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Arctic Systems: Full judgment released

23rd May 2005
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The official version of the full judgment in the 'Arctic Systems' case of Jones v Garnett has been released.

In his concluding remarks, Justice Park said: "The decision of the Special Commissioners in this case has attracted considerable attention among professional tax advisers.

"It seems to have caused much consternation. In my view apprehensions that almost every case of a husband and wife company is going to be affected by this case are greatly exaggerated.

"If a husband and wife set up a joint company and run it together (for example, the company opens a shop and the couple run and staff it), it does not follow from my judgment in this case that the husband is going to be taxed on the wife's dividends.

"It is also an important feature of this case that Mr Jones provided funds directly or indirectly for the purposes of the settlement (see words appearing in section 660G(2), the definition of 'settlor'), by working for Arctic Systems Limited in return for a salary far below his true earning power.

"It would be far harder for the Revenue to establish that there is a settlement or arrangement of which a husband is a 'settlor' if he is paid the going rate for employees carrying out the sort of work which he does.

"I have given judgment at some length because there is widespread professional interest in this case, but I do not think that there is anything particularly novel or alarming in my decision. I believe that it is a simple application of well-established principles. Applying those principles, I dismiss the appeal."

Simon Sweetman, vice-chairman of the tax policy unit at the Federation of Small Businesses, will provide an analysis of the judgment for TaxZone shortly.

Consultants have emerged as the main targets of HM Revenue and Customs' challenge under section 660A, says the Daily Telegraph.

It added that HMRC "says the 100 companies and partnerships it is investigating alongside the West Sussex IT services firm that featured in last month's Arctic Systems High Court case operate in a range of industries."

But accountants believe the "vast majority" will be consultants and "other low-asset backed service companies, such as freelance writers". They are scaling back estimates of how many businesses will be affected by the High Court ruling.

Justice Park indicated that spouses paying themselves market rate salaries would avoid being caught by section 660A. The Telegraph quoted PricewaterhouseCoopers partner John Whiting as saying that the principle introduces a "grey area" of what salary is acceptable.

But Stephen Herring, a tax partner at BDO Stoy Hayward, described it as a matter of judgment. "No doubt it's somewhat less than the company would make in a good year, but it's certainly more than the minimum wage," he said.

Support for anti-avoidance clampdown
The Professional Contractors Group, the trade assocation that backed the taxpayers' unsuccessful appeal, has welcomed a Labour MP's call for a clampdown on artificial tax avoidance schemes.

PCG political researcher John Kell told TaxZone that the PCG believes that "everyone should pay a fair amount of tax".

Andrew Goodall
Editor, TaxZone

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Replies (15)

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By Paul Soper
02nd Jun 2005 22:45

I thought things were very quiet - I have just received a whole wodge of comments on the s660A thread today 2nd June and yet the latest is May 27th - the last of which is Mike Truman (Hi Mike) agreeing with much that I said!

Looking at the various (20 or so comments) received today it is clear that this situation is NOT as simple as Park thinks it to be, and the fact there is likely to be no appeal is a tragedy of considerable dimensions.

The full judgement does not answer the questions we need answering and I shall be very interested to see the 200 plus further comments that are probably lurking behind the delay in posting!

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By AnonymousUser
27th May 2005 17:29

Much as I agree with most of what Paul Soper has written below, I do think we need to be a bit more realistic about the level of involvement of Diana Jones in the business.

The facts are spelled out by the Special Commissioners - in the three and a half years to June 2000, the company dealt with four clients through three agencies. If this was a Lorimer-type case, and there had been a Mrs Lorimer pounding the phones selling his services a day at a time, I think there would have been a much stronger argument that it was joint entrepreneurship, but not here.

She clearly handled the finances of the company very efficiently - billing (presumably monthly), tax returns, accounts, dealing with accountants. But Mr Jones could just as easily have paid a part-time book-keeper to come in and do that work, and would not have had to pay more than the salary Diana received, as Park J points out. The arguments about the law, about charging sections and about 660A(6) are to me where this case is important, not an attempt to show that the business was really a joint venture.

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By NeilW
26th May 2005 10:01

Once again I feel that the focus on this board is the company, its directorate and its shares. That is not the settlement, that is merely the mechanism via which the settlement is enacted.

The settlement bounty, as determined by the judge, is accepting a lower salary than you could reasonably get from a third party. The mechanism by which this gets to the beneficiary of the settlement, whether by trust, gift, partnership or incorporated body is entirely beside the point.

That is why the particulars of the shareholding and the directorate are not important. The property being settled is not the ownership of the company, or the income from the company, or any physical asset. It is the earning power of an individual.

Remove the low salary and Artic cannot apply. The Revenue must find another bounty in the arrangement.

The trick for clients is to apply for permanent jobs at the same time as going for contracts. Any differential between the two can then be legitimately exploited as profit, because you have evidence of what the market premium was at the time.

Alternatively go for the easy life and start paying large amounts into a pension.


