PCG 4: the Arctic Systems case

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Stimulated by the Treasury’s failure to appreciate the importance and value of the contracting industry, freelancers have long lived in fear of HMRC tax investigations. So, when an unexpected brown envelope arrived on the doorstep of Geoff and Diana Jones in 2004, there began an exhausting, all-encompassing, but ultimately successful landmark legal case in PCG’s history: the Arctic Systems case.

Five years had elapsed since the organisation formed in a sea of discontent following the introduction of the controversial IR35 legislation. Its embryonic years were an intense, focussed and all-out battle against the Government, but since then a relative calm had ensued.

PCG was stable, operational and lobbied on numerous issues affecting contractors. The organisation was effective in defeating issues in their infancy, therefore none carried the same interest or indeed importance as IR35. The legislation had, in practice, proven to be manageable and far less severe than first feared.

But then, out of the calm came a storm.

“I remember it like it was yesterday,” Geoff Jones said.

“It looked just like a tax-code notification letter, but a bit thicker. When I opened it up and read it I was completely flabbergasted to see the demand for £42,000 in back-taxes. It was a complete shock because I take pride in my honesty and doing the right thing.

“Indeed, a few years earlier I had realised we underpaid Diana's tax and I approached HMRC to sort it out and repaid the small amount to them.”

HMRC were quick to forget this honesty, however. They were basing their retrospective demand of £42,000 on what they perceived to be a breach of section 660A of the Income and Corporation Taxes Act 1988.

Relating to ‘income shifting or splitting’, HMRC were arguing that transferring part of a business carried on by a husband or wife, who then allowed their spouse to take a substantial percentage of the profits through dividends, would constitute a "settlement" for the purposes of benefitting from a lower tax rate.

In the Arctic Systems’ case, HMRC was trying to prove that, because Geoff was the sole fee-earner, he should be the sole taxpayer on the proceeds. Diana, meanwhile, carried out all the book-keeping, liaised with accountants and the bank, organised business insurance and prepared the value added tax returns.

HMRC, however, didn’t value this obvious contribution to the business and were of the opinion that she had become a shareholder for the sole intention of splitting the income so that they could take advantage of her tax-free threshold. Therefore, HMRC considered them to be in breach of section 660A.

“This, of course, flies in the face of Ltd Co provisions which state that any dividends must be split between the shareholders in proportion to their holdings,” Jones added.

“They concentrated on the perceived chink in the armour, Diana's acquisition of her 50 per cent shareholding. Actually, it was a single £1 share, of two issued – the other to myself.”

“Former Chancellor Norman Lamont had, some years earlier, specifically addressed this issue by making the 'gifting' of shares between spouses legal beyond reproach. HMRC thus attempted the tortuous logic that, if Diana had bought her share, then I could not have gifted it to her (Diana purchased the share from the company formation agents). Rather than, by allowing her to buy it, I had given away the rights to income that I would have been taxed on but she wouldn't.”

“In my opinion, the whole case was politically motivated, part of (Paymaster General) Dawn Primarolo's grubby crusade against anyone and everyone trying to make a crust outside big business and without the unions' help.”

At that point, the couple were not members of PCG or any other union. They sought immediate advice from their accountant, who advised them that HMRC’s case was “preposterous” and they would be happy to fight it on their behalf.

There was still a sense of disbelief, on the Jones’s part, that HMRC were pursuing Arctic Systems with such strong retrospective measures on a piece of obscure legislation. Further clarification and confirmation were needed.

However, correspondence with HMRC only served to reconfirm their intent – though they indicated to the Jones’s that they would be willing to accept a compromise deal.

HMRC ran a check on the bank interest declared in the initial tax return, calculated the Jones’s savings, and then sent a letter asking for all of it.

“In other words, what they in effect were saying: ‘we'll stop short of making you homeless but we're going to completely clear you out: your whole life's worth up to this point will be negated’,” Jones continued. “At that very instant I decided I would fight the HMRC bullies to the bitter end - whatever it cost.”

It had quickly become evident that fighting the case was beyond Arctic Systems’ accountant, therefore the couple went in search of advice from contracting organisations – with PCG their first port of call.

“Geoff was running his company, paying his taxes and doing everything absolutely right. Needless to say, he got very very angry,” Richard Robson said.

He had no idea section 660A existed. We believed Gordon Brown had reached the limit of his stealth taxes – the press was all over his 67 stealth taxes – and therefore we felt that he told HMRC: ‘I don’t want to risk putting out any more legislation that’s going to add to my flak. I want you to look at the existing tax law and be creative

PCG were ready and waiting though. Since their onslaught against IR35, the organisation had matured and had now built up a legal fighting fund which it was using to pursue selected cases – with very successful results – through the courts.

Having built its reputation on making as much noise as possible, PCG’s tack had changed and the organisation was initially discreet about section 660A and any involvement with Arctic Systems.

