Contractors will face a new battle with the Inland Revenue on Monday when a hearing begins to determine how income tax should be spread between spouses working together.
The hearing could have massive implications for thousands of small businesses, said the Professional Contractors Group, which is funding the case of Geoff and Diana Jones of West Sussex, who run a small IT consulting firm called Arctic Systems.
The outcome of the case, which will be heard by the special commissioners for income tax, is likely to be referred to for general guidance in other, similar cases, said David Smith of Accountax Consulting, who is advising the Jones. Since the case is not being heard by the High Court, however, it will not set legal precedent.
According to the PCG this will be the first hearing of the 70-year-old Section 660A, also known as the "settlements legislation", though a spokesman at the Inland Revenue was unable to confirm this. The rules are currently embodied in the Income and Corporation Taxes Act 1988, and are designed to prevent re-characterisation of one person's income as that of another for the purposes of avoiding tax.
"The Revenue has recently argued that dividend income received by a non fee-earning spouse or other connected person should be taxed as the main fee earner’s income, typically at the higher rate of 40 percent," said the PCG in a statement.
The PCG said that the Revenue is seeking to apply the settlements legislation over each of the last six years for Geoff and Diana Jones, amounting to an additional tax bill of around £42,000 for the couple.
S660A legislation is wide-ranging, and in basic terms deals with situations where income arises from something, for example shares, given by one person to another. This is called a "settlement". The aim of the legislation is to prevent people from settling their income on another person who pays tax at a lower marginal rate.
The maximum benefit achieved by redistributing the company’s income in this way is obtained when the non fee-earning spouse has no other income at all and his or her entire basic rate tax band is utilised. This gives a maximum possible exposure to S660A of up to £8,000 a year.
The PCG said it believes that if both spouses subscribed for shares at the outset, then no gift has taken place and the settlements legislation cannot apply. Both partners take an equal risk on starting the business and are thus morally and legally entitled to equal reward from its success, in just the same way as the owners of any other business.
A spokesman for the Inland Revenue said he could not comment on individual cases, but that the rules used are "a quite normal application of the law… which we have been applying for decades."