Monday, January 16, 2006



I was wrong! I felt very certain that HMRC would win the Arctic Systems case (Jones v Garnett) in the House of Lords. I have not rushed into commenting on this case as I have been struggling to understand the basis of the decision. I am surprised that the taxpayer won – and even more surprised at the reason he seems to have done so.

Mr Jones is an IT consultant. He and his wife each subscribed for one share of £1 in Arctic Systems Ltd. He was the only consultant the company employed. Its results were as follows:

Salary Salary Net Profit Dividend
Mr Jones Mrs Jones
1996/97 £7,146 £2,400 68,307 54,000
1997/98 7,140 2,400 62,439 46,900
1998/99 6,868 3,600 74,707 57,500
1999/00 6,520 3,600 26,372 51,535

HMRC contended that there was a settlement, namely an arrangement under which Mr Jones agreed to work for Arctic for a nominal salary, with half of the bulk of the earnings that he generated then being distributed to Mrs Jones as a dividend. That’s what it looked like to me too!

There are a number of decisions in which an arrangement under which a person works for a company at a nominal salary to enable a dividend to be paid to someone else has been held to be a settlement; such as Crossland v Hawkins (Jack Hawkins) in the House of Lords in 1961, Mills v CIR (Hayley Mills) in the House of Lords in 1974, and in the High Court, Copeman v Coleman in 1939 and Butler v Wilding in 1988. It is hard to see why Mr Jones’ position was any different.

The answer I find surprising. Firstly, Mrs Jones worked in the business. She had experience (as a former catering manager responsible for 11 staff) in financial and business management! Although the business of Arctic Systems, being very small, did not need much management, her role in the business was to do what management was required (and her salary was a fair reward for such work). “Ah” said the Court of Appeal, “This is a joint commercial enterprise. Indeed Lord Justice Keen and Lord Justice Cornwath (whose background is in tax) thought that it would be a significant extension of the law to extend the settlement provision to “a normal commercial transaction between two adults, to which each is making a substantial commercial contribution, albeit not of the same economic value”.

Secondly the Court of Appeal held that the arrangement could not include what actually happened as “all those additional factors depended on the will of Mr Jones or wholly extraneous factors. He did not commit himself to working for the Company at any particular rate of salary or at all…If the Company made profits whether to declare any and if so what dividend was a matter for Mr Jones as the sole director and controlling shareholder…I do not think these elements can be included in the “arrangement”. They did not form any part of a structure of things or combination of objects; their uncertainty and fluidity is the converse of an arrangement”.

Thirdly Jack Hawkins and Hayley Mills had service agreements; they had committed themselves to working for the company at a salary substantially less than the going rate for those services; those service agreements were accordingly a part of the “arrangements” in those cases.

Where does this leave HMRC? I suspect petitioning the House of Lords for leave to appeal (the Court of Appeal refused leave). The judgement clearly points the way to how to avoid the settlement provisions in relation to services, namely:

(a) make sure the spouse does some part-time work in the business,
(b) send her on a book-keeping course so that she has the skill to do so,
(c) do not make the spouse a director, and
(d) do not have a service agreement.

Where does this leave the settlement legislation? In tatters.

Where does this leave tax planning? That is an interesting question. Jack Hawkins and John Mills engaged top accountants and solicitors to provide the best advice available. They now seem to have failed because the advice was too good. They were told that the arrangement needed a service agreement to evidence that the company was entitled to the income. Mr Jones seems to have taken advice from a general practitioner accountant who told him that he should have a company and take the bulk of the income as dividends to split it between himself and his wife. I suspect he had no service agreement because the accountant did not think of having one. I suspect his wife was not a director by accident rather than design. The lesson seems to be that muddling along has a much better chance of success than buying expensive advice. Perhaps that leaves the tax planning profession in tatters too!

Robert W Maas


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