A meeting was arranged with Primarolo to discuss the case, but she was steadfast in her conviction that HMRC were not going to back down on section 660A – they were coming after Arctic Systems and other companies in a similar position.

PCG’s board convened and, subsequently, decided to commit the entire legal fighting fund to the case. The organisation backed the Jones’s and Arctic Systems and set about formulating a plan to tackle HMRC.

Given the significant precedent any judgment would have on thousands of small businesses across the UK, the importance of the case could not be stressed enough.

“I felt very strongly about this case and was a huge advocate right from the get-go,” PCG’s then chairman Simon Juden said. “I viewed this as outrageously misogynistic apart from anything else. And, of course, completely misguided.

“The analogy I used to draw was: if you imagine someone who’d set up a mechanic workshop. If the wife repaired all the cars but the man was the person who booked in all the people and made the operation run – well, that business can’t work without either of them.

“Both, in my view, were equally entitled, if they had taken the risk on that business, to share in the reward of that business.”

PCG’s first requirement was to seek legal advice and establish the grounds on which to challenge HMRC. Anne Redston, who had written a book on IR35, was a partner at Ernst & Young and Chair of the personal taxes subcommittee at the Chartered Institute of Taxation (CIOT).

She was commissioned to seek a formal opinion from a barrister as to whether HMRC’s case could be challenged at the Special Commissioners. Redston discovered that HMRC had never previously published their guidance or interpretation of ‘income splitting and shifting’.

Eventually though HMRC released Tax Bulletin 64 which detailed their interpretation and stated that they would be applying this view retrospectively to businesses who had no prior knowledge of HMRC’s stance.

“It’s one thing for HMRC to say that this is their view, but it’s another thing to say that this is our view and we’re going to apply it back six years,” Redston said.  

“But HMRC would not retreat. Malcolm Gammie QC gave an opinion to PCG with me as his instructing accountant. He said that PCG should succeed because HMRC’s view was wrong as a matter of law

“There were a lot of discussions as to which of the small companies under attack should go forward as the test case. Both HMRC and PCG wanted a case which did fairly reflect what was happening in these small companies. HMRC agreed that Arctic Systems would be a suitable case, and forward it went.”

The case would go to the Special Commissioner where Gammie would argue that Arctic Systems was a commercial arrangement. Diana was actually working for the company and had acquired her shares at the same time as Geoff, when Arctic Systems was set up; therefore there was no settlement.

On the opening day of the hearing, HMRC belatedly accepted that three of the four years of their retrospective charges were invalid due to an earlier tax investigation.

The initial sum of £42,000 was reduced to £8,000 and, on the eve of the hearing in September 2004, HMRC offered another settlement. The Jones’s turned it down abruptly because they were confident that common sense would prevail during the hearing and they would not be required to pay anything.

Malcolm Gammie argued at the Special Commissioners that there was no settlement because the Jones’s arrangement did not contain the requisite element of bounty. He relied in particular on the House of Lords judgments in IRC v Plummer (1980) and Chinn v Hochstrasser (1981). Secondly, even if there was such an element of bounty, the acquisition of Mrs Jones’ shares came within the exemption for outright gifts between spouses – for which provision is specifically made by the statute.

“There were two Special Commissioners, one found for us and one found against us,” Redston said. “And, unfortunately for us, the one who found against us was the more senior of the two. She exercised her casting vote and the case was won by HMRC.”

Jones added: “We tried the conventional arguments we'd always used and always believed in, but HMRC's income-splitting ruse was novel and we lost.  My feeling was that the commissioner who found against us didn't really get it and delivered a verdict for HMRC just to be on the safe side.”

The Jones’s decided to appeal the decision to the High Court; with Gammie again representing Arctic Systems in a case that was heard six months later.

“I thought it was a case they should win and that merited taking. I was always of the view that this was not a settlement and therefore they should be successful in litigation,” Gammie, who worked pro bono, said. “But it went to the High Court and Mr Justice Park, who decided against us.”

The appeal was dismissed on the basis that Mr Justice Park believed Mr Jones provided funds directly or indirectly, for the purposes of a settlement, by working in return for a salary below his earning power.

He also stated that widespread apprehensions among tax advisers that a verdict could affect every case of husband and wife companies had been greatly exaggerated.

He said: 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.

For a second time, Arctic Systems had been defeated.

“I always knew I was in the right but confidence takes a knock when decisions go the wrong way,” Jones said.

The second defeat was undoubtedly a body-blow, but the Jones’s were unequivocal they would continue to fight. And so, two months later, they announced they would take their action to the Court of Appeal.

As dispiriting as two defeats had been, the basis of Arctic Systems’ arguments remained exactly the same.

