The long-running tax case known as Arctic Systems has finally reached its conclusion with a decision by the House of Lords in favour of the taxpayer: Mr Jones. This means that Mr Jones will not have to pay higher rate tax on the dividends paid out of his company (Arctic Systems Ltd) to his wife. More importantly, thousands of other couples who set up their companies in a similar fashion to Mr and Mrs Jones should no longer be pursued by the Taxman for additional tax on their dividend income.

Mr Jones set up Arctic Systems in 1992 through which to offer his services as an IT contractor. He was the only director and held one of the two ordinary shares issued by the company. Mrs Jones purchased the other ordinary share from the company formation agents, and also became the company secretary.

They acted on advice from their accountant to take minimal salaries from the company, and pay out most of excess profits as dividends. As Mr and Mrs Jones held the shares equally, the dividends were paid to them equally and were mostly covered by their basic rate tax bands, meaning little higher rate tax was paid. If Mr Jones had paid himself a higher salary, or had been the only person receiving a dividend, he would have paid far more tax as much of his income would then have been taxed at the higher tax rate of 40%.

This type of arrangement has been standard tax planning for many husband and wife companies since the introduction of independent taxation for spouses in 1990. It was even recommended on the Business Link website! However, the Taxman decided to attack the arrangement, saying Mrs Jones only received her share, and the dividends paid on that share, because of Mr Jones work and the decisions he took as a director. The argument was that Mr Jones had effectively made a gift of half the earning capacity of the company to Mrs Jones, and because she is his spouse, the tax law says he automatically benefits from the gift, and thus Mr Jones should be taxed on all of the dividends.  

The House of Lords actually agreed with the Taxman that the shareholdings in the company had been set up to minimise the tax paid by Mr and Mrs Jones. However, because the gift by Mr Jones had been made to his wife, and the gift was not restricted to the earning capacity of the company, but included future rights to capital on liquidation, and the voting rights associated with the ordinary share, there was a get-out clause. This get-out clause only applies to married couples and civil partnerships, and says that if you make a gift to your spouse/civil partner (which comprises more than just income), and there are no strings attached, you should not be taxed on the income arising from that gift.

Mr Jones had allowed Mrs Jones to buy half of the company (the other ordinary share) for a very small sum. This did amount to a gift, but the gift was covered by what is known as the "spouse exemption", so Mr Jones could not be taxed on the dividends arising from Mrs Jones’ share.  The Taxman went away red-faced, and the taxpayer was victorious!

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The Taxman is a bad loser, and after a big defeat like Arctic Systems it is quite likely the tax law will be changed. In fact the Treasury has already announced that they will be looking to change the law to prevent people splitting income between themselves in an unfair way. However, the Treasury spokesperson has also said that they do not want to disturb commercial arrangements.

What should you do now?

1. Don’t Panic. The House of Lords decision stands until the law is changed, and if any change is made it probably won’t come into effect until April 2008. Anyway you have little to worry about if you and your spouse/civil partner are both actively involved in running the business, in other words the ownership split of the business is a commercial arrangement.
   
2. Take Precautions. If you and your spouse/civil partner own all the shares in your limited company, examples of precautions to take to help ensure that your arrangements are water tight and commercial include...
   • You should both be appointed as directors of the company. This means you are both responsible for the running of the company so collectively make important decisions, such as how much dividend to pay, or which contracts to take on. Record all these decisions so you can prove to the Taxman that you are both actively involved in the key business decisions. 
   • Make sure you and your spouse/civil partner both hold ordinary shares in the company whose rights are not restricted in any way.
   • Follow the correct procedure when paying dividends to ensure they can't be reclassified as loans. The directors need to check there are enough profits in the company to pay the dividend, suggest an amount to pay, then the shareholders can vote on whether to pay it out. Dividend vouchers should be prepared and given to the shareholders when the dividend is paid.
     
     
3. Discuss with us. If you want to bring your spouse/civil partner into the business as a shareholder, so you can divide profits between you, come and discuss the matter with us first. However we recommend you should think through the following points...
   • Will giving away some of the dividend income actually save tax? If your spouse/ civil partner already has enough income to cover most of their basic rate tax band, there is unlikely to be much tax saving.
   • Think about what may happen to the business should you divorce or separate.

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There have been some alarmist newspaper articles recently claiming the Taxman is about to crack-down on thousands of buy-to-let landlords. This is not the case, at present he has bigger fish to fry chasing those with undeclared off-shore bank accounts, but that doesn’t mean that landlords are off the hook.

Some of the problems with buy-to-let landlords are...

• Many don't complete their tax returns correctly, or at all. There are possibly 500,000 landlords letting residential property in the UK, but the Taxman knows only about 300,000 people who complete the land and property pages of their personal tax return to report income from a let property.
  
  If you let a property, even one that used to be your own home, you must report the rental income on your tax return. This applies whether or not you actually make a profit from the letting. The income and all tax deductible expenses have to be shown to tell the Taxman you have made a loss for the year. You can’t set that loss against your other income, unless the property is regularly let as furnished holiday accommodation, but you can carry the loss forward to off-set against future profits from a lettings business. If you don’t claim the loss you won't be able to use it in the future.
  
