisers and supporters decided to appeal to the next stage: the High Court.

But the stakes also rose. The Special Commissioners verdict did not set case law, so a loss or win at that stage was only applicable to these particular circumstances and could only be used as guidance. A victory or defeat in the High Court could have much wider-reaching implications for all husband and wife businesses.

The High Court hearing took place in March 2005 and Mr Justice Park delivered his verdict on April 27 2005. It was another defeat for Arctic and a victory to the HMRC. But still the issue was not clear cut.

The small business community was shaken by this defeat. The PCG, who had supported the case, described it as 'a bitter blow', and tax expert, Anne Redston, called it 'a black day for small business'.

However when the dust settled, it became clear that it had left as many questions unanswered as it had solved.

For example, the judge made reference to a belief that the HMRC might have taken a different approach if Mr Jones had paid himself 'a market salary'. But what is a 'market salary' and where is it defined and by whom?

The judge also said that this ruling was unlikely to affect many small businesses. He cited the example of this not being the same as a husband and wife running a shop. Why? At what point does a partner make 'an acceptable contribution to the business'?

Nevertheless it was now HMRC 2 -0 Small Business and the stage was set for the next act.

Court of Appeal

Geoff and Diana Jones with then PCG Chairman Simon Juden (centre)

Arctic Systems, their supporters and advisers decided to appeal to the next court up the chain - the Court of Appeal.

Initially, the case was scheduled for hearing in January 2006 which brought new groans from the accountants and small businesses who then faced the prospect of filing end of year tax returns without the benefit of a decision or guidance from this case.

However, the date was moved forward and the case was heard in the Court of Appeal on December, 2005 with a decision a few weeks later.

This time the decision went in favour of Arctic Systems, with the judge ruling that HMRC had looked at the legislation and made a 'significant extension' to it - which was found to be incorrect.

The small business community was jubilant - but the celebrations were short lived as the Government decided to appeal the decision to the highest court in the land - the House of Lords

HMRC 2 - 1 Small Business

What happens next?
The case is expected to last three days (June 5-7), although a decision is unlikely for some considerable time.

Which ever way the decision goes, the result is likely to be the end of the legal road and will take precedence over the previous court decisions. A victory for HMRC could see a vigorous attack on tens of thousands of small businesses owned by husband and wives, who could face hefty tax demands. A victory for Arctic Systems would bring an almighty sigh of relief from similar small businesses who jus thought they were following good advice at the time.

However, it is also worth remembering that one of the parties involved in this case has the ability to change the law or introduce new legislation - while the other has the obligation to comply with it.

Further information
Hardhatter's sister site, Shout99 has followed this case closely and all 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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Susie Hughes
The Editor © Hardhatter 2007