Tens of thousands of small businesses could face a combined tax bill of £1 billion if the Law Lords rule in favour of the Treasury in its long-running battle against a small business owned by a married couple.

The legal battle, which started in 2003, reached the House of Lords yesterday. An estimated 30,000 couples will face crippling tax bills if the Treasury wins in its attempt to enforce a clampdown.

The Treasury is cracking down on married couples who create companies based around one spouse’s work. In 2003 HM Revenue & Customs (HMRC) sent a £42,000 tax bill to Geoff and Diana Jones, of West Sussex.

Its actions were backed by a tax tribunal and the High Court, but the Court of Appeal overturned the assessment last year. This effectively shut down the Government’s campaign against couples who cut their tax bills by taking cash out of their business as dividends rather than income. Amid outrage from accountants and small business groups, the Treasury sought leave to appeal to the House of Lords this year.

Yesterday the Law Lords heard opening remarks from Michael Furness, QC, counsel for HMRC. Mr Furness argued that Mr Jones, an IT consultant, had drawn an “inadequate” salary from the couple’s company, Arctic Systems. Mr Jones was “solely responsible” for the income generated by the company, Mr Furness said.

In one particular year, Mr Jones drew a salary of £6,250 from the company, in addition to £25,700 paid in dividends. His wife, who undertook administrative duties for the company, drew £3,600, but she also received £25,700 in dividends.

Mr Furness argued that, because Mr Jones “was the sole earning power of the company” he should have received a greater share of the profits. Because Mr Jones was a higher-rate taxpayer than Mrs Jones, the profits would then have been subject to tax at a higher rate.

The Joneses set up Arctic Systems with equal shares. The company had an annual turnover of £100,000.

Lord Hope of Craighead told the court: “We have to have an eye as to how other family businesses will be affected.”

Sir Andrew Morritt, Chancellor of the High Court, argued in 2006 that Mrs Jones’s services were just as commercially important to the company.

Bill Knox, taxation chairman of the Federation of Small Businesses, said: “HMRC’s conduct towards a family-run business in this case is utterly shameful.

“Hounding hard-working 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.

“The craven decision to pursue the case further will be at the expense of the taxpayer and will result in a damaging loss of confidence in HMRC’s record with small businesses.”

Chas Roy-Chowdhury, of ACCA Global, the accountancy body, said that married couples had been given little choice but to pay tax at the rate paid by the higher-earning spouse.

A spokesman for HMRC said: “The Government is keen to ensure that businesses have as much certainty as possible while the case continues. HMRC has issued guidance on how taxpayers whose circumstances are consistent with the situation in the Jones v Garnett case should handle their tax returns while waiting for an outcome in the case.”

The Treasury has said that £250 million is at stake under existing arrangements for married couples’ companies. The Professional Contractors Group, which has funded the Joneses’ case, said that the figure was closer to £1 billion.

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