Section 660A's threat to freelancer family businesses

I am setting out below the submission I have made to the All Party Small Business Group consultation on freelancers regarding Section 660

Section 660A Income and Corporation Taxes Act 1988 ('Section 660')

Following the problems introduced by IR35 Section 660A has recently emerged as a second major problem facing many freelancers and family businesses.

The legislation was designed to prevent the transfer of income earning assets from a higher rate taxpayer to a lower rate taxpayer in order to avoid taxes. This legislation has been around in various forms since before the Second World War. The legislation has a specific exemption for transfers of assets between spouses, except where the assets being transferred are 'wholly or substantially a right to income'.

The Revenue has recently challenged the treatment of dividends paid by a freelancer's company to his spouse, who only plays a secondary role in the business. They have argued that, because the main director chose to take a low salary, the profits of the business were inflated, creating a bounty. Out of this bounty the company has paid dividends to the spouse who is a lower rate taxpayer. They are seeking to treat these dividends as income of the main worker to be taxed at his higher tax rates. They are trying to back-date this treatment over six years and the additional tax with interest now exceeds £42,000.

Many experts consider that the Revenue have adopted a new approach to Section 660 by considering that the ordinary shares held by the spouse can be regarded as wholly or substantially a right to income. They would argue that ordinary shares always involve a complex set of rights and responsibilities and that a right to income only arises if the shareholders so agree.

This new treatment has created much concern and uncertainty amongst freelancers and other small businesses and their advisers who are now concerned that their financial arrangements of the last 6 years might be challenged and could be unravelled at great expense to them as shareholders. This approach to Section 660 could impact upon hundreds of thousands of family businesses.

Because of the concerns amongst professional advisers at the new thrust of the Revenue's approach to Section 660 the Revenue agreed to include guidance and examples of how they viewed section 660 in tax bulletin 64 issued in April 2003

This guidance makes it clear that the Revenue considers it can use Section 660 to attack a wide variety of situations, for example:

· Shares subscribed at par that carry only restricted rights.

· Shares given away that carry only restricted rights.

· Shares subscribed at par in a company by someone else where the income of the company derives mainly from a single employee.

· A share in a partnership gifted or transferred below value.

· Dividend waivers.

· Situations where dividends are paid only on certain classes of shares.

· Dividends paid to the settlor's minor children.

The Revenue regards the following factors as indicative of situations where they may launch a Section 660 investigation:

· Main earner drawing a low salary leading to enhanced profits from which dividends can be paid to shareholders who are friends or family members.

· Disproportionately large returns on capital investments.

· Differing classes of shares enabling dividends to be paid only to shareholders paying lower rates of tax.

· Dividends being waived so that higher dividends can be paid to shareholders paying lower rates of tax.

· Income being transferred from the person making most of the profits of a business to a friend or family member who pays tax at a lower rate.

The Revenue's application of Section 660 also appears to revolve around a number of essentially arbitrary or subjective judgements on matters such as:

· Who 'earns' the income in a business, where the assumption appears to be that supporting the main client-facing worker(s) does not, of itself, contribute to earning the business's income.

· What constitutes 'the market rate' for a salary.

· What represents 'substantial assets' such that ordinary shares have a capital value

There is a general assumption that a spouse, who might act in an administrative role in the business, is only entitled to receive a modest salary and cannot share in the profitability of the business. This is in strange contrast to the Revenue's approach in other areas, such as capital gains and inheritance tax, where transfers between spouses have long been accepted as a way of reducing taxes.

It is also in stark contrast to the view that is increasingly being taken in the divorce Courts. Here spouses are considered to have contributed substantially to the growth of a family business by providing the necessary background support, raising the children etc and, as a result, are frequently a substantial or even equal share of the couple's assets including any business.

Section 660 and Knowledge based freelancers

This interpretation of Section 660 appears to be particularly harsh in respect of businesses that provide knowledge based personal services. These businesses have several characteristics that make them more likely to fall foul of the Revenue's view of Section 660. These are:

· There may only be one client-facing fee earner

· The business is based on selling knowledge and expertise. Hence it does not have or need much by way of fixed assets and tends not to have stocks or many debtors. Hence its working capital needs are low as its asset base and the shares may only have a low capital value

· Profits may be disproportionately large in relation to the business's asset base.

It appears that the Revenue may regard Section 660 as providing them with a backup to IR35. If a knowledge-based freelancer can pass the IR35 status tests and thereby retain the flexibility to distribute profits as dividends, the Revenue can seek to apply Section 660 so as to ensure that all of the distributed profits are taxed at as high a tax rate as possible.

