Arctic ruling prompts tax law change
Hot on the heels of the House of Lords’ decision in favour of the taxpayer in the Arctic Systems Ltd case came a statement from HM Revenue & Customs (HMRC) that the government will change the law on ‘the tax treatment of income splitting’. It was followed by an announcement in the Pre-Budget Report that the Government would consult shortly on legislation to remove the tax advantage from shifting income to a person subject to a lower tax rate. It will take effect from 2008/09.
HMRC views it as ‘unfair’ that a person can reduce their tax liability on business earnings by paying dividends to a non-working spouse or civil partner – the issue at stake in the Arctic Systems case. The Pre-Budget Report indicated that the new rules would work alongside existing rules on business deductions and settlements, and would only apply to income in the form of dividends or partnership profits. Employment and savings income would not be affected. It was the settlements legislation that HMRC invoked in the Arctic Systems case.
The changes will not affect any income arising in 2007/08 or earlier. HMRC is now reviewing all cases kept open while awaiting the House of Lords’ decision, and will settle them in accordance with the ruling. However, HMRC has pointed out that not all arrangements are exactly the same as in the Arctic Systems case, and has therefore promised to publish detailed guidance well before the 31 January 2008 deadline for the submission of 2006/07 tax returns. The guidance should also help in deciding on dividends to be paid in 2007/08.
The House of Lords rejected HMRC’s argument that Mr Jones, the company director in the case, was taxable on dividends paid to his wife who only worked for a few hours per week in the company. Nevertheless, they considered – in contrast to the Appeal Court – that the incorporation of Arctic Systems Ltd was a ‘settlement’ within the anti-avoidance rules, because its purpose was to share income and therefore reduce tax. However, Mr Jones could not be taxed on dividends paid to his wife because of the exemption for an outright gift of property between spouses. The House of Lords then rejected HMRC’s argument that the ordinary share held by Mrs Jones was only a right to income – and therefore outside the exemption – because the share also conferred voting and other rights.
Some commentators have suggested that the exemption might be lost if dividends are paid into a joint bank account, because the donor’s access to the income would mean there had not been an outright gift. Holding separate bank accounts is therefore a sensible precaution.