  
• The other problem is that landlords make mistakes about what to deduct as expenses from the rents received. Valid expenses include the costs of running the property from day to day, such as a management agent's fees, repairs, advertising for tenants and insurance. Tax deductible expenses do not include the costs of acquiring the property, such as stamp duty, estate-agent's, or solicitor's fees.
  
  The interest you pay on any loans or mortgages connected with your lettings business is deductible, but not the repayment of the capital borrowed. If you have a repayment mortgage you must be careful only to include the interest part of the monthly payments on your tax return. The lender should break down the total you pay over a year into interest and capital repayments, and show this on your annual mortgage statement. We can help you make the right claim on your tax return for all your letting expenses.

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H M Revenue & Customs (HMRC) has the power to open an enquiry into any tax return or set of business accounts.  No reasons are given for opening enquiries and thousands are started every year at random.  The past few years have been generally "quiet" in terms of tax enquiries and investigations at local levels due to the reorganisations due to the merger of HM Customs & Excise and the Inland Revenue.  Now that the new single organisation is up and running  the risk of an enquiry is greater than ever and the costs of dealing with these enquiries have increased, as now there is more likelihood of a combined enquiry covering all taxes i.e. income or corporation tax, plus VAT, plus PAYE, etc which inevitably makes enquiries more complex and time consuming.

We strongly recommend that you obtain protection against the additional fees that will arise in the event of a tax enquiry or dispute.  If you do not do so, then you may be liable for hundreds if not thousands of pounds of professional fees incurred in defending you, or worse still, if you can't afford the costs of defening youself, you may have to meekly accept whatever tax bill the inspector decides!

Fee protection insurance is available, often free or at low cost, from numerous sources.  Members of the Federation of Small Business, local Chambers of Commerce and other professional or trade organisations often receive some form of legal advice service or fee protection insurance free of charge as part of the membership subscription.  Similar protection is often included or can be added at nominal cost to your business insurance combined policy.  However, the service and cover provided varies between organisations and in most cases, you will have to use their own preferred accountants/lawyers who have no knowledge of you - they generally do not cover you to use your own preferred professionals to help defend yourself - you will have to show and explain your books and records and your business to someone you have never met before wasting your valuable time!

We have therefore teamed up with QDOS, a leading firm of tax investigation specialists, to offer all our clients the opportunity to join our in-house Enquiry and Dispute Fee Protection Service.  For a heavily discounted annual fee (cheaper than the similar protection offered directly by QDOS) we shall represent you during any full tax enquiry or PAYE/VAT dispute that may arise (including IR35).  Our scheme will mean that we represent you to defend your position, without you having to worry about our fees.  This means that as we already know about your business and have plenty of information about your books and records on our files, we can deal directly and quickly with HMRC with the minimum of fuss and inconvenience to you.  We can also call upon the specialists from QDOS to help where complex issues of law are in question, to give you the best possible chance of ending the enquiry or dispute at the least possible disruption, cost and hassle to yourself.

Over the next couple of weeks, we will be posting out a letter and application form to join our scheme.  The rules we have to work under mean that we have to send out the invitation to all clients, even those who have previously confirmed that they don't wish to join the scheme.  If you are not interested in joining our scheme, please accept our apologies!  If you have any queries about the scheme, please don't hesitate to contact us.

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Q. I am about to sign a lease for a new shop, but the landlord wants to charge VAT on the lease rental payments. The solicitor has grossed up the lease payments including VAT for the full lease term, to calculate the Stamp Duty Land Tax due. This means I am paying Stamp Duty on the VAT on the rents. Is that right?

A. Unfortunately the solicitor is correct. If the landlord has opted to tax the building for VAT purposes he must also charge VAT on the rents due under the lease. Stamp Duty Land Tax is calculated on the net present value of the gross amount of the rents, including the VAT charged, whether or not you can reclaim that VAT.

Q. I'm a driving instructor and operate through a limited company. The Taxman wants to tax me for using my instruction car and fuel as a taxable car benefit. I don't think that's fair as the car is necessary for my business. Is he right?

A. Essentially the Taxman is correct. If you use the instruction car for even one mile of a private journey, there will be an income tax charge. It is irrelevant whether the car is necessary for your business or not. Taxi drivers who run their businesses through limited companies have the same problem. If you can show that you make absolutely no personal use of the instruction car, perhaps because you use another car for all private journeys, the Taxman may be persuaded to treat the instruction vehicle as purely business. However, he may want to see an insurance policy that prohibits private use.

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Generally all quite in the holiday season, just

August is a good time for you to send us your accounts/tax paperwork if you havn't already done so for use to prepare your 2006/7 accounts and tax returns.  The sooner we can prepare your returns, the sooner you will know how much and when your future tax liabilities are due to help you budget for them, if you are due a refund, you'll receive it sooner, and if there are any tax planning opportunities, they can be actioned sooner, making the benefits greater.  It also helps to avoid "last minute panics" by leaving things too close to the deadlines which could land you with hefty late submission penalties, interest and surchages.