Uncertainty

For freelancers this again adds to the uncertainty they currently face. Even if they can master IR35 and its issues they now know that, if they allowed a spouse or partner to share in the profits of the business at any time over the last six years, the Revenue may try and tax that income at the freelancer's highest rate.

As was reported above in one case six years of tax and interest amounts to over £42,000.

This is a considerable potential liability. Freelancers face even greater uncertainty than under IR35 because tax professionals cannot even agree that the Revenue's interpretation of what is a settlement and whether the exemption for transfers to a spouse can be applied as the Revenue contend. At least under IR35 there is general agreement on what the key status issues are.

Most freelancers working via a company will have been advised by an accountant as to how to set up and structure their business including shareholdings. In many cases accountants will have suggested a share split with the spouse or other close partner as this has long been regarded as acceptable tax planning.

Now freelancers do not know whether their arrangements are still valid or not. They do not know whether past self-assessment returns might be incorrect. Section 660 has been in its current form since 1995 but the Revenue does not appear to have challenged many family companies under their current interpretation of section 660.

Given that the Revenue will always have been aware that the shareholdings in the company were split between two or more shareholders it seems somewhat arbitrary for them to now claim they can reopen up to six tax years of tax returns.

The use of Section 660 by the Revenue also seems rather arbitrary. Certainly amongst the freelancer community, where information is widely shared, it appears that the first mention of such a challenge did not arise until late 2001 and even now there are only a few known cases. So it appears to be a piece of legislation that is being used very selectively at the moment.

If the Revenue's interpretation of Section 660 is correct then there must be thousands of family businesses that could be attacked. However, there is mention on various public discussion forums that the Revenue may only be targeting up to 50 Section 660 cases. This seems to beg the question, is the Revenue merely trying to intimidate family businesses into changing their profit distribution policies while hoping that their approach will not be challenged via the Commissioners and the Courts?

For freelancers there is uncertainty as to:

· Whether the Revenue's interpretation of Section 660 will be upheld by the Courts and

· How the subjective aspects of the Revenue's interpretation (what is a significant contribution, what is a market rate salary etc?) will apply?

· Whether they will be challenged or not?

There is also considerable uncertainty for professional advisers, who may have advised clients to set up a business with ordinary shares held by two or more family members or friends. Many will argue that this was valid advice. However, there are some who will also argue, as does the Revenue, that Section 660 has always posed a risk to such shareholder structures.

So many accountants and tax advisers are now facing an uncertain exposure to what may be a liability for negligent professional advice going back many years.

Quantifying the costs and risks

A Section 660 challenge is only likely to arise if there is scope for the income to be taxed at a higher rate. Hence the general maximum additional tax that could be gained is the maximum amount of dividend that can be received by a taxpayer and taxed at the lower rate of 10% rather than at the higher rate for dividends of 32.5%. This is determined by the start of the higher income tax rate band of 40% - currently £30,500, and the personal allowance of £4615 which enables up to £35115 of dividend income to be passed to a lower rate tax payer in the tax year 2003/4 to suffer an effective charge of 10% tax. If that were all to be taxed at the higher rate this increases the tax charge by around £7900.

Frequently the lower rate shareholder already receives some salary from the business in return for their administrative duties, which absorbs the personal allowance leaving up to £30,500 of dividends taxed at the lower rate.

Once again freelancers are forced to seek professional advice. The market place has responded with a number of new services being offered whereby tax advisers will review a business's structure and history to determine if there is a risk of a Section 660 claim. The costs for these services seem to start at about £175 adding further to the regulatory burden on the business.

Conclusions

Freelancers are now coming to grips with the implications of being the subject of additional tax demands going back six years and perhaps amounting to £40,000 plus interest. For many this has been the last straw, coming as it does after 4 years of uncertainty arising out of IR35, and they are now considering closing their business and leaving the freelancing market.

As with IR35 I believe that this new added uncertainty is very damaging to the freelancer market and will be detrimental to the economy. We urgently need clear and certain guidance as to the situation regarding Section 660. However, while case law may eventually provide such guidance this would require a test case – which could take up to three years before a final outcome is available.

The uncertainty created by Section 660 requires more urgent action.

First, it would reassure freelancers and other family businesses, who have been long established, if the Revenue would agree that they would not seek to apply their interpretation of Section 660 to past years, except in clear cases – such as the use of preference shares that are merely a right to income – which clearly breach Section 660.

Second, I believe that the legislation needs to be clarified by Parliament, who should consider what are the legitimate targets of Section 660A and whether the legislation should be amended to make sure that there is certainty and clarity for all family businesses.

Kevin Miller FCA