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By AnonymousUser
26th May 2005 11:33

If only it were that simple...
The whole 'Market Salary' idea is completely spurious once you try and tie it down.

If a Contractor works a set of contracts then on one contract he may be working in London as a Garbage Collection Specialist, in another he may be in Leeds as a Call Centre Operative, in another he may be Programming or whatever. Each role has a different Market Rate.

Mr C. may be capable of earning £100K if he goes to London for some roles and £20K for other roles that he does. What is the market rate. If he works in Leeds then this is a different rate and so on.

You can only sell things that people want to buy. If you cannot sell your Origami skills for any price TODAY the market rate is 0.

If you can find a job offer in Nepal for £15K for Origami then is that the market rate?

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By Anonymous
26th May 2005 12:56

Market Rate

I suspect that if HMIORAC (!) has a set of accounts thrust at him with £24,000 of PAYE salary for Mr. Big, and similar amount of divs, and some sensible expenses he will not quibble in most cases whatever the industry. It’s the £4k. salary £44k. divs guys he is targetting.

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By andymeeson
26th May 2005 14:51

Agree with Neil W and James S
The "settlement" definitely lies in the fact that Mr Jones generated all the revenue and yet chose to pay himself far less than he would have accepted from an arm's length employer.

It matters not a bit exactly what the elusive "market rate" may be. All that matters is that what Jones paid himself clearly could NOT have been the market rate. That, in Park's view, is enough bounty to make a settlement.

@ Daren P: I quite agree that if another fee-earner brought in 25% of the firm's revenues, there could still be a settlement. It would be a settlement in respect of the 75% which the "settlor" brought in.

On your point re W earning a reduced admin salary, I think there could be some negotiation room there in appropriate cases. However, in Arctic, Park explicitly commented that there was no dispute that Mrs Jones' salary was fully commensurate with her work (4-5 hrs a week).

Musings: there could well be a philosophical mismatch between consultancy-based fee income and the very structure of a limited company. HMRC appear to appreciate this mismatch somewhat better than many in the profession. The mismatch I refer to is this:

On the one hand a shareholder in a company may expect to receive dividends as a return on his investment in the company, as a reflection of the company's success. On the other hand, a fee-earning consultant is bringing in revenue based almost entirely* upon his personal skills and expertise. One may argue (and HMRC do) that it is hard to see how a non-contributing shareholder's dividend based on such income can represent a "return" on his "investment"...

* Circumstances may of course differ: a consultant working for a well-known company with a "brand image" and reputation may well be seen to derive a substantial proportion of his fee income from the brand and infrastructure rather than from his personal qualities. This is almost certainly where HMRC's arguments about a "capital base" come in.

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By davidkitley
27th May 2005 09:24

What about splitting salaries and shares in proportion to 'contr
If Mr 'contributes' 75% to the working and running of the company and Mrs 25%, the shares are split 75:25, the low salaries are split £4500:£1500. Therefore everything is in proportion to the Directors (if they are both Directors)perceived and agreed contribution to the business. In Arctic's case Mrs J must have made some contribution to running the business even if it was only 10%.

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By Malcolm Veall
27th May 2005 13:28

Doing the Sums
I have not done the sums yet but I wonder if anyone else has?

If the 'business' is generating profits up to c.£35K then the advice now presumably is simply to give all, (or most), of the shares to the 'earning' spouse. But what if there is the potential for the profits to increase well above the basic rate band for one person?

If profits are well above the higher rate threshold then do we have to compare:
- 22% Inc Tax + 8% NIC as self-employed with,
- 22% Inc Tax + 11% Ee NIC + 12.8% Er NIC on the "market rate" plus dividend rate Inc Tax on dividends of the balance of the profits, (which presumably now can be 100% in the hands of the non earner spouse).

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By AnonymousUser
25th May 2005 11:23

Market Rate Salary unworkable
I find this concept of Market Rate Salary slightly difficult to determine. Put simple What is Market Rate Salary?

Is it what the company can sustain or what other companies in the area pay.

If it is other companies which area; where the company is based or where it's client's are based.

Is it perhaps the average; if the average the modal, mean, or median average.

Is it measured based on the town, city, county or region, or national average.

A Director of a limited company has a legal duty to ensure the company is solvent. Is this removed because when working out the Market Rate Salary it's bigger than can be sustained by the company (I doubt it).

Is it perhaps the salary the worker sustained prior to becoming a consultant.

Would the consultant be considered outside S660 if the company had products other than the result of their work (I know a number of consultants including me for whom this is true).

Would they be outside of S660 if the company had substantial assets - if so what constitutes substantial assets.

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By Paul Soper
25th May 2005 11:34

I must confess disappointment in reading Park's judgement - he does not appreciate the nature of the case as a test case, even though he says its a test case (although the revenue deny that to stifle further appeal. But as Darren identifies he hasn't looked in any detail, it seems, at the reasoning that lay behind Nuala Brice's finding concerning the influence exercised by Graham, rather than Diana, and that this brought the shares into the realm of wholly or substantially a gift of income and so outside s660A.

