A landmark court case that will decide whether hundreds of thousands of owner-managed small businesses will face significantly higher tax bills began today in the House of Lords.

The long-running dispute between Geoff Jones, one-half of the husband and wife team behind IT contractor Arctic Systems, and HM Revenue & Customs (HMRC) is being closely watched by thousands of small businesses in a similar position.

Mr Jones and his wife Diana, who owns a half-share in the business but has less day-to-day involvement than her husband, have been fighting HMRC since being hit with a £42,000 back tax bill in 2003.

The case centres on whether Mrs Jones’ share of the company profits, paid to her as a shareholder in the form of a dividend, should be taxed as if it were income.

UK tax laws allow business owners to pay less tax on dividends than salaries or other forms of income.

HMRC were concerned that Mr Jones – and hundreds of thousands of people in a similar situation – had deliberately paid himself a lower salary in order to pass a larger share of company profits to his wife in the form of dividends.

The mechanism is used by millions of small businesses which argue, as Mr and Mrs Jones did, that the business is a joint effort between two parties who share the risks and should therefore be allowed to share the rewards.

Michael Furness, QC, representing HMRC, told the panel of five law lords that the scheme operated by the couple was not permitted under tax regulations.

He said Mr Jones, 50, of West Sussex, drew an “inadequate” salary from his company, Arctic Systems, which led to it having “excessive reserves”.

These reserves were then used to pay “excess” dividends to Mrs Jones, who had a 50 per cent share in the company where she was the business manager. “This meant that Mrs Jones was effectively sharing income with Mr Jones and as a result the arrangement involved an element of bounty.”

He added: “Permitting such arrangements would be tantamount to facilitating for these couples whose circumstances allowed them to take advantage of it, a new form of voluntary joint taxation, albeit one much more favourable than the old system of single taxation of husband and wife.”

Francesca Lagerberg, a tax partner at Grant Thornton, said: “This case is much bigger than just Arctic Systems and will affect hundreds of thousands of UK businesses. If HMRC wins, then thousands of businesses could face crippling back-tax bills and many more will need to reassess their tax status.”

After losing an initial hearing at a tax court in 2004 and a subsequent High Court appeal in March 2005, the Joneses succeeded in overturning the judgment by a unanimous ruling in the Court of Appeal in December 2005.

Ms Lagerberg said that although the Court of Appeal judgment was strongly in favour of taxpayers, the House of Lords may well weaken or overturn it.

The hearing is expected to last three days, though a ruling may not be announced until the end of the year.

The Professional Contractors Group, which represents small businesses, has contributed to Mr and Mrs Jones legal costs throughout the case.

Chris Bryce, director of PCG, said: "PCG is supporting Geoff and Diana Jones because it believes that HMRC is wholly wrong, both morally and in law, to penalise small businesses with a retrospective reinterpretation of tax law. Geoff and Diana took on the risks and responsibilities of owning and running Arctic Systems together, and are entitled to share in the rewards together - the same goes for all the other couples who set up in business together."

Hartley Foster, a tax partner at the law firm DLA Piper, said: "It will be fascinating from a legal point of view to see how the House of Lords approaches this case. The total sums involved are not huge amounts in the context of the UK's tax take, but are to those who have been embroiled in the case for a number of years.”

The Federation of Small Businesses (FSB) issued a statement attacking the Revenue's decision to pursue the case.

Bill Knox, FSB Taxation Chairman, said: “HMRC’s conduct towards a family-run business in this case is utterly shameful.”

He added: “Hounding hardworking small business owners in this way sullies the good name of HMRC and will not instil confidence in the UK small business community as a whole, which rightly expects to be treated proportionately and fairly by the tax authorities."

Explore Law

• Columnists

• Law Panel

• Law Reports

• Student Law

Times Recommends

• BGC 'set aside £40m to lure Tullett brokers'
• Legal aid review to ensure value
• Fears as 21 magistrates' courts face closure