HM Revenue and Customs suffered a major defeat today when the House of Lords gave the legal all clear to a tax saving arrangement used by thousands of husband-and-wife small businesses.

IT consultant Geoff Jones and his wife, Diana, took on the Revenue after Mr Jones received a £42,000 back tax demand in 2003.

Mr Jones, 50, won his case at the Court of Appeal in December 2005, to the delight of an estimated 30,000 other couples in the same situation, who believed they could legally save on their tax bills by drawing a large part of their income in the form of share dividends, which are taxed at a lower rate than income.

The case centred on whether Mrs Jones’s share of the company profits, paid to her as a 50 per cent shareholder in the form of a dividend, should be taxed as part of her husband’s income.

Mr Jones and his wife, who played a lesser role in the company, both drew a small salary as well as a dividend, which was split equally between them.

HMRC argued the scheme operated by the couple was not permitted under tax regulations and took their case to the House of Lords.

The Revenue was concerned that Mr Jones — and thousands of others like him — had deliberately paid himself a low salary in order to pass a larger share of company profits to his wife.

Its lawyers contended in the House of Lords that Mr Jones, of Broomershill Lane, Pulborough, West Sussex, drew an “inadequate” salary from his company, Arctic Systems, which led to it having “excessive reserves”.

Those reserves were then used to pay “excess” dividends to Mrs Jones, who had a 50 per cent share in the company as its business manager.

This meant Mrs Jones was effectively sharing income with Mr Jones and he should therefore be assessed for tax on the entirety of his wife’s dividend income, it was argued.

The Professional Contractors Group, which funded the case for the couple, estimated that the case would cost the taxman £1 billion a year.

After today’s unanimous ruling by five law lords, Paula Tallon, a director at tax advisers Chiltern, said: “Family businesses will breathe a big sigh of relief this morning.

"This eminently sensible decision will provide certainty to family companies across the UK who are already out of pocket after this year’s Budget.”

"The ruling will also enable small companies and their advisers to complete their tax returns with confidence and manage their tax affairs in the most efficient way.”

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