I think he could be said to be correct in arguing that there was no outright gift (in the shares) because they were acquired at their then market value, but goes on to describe the settlement as being the whole arrangement, of which the acquisition of the shares was one element, where surely there must be the characteristic of the gift as it is surely the counterpart of bounty. You receive something bounteously because it is gratuitous, it is gifted.

The more I reflect on Park's judgement the more flawed I find aspects of it - and yet reading the judgement and considering the part played by counsel for the Jones's, if commentaries like Simon Juden's are anything to go by, Gammie seems to have acquiesced in the whole process. I cannot see why Pepper v Hart arguments concerning parliament's intention were not raised by him at the Commissioners and why he did not press Park to rule on the consequences of Nuala Brice's casting vote. He and the judge seemed to have accepted that it is of no consequence here - and yet if Nuala had ruled in favour of the Jones it would be the revenue pressing to bring an appeal and their would have been a greater chance of their funding the appeal.

I am no barrister, and I am sure the legal team acting for the Jones's had good reasons to advance the arguments they used, but in allowing the judge to narrow the judgement to only two issues, is there a settlement and is there an outright gift, an opportunity to force a broader consideration of the nature of settlements has been missed.

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By Paul Soper
25th May 2005 11:46

Market Rate Salary
A further annoying aspect of this case is that the good judge confines his arguments to one year 1999/00 as three earlier assessments had been dropped. That year was the last year before the implementation of IR35. In the two following years Graham paid himself a salary to avoid IR35 and took no dividends, nor did Diana draw a salary, then in 2002/03 returned back to his former practice as it seems that IR35 should not have applied. Justice Park seems to have taken Graham's salary under IR35 conditions as indicative of his market salary but...

Income is derived from work, but it is also derived from enterprise. Many consultants became such not just to receive a salary under Schedule D but to earn additional profits which stemmed from his, and his wife's entrepreneurship. It is clear that they embarked on this venture jointly and both the Commissioners and Justice Park make comments that Diana took a real part in the process. Now if we accept that there is a settlement (which I still don't) in Graham donating his market salary, both he and Diana contributed to the further element which was derived from their entrepreneurship. Surely we have advanced beyond the concept in any commercial enterprise the profit is derived solely from the sale of goods - all of the operating and support parts of any enterprise of any size have to work together to generate profits and all contribute to the profit generated - that is surely which our transfer-pricing regime looks at business facilities of whatever description - provide advice of share schemes, as in the Waterloo case and it has a return - so must the support work contributed by Diana.

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By carnmores
25th May 2005 18:27

It would be foolish
to think otherwise that judges have fearsome intellects but i sometimes wonder about their take on the commercial world.

by the way what is the market rate for a judges pay these days

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By Anonymous
26th May 2005 09:31

icy blast
OK so the learned judge is adhering to the letter(?)of the law at section 660G(2)which appears to be a crucial part of all this.That would according to his interpretation appear a fait accompli for past cases that square.Each case on its merit and all that.Surely to get around it in future (which whilst Tonys Cronies deliberate on the future of small companies is as important?) is to make the "non earning" spouse the sole director and 51% shareholder.In such circumstances Mr Jones could not "indirectly" or otherwise direct income because he does not (in company law not interpretation)control the payment of his salary.He would have to be on minimum wages but I am not aware of any association of directors powers between spouses ??
Makes you wonder that if its such a "simple application of well established principles" why it took him 6 weeks and the whole thing years to be decided?

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By andymeeson
25th May 2005 10:18

Type of business is as critical as salary level
For me, one of the most interesting comments made by Park J in his judgement are these:

"the salary paid to Mr. Jones was plainly far less than his expertise was able to generate for the company"

"all of the receipts of the company, which enabled it to have profits and to pay dividends, were attributable to Mr. Jones"

The judge is clearly suggesting that there was only a possibility of a settlement because Jones himself generated all of the income; Mrs Jones could not have generated any of it. Park J's extended comments on the application of Crossland v Hawkins strongly support this view.

I don't see the asset backing as having any huge impact in Park's thinking. What counts for him appears to be the fact that a company's income is derived directly from one individual's skill, training, experience and know-how. This appears, in the judge's thinking, to make it "his" income, which he is "settling" on the fellow shareholder by taking less than he could expect to receive commercially for it as a director/employee of an "arm's length" company.

My reading of the judgement is that there are two triggers for an "Arctic" - (1) all or most of the company's revenue is derived from the skill of one shareholder and (2) that shareholder takes an uncommercially low salary. But both must be there.

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By AnonymousUser
26th May 2005 14:58

I suspect
That James S is correct. However, that is not what the judgement said and it has introduced a new concept into the Tax Law equation.

Based on previous experience, sooner or later some HMRC Inspector is going to see a Salary of £24K and a Divi of £24K on a Company and consider it fair game.

Sometimes Cost-Benefit analysis is used, sometimes it is bloodymindedness.

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