HIGH COURT JUDGEMENT SET TO AFFECT WELSH FAMILY BUSINESSES

by
Steve Screech
Tax Director, Broomfield and Alexander

Family businesses – of which there are many thousands in Wales – will be holding their breath this week after a high court judgement which may close the door on a very common tax planning practice.

Husband and wife companies have traditional recently paid themselves nominal salaries from their business, but awarded themselves dividends, which is currently tax efficient.

This method of reducing a husband and wife joint tax bill was challenged by Her Majesty’s Revenue and Customs, or HMRC, formerly the Inland Revenue, in a test case two years ago. The HMRC argued that Geoff and Diana Jones, who own an information technology business, Arctic Systems, owed an extra £42,000 tax on dividends they had paid themselves during the previous six years.

The couple, both equal shareholders in the busines, received a small salary and like many family busineses, took most of their funds in the form of dividends. As equal shareholders, each received equal dividend payments, even though only one, Mr Jones, generated the income. The question broadly was: could Mrs Jones’s dividend be reallocated and treated as belonging to Mr Jones, and extra tax sought upon it?

The Jones’ challenged the HMRC, and the case was heard by two special tax commissioners early last summer. The commissioners came down in favour of the HMRC – but only on the casting vote of the chair – and the case ended up in the High Court.

The High Court also ruled at the end of April in favour of the HMRC, which is now considering its next move.

In the worst case scenario, tax advisors estimate that thousands of husband-and-wife companies could be affected by the ruling, with each married couple facing an additional tax bill on average of £9,000.

This is a commonplace tax planning strategy used by many in family owned businesses, and whilst it has been considered to be in accordance with the legislation, this ruling now opens up the interpretation of the strategy.

However, it’s early days yet – the HMRC may take a more conciliatory line. The Jones’ situation was arguably an extreme one, in which Mrs Jones played literally no role in the businesses – Mr Jones was the only driver of revenue and took a significantly lower than market average salary. The HMRC may yet determine that other circumstances – for example, where the spouses take a more balanced share of the workload, or the company has a significant asset base, making shares merely a right to income - are acceptable.

It appears that companies where only one spouse actually performs the vast amount of income generating services for a less than commercial salary are particularly at risk following this decision.

In our view, the HMRC is less likely to challenge a case where there is a more substantial business activity being carried on rather than purely the provision of personal services by one or other spouse. The position may also be more defendable in cases where the company’s balance sheet has some additional value e.g. property, apart from its earnings.

As leading tax advisors, Broomfield and Alexander will be following up with its clients, giving them detailed advice once formal guidance and clarification has been given.

In the meantime, if you think you might be affected by this ruling, the advice is to consult your tax advisor, and consider taking out tax investigation fee insurance if you think your company might be one that could come under investigation – the costs of preparing a defence could be high.