Sunday Times
April 20, 2003

Small Business: Taxman attacks husband-and-wife firms
Experts are shocked as an obscure law is used to tax wives incomes at the higher rate. Louise Armitstead reports

THE Inland Revenues treatment of Geoff Jones and his wife will send shivers down the spine of family businesses.
Eighteen months ago Jones, 42, was shocked to receive a letter demanding 42,000 in unpaid taxes from Arctic Systems, an information-technology company he set up with his wife in West Sussex 13 years ago.

Jones desperately tried to make sense of the letter. It seemed to contain incomprehensible jargon about an obscure tax law, section 660a of the settlement legislation (1988).

He says: It was frightening. Id never heard of section 660a and frankly didnt understand the letter.

His tax return had always been on time and completed with the help of experts: the Revenue had surely made a mistake. But one frantic telephone call confirmed that the letter was a genuine demand.

It was only when Jones sought expert advice that he realised the taxman was claiming the 42,000 under powers that not even Britains top tax consultants knew existed.

Linda Eales, tax expert at Qdos, was the first to look at Joness letter. I was very surprised, she says. The Revenue was using settlement legislation, which taxes gifts of income producing shares between two parties, in a way not used before. It was extraordinary.

Jones went to the Professional Contractors Group (PCG), the trade association that started life four years ago as a lobby group to fight against the controversial IR35 tax. If there was a bizarre new business tax, he felt, it would know about it.

It didnt. But it realised at once that every family business was potentially liable for a similar bill to the Joneses.

To reach its conclusion that Jones had been underpaying, the Revenue had taken a broad view of Arctic Systems structure and the way money was released from it.

Like most small family businesses, the couple each have a 50% shareholding in the company. They both draw salaries from the business and dividends from the shares.

The Revenue seems to be saying that since Geoff, as the IT consultant, is Arctic Systems only fee-earner, all the businesss profits are his, rather than the companys, says Mike Warburton, tax partner at Grant Thornton. As a result, Geoff is using the dividend to give his wife income that would otherwise be his.

It claims he is avoiding tax because the income from the dividends has been taxed at his wifes basic rate of income tax rather than his higher one.

Although it had never asked for the tax before, the Revenue was demanding tax backdated for six years. It said we owed 30,000 in unpaid taxes, plus 12,000 interest, says Jones. I have recently been told that I now owe another 2,000 in interest because I havent paid yet. The simple fact is: I cant.

Joness case shocked even experienced tax experts. Our immediate reaction was utter disbelief, says Simon Dolan, tax specialist at SGD Accountancy. Generally the Revenue has not attacked husband-and-wife companies under the settlement legislation.

The case has caused so much confusion that the Chartered Institute of Taxation demanded that the Revenue clarify its view immediately.

Last week it issued a statement in its quarterly tax bulletin confirming: The settlement legislation is intended to prevent an individual from gaining a tax advantage by making the arrangements which divert his or her income to another person liable to a lower rate of tax.

The wider implications are obvious. There are more than a million family businesses in Britain, most of which are structured in the same way as Arctic Systems and all of which could be attacked by this tax.

The Revenues view will cause panic among husband- and-wife limited companies and the accountants who advised them to set up companies in this way, says Eales. We think its stance is legally unsound and will be seen as a new tax on a large number of small businesses.

Grant Thorntons Warburton agrees: The Revenue is stating in its tax bulletin what it thinks the law should be, rather than what judges have decided it means. This may scare people into paying unnecessarily.

As far as I can see, the line taken with Geoff Jones is utterly iniquitous. There is no legal precedent or justification for this.

The PCG has written to the paymaster-general to express its concern. Individuals running small family businesses who believe they comply with the tax system will find they are unexpectedly branded as tax avoiders and have large, possibly unpayable bills, it says.

We believe the (Revenues) approach is legally flawed, unprecedented, and will be seen as an unfair new tax on small businesses.

Anne Redston, tax partner at Ernst & Young, agrees: This is a very serious issue. Husband-and-wife partnerships have been unaware that the Revenue was going to take this position. They are in for a nasty surprise.

Experts say it is no coincidence that the Revenues new rigorous enforcement of this law coincides with the governments determination, repeated by chancellor Gordon Brown in his budget a couple of weeks ago, to make tax collection more efficient. According to the PCG, it could raise 1.2 billion in additional revenue.

The Revenue denies there has been any change in its policy. There is nothing new in this legislation or its use. It has been on the statute books for many decades. All we are seeking is to ensure fairness in the application of the law and that the right amount of tax is paid by all our customers.

Nevertheless, the Revenue has a fight on its hands. Qdos is preparing to take Joneses case, and two similar ones, to tax commissioners, alleging that they are being illegally taxed. The case could go all the way to the House of Lords.

Businesses are keenly awaiting the test case. In the meantime, experts say that managers who receive unexpected tax bills under section 660a should seek immediate advice.

It seems that this will be applied to IR35 situations where one party is the sole fee earner. On the face of it, it would seem to be correct. The dividing of his income between his wife and him to take advantage of her allowances and put some of the income into a lower tax bracke is a device to avoid IR35. It may not be pleasant, but it looks quite legal and not unreasonable. I would expect that people who bring cases against the revenue would almost certainly lose. The implications of IR35 are more far reaching than people realise. It effectively treats the person as though they were on ordinary PAYE. Perhaps a few people should try and have their income from normal employers spit between them and their wives and see what the reaction of the revenue would be.

Interesting stuff.

An "ordinary employer" would not of course play ball in splitting income: the wife (one assumes in a sexist manner) would then be entitled to all sorts of other benefits and protection in employment from the employer.

My experience of this sort of thing (IR35) is that if an effective and determined case is made for it NOT to apply, the Revenue will back off in individual cases. Relying on accountants and lawyers is less effective that making your own (low-profile) case. The Revenue do not want to (therefore will not) lose high profile cases that set precedents that they don't like.

The thing to show is that the wife is a key part of the business and contributes to the fee earning.

MM

This is an old story, which seems to re-appear on a regular basis.

It's as MightyMicro says, except contributing to the fee earning is not as important as actually being paid a fair rate (e.g. minimum wage)for a reasonable amount of work carried out for the business.

Too many wives are paid a salary without doing anything for it or in many cases even being aware that they are being paid at all! This is a gift not a salary, so it's hardly surprising the IR may not allow it.

The problem with IR35 is that the revenue will not generally accept another person being paid as they do not accept that normal expenses can be claimed. When IR35 is applied there is a very low limit of expenses that are acceptable for the business. In fact the revenue do not really regard it as running a business at all. They treat most of the income as though it came from an employer. Therefore another person taking an income from the business would not be reasonable in their eyes. It would seem that this approach and application of the tax rules is the logical outcome of IR35 and as such would seem to be inevitable.