The case concerns the taxman's treatment of dividends paid by companies which are jointly owned by husband and wife.

Geoff and Diana Jones ran an IT company called Arctic Systems. Mr Jones was an IT specialist and the sole director of the company. Mrs Jones acted as company secretary and looked after much of the financial administration of the company. Each held one share in the company; Mr Jones was paid a small salary and both received dividends from the company when it had sufficient profits to pay them.

Theirs is a common situation which can exist in any of four forms: a) companies where both spouses receive shares at the outset, but only one is active; b) partnerships where one spouse is active but the other is not; c) companies where one spouse gives shares to the other; d) companies where both spouses receive shares from the outset and both make an equal contribution to the company's profits.

Business Link, the support agency run by the Department of Trade and Industry (DTI), in fact advises family companies to adopt a "consistent, fair and open" policy regarding the payment of remuneration. Its guidance does not suggest deliberately diverting income from higher rate taxpayers to other family members to save on tax, but does suggest that family members' remuneration might be "topped up" through share dividends.

It points out that shareholdings between husband and wife are "a perfectly acceptable way for them to do business".

Using anti-avoidance legislation dating back to the 1930s, Mr and Mrs Jones were presented with a £42,000 tax bill in respect of six years' retrospective tax, based on the Inland Revenue's assertion that Mrs Jones's purchase of her share was "a settlement" - a term which includes, but is not restricted to, a transfer of assets from one party (the settlor) to another.

Prevent avoiding liability

The relevant legislation, which is now contained in section 660A of the Income and Corporation Taxes Act 1988, was originally designed to prevent a taxpayer avoiding liability to Income Tax and Surtax by transferring assets to his family.

At that time, it would have been pointless for a husband to transfer income-producing assets to his wife, as a wife's income was deemed to be her husband's for tax purposes - independent taxation of husband and wife was not introduced until 1990.

Section 660 is wide ranging and applies to situations involving individuals, companies, partnerships and trusts. It provides that any income arising under a "settlement" is to be treated for tax purposes as the income of the "settler". So where one party makes a "settlement" for the benefit of another party, the settlor remains liable for tax on income arising from the asset.

There are some important exemptions from the basic rule on the taxation of settlements.

Most significantly, there is an exemption where the property passed to a spouse is an outright gift, though the exemption will be lost if the property being passed is wholly or substantially a right to income.

In the Arctic Systems case, the Inland Revenue took the view that, because the bulk of the IT expertise was the contribution of Mr Jones and because he drew a low salary, the share owned by Mrs Jones was "wholly or substantially a right to income". Accordingly, it held that the dividend income was covered by the settlement rules and not entitled to the statutory exemption - the income was therefore taxable.

The Arctic Systems case was taken up by the Professional Contractors Group. When proceedings began in June, the Revenue dropped its claim for back taxes, claiming only the tax for the most recent tax year.

The case was heard by two special commissioners who disagreed with each other's findings. The presiding commissioner used her casting vote to decide the case for the Revenue.

The case is disturbing for several reasons, not least because it raises the question of whether a case should be heard by two commissioners, if one has the authority to overrule the other.

The case is significant because it affects so many family companies whose shares are held within the family and not necessarily for taxation reasons. Also, the ruling overlooked the fact that capital contributions are often made by the "receiving spouse".

Equal risk

In such cases, both spouses could be taking an equal risk in financing the business.

How does this decision affect other family companies?

It appears that the presiding commissioner was influenced by the fact that Geoff Jones was the sole director and it was in his power to declare dividends. But it is often the case that both shareholders are also directors.

Disincorporation, ie, stripping the business of its limited company status, would not make a difference to the situation, as the "settlements legislation" applies to partnerships and trusts as well as to family companies.

It is, however, important to remember that the circumstances of other cases may be different in various respects from the Arctic Systems case and each case must be looked at according to its individual circumstances.

The best advice at present is: Don't panic! If you are a family business and think you might fall victim to the commissioners' ruling, talk to your accountant and consider your options. These may include appointing both spouses to the board, ensuring that a fair price is paid by the "receiving spouse" on the acquisition of shares, or enhancing the ownership rights attached to the shares.

The Inland Revenue has announced that it will issue new guidance to family businesses on what the Arctic ruling means for them. The case may also yet be appealed.