Late last year HMRC issued a consultation on “Income Shifting” – essentially a set of anti avoidance rules to combat perceived tax avoidance by people shifting income to others.
The background to this is the ongoing Arctic Systems case which HMRC lost. In that case Mr Jones, a IT consultant, set up a company, and brought in his wife as a co-shareholder. Mrs Jones did not carry out any substantive work for the company, merely some administration. As Mrs Jones was a shareholder in the company, she had half the company dividends, hence using up her tax allowances and achieving a tax saving for the family. HMRC challenged this under the so called “S660a Settlements Legislation”. HMRC won at the Commissioners and first appeal, but subsequently lost the case in the House of Lords.
The proposed new rules apply from April 2008 and are at:
They tackle situations where income is shifted for perceived tax advantage, and arrangements are deemed uncommercial. Its probably easiest to explain this with some examples.
1. Husband and wife open a shop together. They both work full time in the shop. Profits are £100k pa, split equally. Income shifting does not apply as both put in the same effort.
2. Husband and wife open a shop together. Wife works full time in the shop, husband works part time elsewhere. Profits are £100k pa, split equally. Income shifting does apply as the effort is different. The husbands profit share is transferred back to the wife for tax purposes.
NB its been suggested this is unfair – if, for example, if the husband only works part time due to care commitments, and thus releases his wife to work full time. Also, for example, if there was a marriage breakup the starting point would be a 50:50 split of joint assets, including the business – commentators suggest its unfair to allow the asset to be split in divorce but not marriage.
3. Husband and wife open a shop together. Wife works full time in the shop, husband works part time elsewhere. Husband has leant £200k to the business interest free. Profits are £100k pa, split equally. Income shifting probably does not apply as although the effort is different, husband has loaned money to the business. “Probably” because the consultation does talk about assessing the notional return on the capital invested and maybe treating any excess over that as income shifted, but in reality its unlikely this is going to come up much in practice.
What does this mean in practice?
1. For husband and wife businesses where both parties work in the business with a similar effort, no effect.
2. For husband and wife businesses where the inputs to the business in terms of time and skill are very different potentially the income splitting rules apply.
3. If the time and skill inputs are different, there may be a let out if money has been lent to the business, or a joint asset used as collateral.
4. In theory these arrangements apply in any business relationship, not just husband and wife. For practical purposes however, there is an exemption if the arrangements are commercial, and that is likely to be the case in non family situations. For example:
a Husband and wife set up a business together, as florists, and split the profits 50:50. Husband does deliveries and admin, wife is the florist. Potentially the rules apply, on the grounds that the skill, floristry, is with the wife.
b Bill and Ben set up a business together, as florists, and split the profits 50:50. Bill does deliveries and admin, Ben is the florist. Potentially the rules apply if Bens input as a florist is deemed more valuable than Bills as a driver / administrator, however if Bill and Ben are unrelated then this must be a commercial transaction and hence the rules would not apply.
These examples show that the rules are somewhat arbitrary, and may be difficult to police. Their arbitrariness is worrying – it has the makings of another IR35 confusion.
A few other points to note:
1. Adjustments are only made if there is a tax advantage, so if a business is set up on a 50:50 basis with unequal inputs but the tax would be the same if 100% went to the main contributor, then no adjustments are made.
2. Although, as stated above, the rules apply to all relationships, it is of course family relationships, eg marriage, civil partnership, parent / offspring, where the greatest risks are.
3. The rules only apply to company dividends and partnership profits. They don’t apply to salaries or other income, eg loan interest or rent.
– salaries – there is unlikely to be any benefit in swapping a percentage dividend away from a non contributing spouse into salary as the NI costs on the salary, employers and employees is going to be broadly equal in most cases to the difference between Basic Rate and Higher Rate Income Tax.
– loan interest – a excessive interest rate on a loan from a connected party could probably be challenged successfully, either as a schedule D disallowance or as a distribution, so is unlikely to be successful.
– rent – this has possibilities. If the business is home based, renting part of the home back to the business may be superficially attractive, but CGT issues – the loss of private residence relief – may render it uneconomic – also think about Business Rates / NNDR. If the business is in commercial or retail premises, then there are real possibilities for savings by having the property in joint names and paying rent. I’ve long recognised this as a possible route of salvation for husband and wife / civil partnership businesses if there was a crackdown like this.
1. For many current income splitting arrangements, the game is now up. This is going to be particularly so for contractors operating via Personal Service Companies, and for professionals such as Estate Agents where income is split with a spouse / family member but they have no practical involvement with the business.
In these circumstances it will probably pay to maximise drawings in 2007/08 under the old regime, then, for simplicity, transfer company shares or partnership profit shares back to the main contributor from April 2008.
For 2007/08 there is probably no benefit in drawing excess profits if they are going to be in the Higher Rate Tax band anyway – as you will be no worse off under the new regime, and there will merely be an acceleration of tax.
2. For situations where there is genuine, substantive work, from both parties, then slight inequalities in contribution are not likely to be a issue.
3. For situations of genuine doubt, dependant on your appetite for risk, its probably worth while leaving arrangements as they are. If you are challenged in a future year and cannot convince HMRC you are outside the rules, then you are only looking at paying the Tax and NI you would have paid had you given in now, plus interest / penalty. Any penalties are likely to be small, if any, where there was genuine doubt and good faith can be shown. To this end the real risk in interest on back taxes, and many will feel this a risk worth taking.
These thoughts are shared as a thought starter, and no responsibility is accepted for them. Please take professional advice before following any particular course.