Practical examples needed of income shifting difficulties

A respected tax body has warned that the proposed new income shifting rules will lead to greater uncertainty for many owner-managed businesses and has called on small businesses to provide HMRC with practical examples of the difficulties it will pose.

The warning, from the Institute of Chartered Accountants in England and Wales (ICAEW), follows similar concerns from other bodies, after HMRC announced a consultation on changes to prevent income shifting between individuals in business together.

The proposed new rules are aimed at businesses where one person does most of the work, but tax is saved by transferring income to another person who, HMRC believes, may not have earned it.

But uncertainty arises as it requires taxpayers to assess whether income has been 'shifted' and how much income has been 'foregone', then for the person who has 'forgone that income' to include it on their self-assessment return at the end of the relevant year, for income tax purposes.

The changes, which will apply from April 6 2008, are meant only to affect those who split dividends or profits so as to move income from a higher to a lower rate taxpayer; however the ICAEW believes that many commercial arrangements may also be caught.

Definition

Francesca Lagerberg, Chairman of the Technical Committee at the ICAEW Tax Faculty, said: "The proposed income shifting rules are very widely drafted. They will catch many owner-managed businesses involving husbands and wives and other family members. The difficulty will be working out whether they are caught by the definition or not.

"This will lead to yet more uncertainty for many entrepreneurs, who are likely to have to spend much more time looking over their shoulders to see if HMRC will attack their structure."

HMRC has published a 44-page consultation document outlining its thinking and including some case studies. Ms Lagerberg said: "HMRC has provided a lot of detailed examples but most are very simple and do not take into account the real complexities of most businesses.

"Many spouses do not have formal meetings to discuss their business arrangements, they just have their own way of working together. Owner-managers will need to try and establish whether their existing dividend or profit allocation is still acceptable and for many businesses this will be no easy task."

Consultation

The ICAEW is urging businesses to review the HMRC consultation document and to respond to its questions before the legislation is finalised.

Ms Lagerberg said: "The more practical examples that HMRC receive, which show where this will cause real difficulty, the better the chance of change. If HMRC wants to make this work it will need to consider offering some form of clearance procedure to help taxpayers work out where they stand."

If any UKTECH readers wish to contribute to the consultation, particularly with the practical examples Ms Lagerberg refers to, please post here or email me on: susie@UKTECH.

Background

The consultation follows the ground-breaking Arctic Systems case (Jones v Garnett) which went to the House of Lords in July 2007. The husband and wife team of Mr and Mrs Jones had set up a business together, which was structured as a limited company, and both purchased a £1 share in an off-the-shelf company called Arctic Systems Ltd.

They each drew small salaries and distributed the majority of their income in the form of dividends, which they shared equally.

Mr Jones was a higher rate taxpayer whereas his wife paid tax at a lower rate. HMRC argued that as Mr Jones did the majority of the work in the business the dividend received by his wife should be taxed as Mr Jones's income at the higher rate, and sought to claim the difference.

In order to achieve this HMRC argued that Mr Jones had diverted income to his wife and for tax purposes this action was ineffective because it was caught by the settlement provisions, known as Section 660. However, HMRC's argument was rejected by the House of Lords in July this year.

The Government immediately announced it would introduce a new law to prevent this practice. The income shifting proposals are the outcome.