Arctic Systems: new legislation announced following HMRC's defeat in the House of Lords

On 27 July, the House of Lords gave its judgment in Jones v Garnett [2007] UKHL 35.

The facts are relatively common in family owned businesses. Mr and Mrs Jones each acquired half the ordinary share capital in a company. Mr Jones provided IT consultancy services via the company and earned the income of the business. Mrs Jones provided administrative support. Both took a salary but Mr Jones' salary was less than he would have earned in the market. The balance of the company's profits were paid as dividends. This reduced the total tax bill because national insurance contributions are not payable on dividends and Mrs Jones paid tax at lower rates than Mr Jones.

HMRC argued that anti-avoidance rules applied to the dividends paid to Mrs Jones to treat the dividends as income of Mr Jones. The rules apply to gifts between spouses if the transferor (or spouse) has an interest in the asset or income deriving from it and the asset is wholly or substantially a right to income.

Their Lordships agreed that the anti-avoidance rules applied in principle but dismissed the appeal on the basis that ordinary shares are not substantially a right to income. HMRC immediately announced that legislation will be introduced to reverse the decision.

Individuals that are considering providing their services via a corporate vehicle must consider carefully whether incorporation is appropriate. Such companies are likely to be caught by the IR35 rules or the new managed service company rules. Additionally, the changes to income tax and corporation tax rates announced in Budget 2007, will make incorporation less attractive. HMRC's announcement of more legislation will no doubt add further complexity without addressing the underlying problem of different tax rates applying to employed and self-employed income and earned and unearned income.


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