The hearing was scheduled for January 2006, but was brought forward so as to give guidance to taxpayers before the January 31 deadline. And so, in late November, for a third time, the Jones’s readied themselves for another hearing, this time in front of Sir Andrew Morritt – the Chancellor of the High Court – with Lord Justices Keene and Carnwath.

“Anyone who’s involved with the tribunals and the courts will know that we couldn’t be sure that we were going to win, but we believed our legal arguments were stronger,” Redston said. “The legal position was still the same and our arguments were the same throughout.”

Sir Andrew Morritt accepted Jones’s submission that each of the two assigned shares carried a right to share in the dividends, and therefore decided that no settlement had occurred.  The other two judges both agreed. 

Lord Justice Keene believed HMRC’s arguments were too speculative and uncertain. Lord Justice Carnwath said HMRC’s foundation was based on cases that pre-dated the introduction of the 1988 Finance Act and were therefore invalid – both parties were actually making a substantial commercial contribution, albeit not of the same financial worth. Both agreed with Sir Andrew Morrrit’s verdict – Arctic Systems had defeated HMRC.

“Malcolm successfully argued there was no effective difference between 'gifting' the share and allowing the share to be bought; and for the High Court to have drawn the opposite conclusion had been incorrect,” Jones said.

As committed as the Jones’s had been in the wake of their two defeats, so too now were HMRC who announced, within a month, their intention to appeal to the House of Lords. In March, the House granted them permission, with a date set for the following June.

The case would be decided by an appellate committee made up of Lord Hoffmann, Lord Hope, Lord Walker, Baroness Hale and Lord Neuberger.

As they had in every previous hearing, Arctic Systems contextualised their argument with a series of effective examples which were intended to illustrate how someone could be absolutely crucial to a business without actually being the person bringing in the money.

“The examples ourselves and the QCs took into the House of Lords, as well as all the other levels of courts, were never freelancers – and quite intentionally,” Robson said.

“Malcolm Gammie used to talk about restaurants where the chef was the husband and the wife was running the front desk. Or the garage, where the mechanic is doing the fee-paying work but her husband is running the office – we loved these little contrasts.”

The arguments were heard and, when eventually the decision was delivered, the Law Lords ruling was emphatic: 5-0 in favour of Arctic Systems.

Their decision – based on the 1988 Finance Act that made the gifting of shares legal beyond reproach – found that although there was ‘settlement’, the specific statutory exemption for gifts between spouses meant that there was no tax to pay. As a result, Mr and Mrs Jones were taxable as two independent people.

But, after an exhausting three-year process, was the eventual ruling bitter sweet, given that it had taken so long to deliver a decision that so many people had known to be abundantly obvious from the outset?

“The feeling was complete elation tinged with, ‘Why did we have to go through all this for such an obviously trumped up and preposterous politically-based tax grab?’,” Jones said.  

“I always felt sure we would win but there's always that monkey on your shoulder. Then I felt anger, and elation again. Then there was media madness, journalists, taxis, TV, makeup, drinks. And finally, relief that it was over.

“Everything had changed: PCG were squaring up to HMRC and the Government, duking it out all the way to the top and winning!”

Anne Redston added: “This affected hundreds of thousands of small husband and wife businesses. This wasn’t some multinational challenging HMRC here; they were little companies and it was good for these small companies to show that the courts would uphold their legal rights. They succeeded and it was very good to see that.”

HMRC accepted that Arctic Systems had given rise to case law which would act as a precedent unless the law was changed.

“If HMRC had succeeded in their early experiments, it would’ve given them scope to go and tackle any family business.” Robson said. “It was clearly not the intention of parliament to come between husband and wives’ financial affairs.

“The exemption was introduced at the time when the married couples' allowance was removed and husband and wives were taxed independently, and the fact that Section 660A had a clear exemption for outright gifts between spouses should have spoken for itself!”

PCG had achieved numerous victories during its eight years of existence. However, they all now paled into relative insignificance given the size of, and precedent set by, the Arctic Systems’ victory in the House of Lords.

Even PCG’s fiercest critics would be forced to reassess their previous assertions and consider it an organisation of great stature and legitimacy.

Relationships with leading legal representatives such as Gammie and Redston, its considered, persuasive and effective way of campaigning, and the very nature of a victory against HMRC in the House of Lords made it a force to be reckoned with.

“I don’t think HMRC expected the calibre of the legal representation we were able to bring in, and I certainly don’t think they expected us to come up with someone like Geoff Jones who was prepared to dig his heels in and really fight this,” Robson added. 

"Rough calculations suggest that PCG saved small family businesses from being unfairly pillaged to fuel Gordon Brown's ambitions by as much as £2 billion a year. Nobody who was a target of 660A with a similar company structure had to pay – not a spectacular thing in that respect, but it was certainly very satisfying to be at the House of Lords when the judgement was handed down!”

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Tom Hayward

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