Inland revenue’s victory on family business dividend payments cause for concern?

Standard tax planning for family companies appears to have been overturned in the recent landmark High Court case known as Arctic Systems.

If you are a shareholder in a family company, the following questions may now be a cause of some concern:

Are salary payments of husbands reduced in order that increased dividends can be paid to their spouses?

Do different classes of shares exist in order that higher dividends can be paid to holders of certain classes of shares in preference to other classes of shares?

Are shareholders, who take no active part in running the business, receiving dividends which are not proportionate to their fellow shareholders who work for the company?

If the answer to any of the above questions is yes, then an Inland Revenue enquiry may now beckon.

Case Outline

Arctic Systems Limited was a company with two shares – one owned by Geoff Jones and the other held by his wife Diana. These shares had each been acquired when the company was created. Geoff Jones, the only director of the company, worked as an IT consultant generating the company's income.

Diana Jones was company secretary and dealt with company administration. Geoff Jones and Diana Jones were each paid a small salary with the balance of profits being extracted by way of dividend in equal amounts. The Inland Revenue (now known as HM Revenue & Customs) argued that Geoff Jones, as the only director and the individual that earned the company's income, would have expected to earn a much larger salary. Consequently, he had made a settlement to his wife because in taking a low salary, the company profits where increased which, in turn, had increased his wife's income by way of dividend.

Being the sole director, Geoff Jones decided upon the level of dividends and he was therefore taxable on the income arising to Diana Jones as settler of the settlement.

The Inland Revenue issued an assessment for the additional tax in respect of 1999/2000 and earlier years. Geoff and Diana Jones appealed to the Inland Revenue Commissioners and the Revenue agreed not to pursue the claim for tax in respect of the years prior to 1999/2000. However, the appeal was dismissed. Geoff and Diana Jones then took their appeal to the High Court where the Judge dismissed the appeal and handed a further victory to H M Revenue & Customs.

Implications

Not all family companies will be affected. If the shares in the company are held equally between a husband and wife who work together in the running of the company, and market rate salaries are paid or dividends are commensurate with input to the business, then this situation will not be caught by the Arctic ruling.

It also appears the ‘vast majority’ of family companies which may be caught by this case relates to low asset backed service companies and companies which do not require significant capital.

Consequently, if dividends are received by shareholders who have contributed a significant amount of capital into the company, then it would appear the Arctic ruling would not apply.

Situations which may invite attention from H M Revenue & Customs include the following:

1. The company's main earner being paid a low salary which, in turn, leads to dividends being paid to shareholders who do not work for the company or contribute a significant part in generating the company's income and profits.

2. Different classes of shares enabling dividends to be paid to shareholders who suffer lower rates of income tax.

3. Dividends being waived in order that dividends can be paid to shareholders to suffer a lower rate of income tax.

One further consideration of the Arctic case is that the Inland Revenue agreed to only pursue a claim for 1999/2000 and not to pursue the claim for earlier years. There is no guarantee the Inland Revenue will adopt this approach in any other cases it pursues.

Conclusion

If your company has similar circumstances to any of those described above, it is important that the arrangements for the extraction of profits are reviewed to consider whether a potential liability exists.

Final Note:

At the time of writing this article, it is understood an appeal has been lodged against the High Court decision to the Court of Appeal.

Perrys, Chartered Accountants, represent and advise a significant number of family companies and would welcome the opportunity of reviewing arrangements in light of the above. Details of specific office contacts are available on: www.perry-company.co.uk