We are delighted to announce that in the 2008 PBR, HMRC have decided to delay indefinitely the introduction of legislation designed to prevent income shifting between spouses and partners. If you would like to discuss how to structure your family circumstances in the most tax efficient manner, please ask to speak with one of our tax advisers.
A good starting point is to quote from the government’s written response to Parliament the day after HMRC lost the Arctic Systems case:
“Some individuals use non commercial arrangements (arrangements that they would not reasonably enter into with an arms-length third party) to divert income (which would, in the absence of those arrangements have flowed to them) to others. That minimises their tax liability, and results in an unfair outcome, increasing the tax burden on other tax payers and putting businesses that compete with these individuals at a competitive disadvantage.
It is the Government’s view that individuals involved in these arrangements should pay tax on what is, in substance, their own income and that the legislation should clearly provide for this. The Government will therefore bring forward proposals for changes to legislation to ensure this is the case.
The Government would not want commercial arrangements to be caught by any change to legislation. Consultation should help to ensure this.”
The Government has issued its consultation exercise and whilst it is only draft legislation at this stage, we have every expectation that when it reaches the statute book, it will not look too dissimilar from that draft. It should be noted that throughout the consultation, the Government uses the emotive term “Income Shifting”, which seems to give the impression of underhand connotations, yet “Income Splitting”, which seems to us a more accurate reflection of the realities of the this type of tax planning, was only used once in the entire document.
HMRC is aware that it is not uncommon for an individual to set up a limited company and then introduce another individual as a second shareholder, who in a small business is often a spouse, partner or other household member of the first individual. They accept that there are often legitimate commercial reasons for doing so, for example the second individual contributes labour or capital to the business. In these situations the Government believes that it is right for the distributions from the company to reflect the contribution that both individuals have made.
However, where the second individual has little or no involvement in the business, but the income is distributed such that the first individual forgoes income which can then be distributed to the second individual and taxed at a lower rate, then in this situation HMRC considers that income has been “shifted” from the first individual to the second.
HMRC believe a similar outcome can arise if two or more individuals decide to establish a business in partnership form (including a Limited Liability Partnership). By agreeing to a particular allocation of the partnership profit, the first individual can again forgo income so that it is taxed on the second individual at a lower rate.
Therefore, in order to establish the correct treatment in these situations, it will be necessary to consider:
- Is Individual 1 in a position to shift income, with power to control or influence any arrangements? In other words, can Individual 1 decide or secure how the profits from the business are distributed? (HMRC’s Condition A)
- Has that individual forgone income that formed part of the second individual’s income within an arrangement that would not be entered into at arm’s length? (Condition B)
- Does the shifted income consist of distributions from a company (for example, dividends) or a share of partnership profits? (Condition C)
- Has a tax advantage occurred as a result of shifting the income form the first individual to the second individual? (Condition D)
The effect of the proposed legislation is that where a distribution made from a business represents shifted income, the individual who has forgone that income should include it on their self-assessment return at the end of the relevant year, for income tax purposes. To determine whether the Income Shifting legislation may apply to you consideration must be given to the four Conditions. Yet, unlike the Settlements Legislation, income shifting will apply if income is shifted from one individual to another; there is no requirement for the individual to have retained an interest in the income. Essentially, this widens the scope of HMRC powers.
We cannot know how this new legislation will be applied in practice. The Self Assessment regime requires the individual to declare any income that may have been shifted to someone else; this is a subjective test of both fact and degree.
Then there are HMRC’s many examples in the Consultation Paper, which demonstrate that at the extremes making that decision may be straightforward, but there are huge swathes of grey in the middle and the grey has many different shades. Furthermore, the examples make reference to the ‘input’ into the business of the second individual, but do not show how to measure this ‘input’.
We think that the place to start making the decision is in fact with the final Condition D: is there a tax advantage? We believe this is where HMRC will focus their efforts to determine when to open an enquiry.
If it can be seen that Condition D is satisfied and a tax saving has arisen, then one needs to consider the three remaining criteria. Conditions A & C should be considered next as they are largely matters of fact. If a family Company or Partnership is being used, it should be fairly easy for HMRC to demonstrate whether Individual 1 is party to, or has the power over the arrangements and thus influence the amounts being distributed.
Finally Condition B must be considered. This requires that the income being shifted is that of individual 1. This could be a very subjective test. For example, where two individuals work full time in a business, the income shifting legislation will not apply just because individual 1 is the sole fee earner. Consideration needs to be given to the rewards being received by each individual in relation to the work they undertake and any financial risk they carry such as investing capital in the business. It is the responsibility of the individuals involved to determine whether and to what extent the legislation should apply and this can only be done on an individual basis based on the facts and information available.
Any decision made could be challenged by HMRC who, based on experience, may, just consider the number of hours worked by an individual, rather than the wider contribution to the business of that individual.
Whatever decision you make, you should record why the decision was made and retain any records used in the decision-making process to demonstrate the extent of each individual’s input. HMRC tried to argue in the Consultation Paper that there would be little or no additional record keeping required by businesses under this legislation – we believe that making a permanent record of such decisions could be the key to deciding future arguments on Income Shifting.
The accountancy profession and others have already been making the case for the family-run business where Individual 2 – often the long-suffering spouse/partner will find themselves “on duty” 24/7 and not just the 5-10 hours a week that the spouse/partner allocates to the admin and bookkeeping. Now you may have to prove it!
If having considered the above, you determine that you are caught by the income shifting legislation; you will need to determine the quantum of the income that has been shifted to another individual. This amount must then be declared on your own Tax Return with an appropriate note being made within the ‘white space’. This income will then be included with your other chargeable income and taxed at whatever rate you are liable at. The amount of additional tax will depend on the level of ‘shifted’ income that you declare and your marginal rate of tax.
Summary – Income Shifting
It is important for readers to be aware; Income Shifting does not replace the S660 Settlements Legislation, which continues. Income Shifting is essentially designed to plug the gap, which from HMRC’s perspective, seemed to appear as a result of the Arctic Systems decision. However, it potentially represents a far more draconian additional burden upon the small family-run business. At this stage, we cannot know if it will become law, but assuming it does, there is much to concern the several hundred thousand contractors who make such an important contribution to this country’s economy.
The consultation document is available below in Adobe Acrobat Portable Document Format (PDF). If you do not have Adobe Acrobat installed on your computer you can download the software free of charge from the Adobe website. For alternative ways to read PDF documents and further information on website accessibility visit the HM Treasury accessibility page.