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In response to HMRC's loss in the landmark Arctic Systems case earlier this year, the Treasury has issued a long-awaited consultation document.
The Government's hope seems to be to put an end to income shifting from one person to another with the intention of avoiding paying taxes.
As expected the document's illustrative draft legislation reverses the House of Lords' decision in the Arctic case (officially known as Jones v Garnett).
'Income shifting: a consultation on draft legislation' sets out the Government's view that income shifting, through which one individual can shift their income to another for tax purposes, leads to unfair outcomes.
The legislation is to apply to distributions - i.e. dividends, from companies and partnership profits. Commercial arrangements are not affected, nor are those conducted on an arm's length basis.
Four conditions have to be satisfied for the proposed legislation to apply:
- the first individual is party to or has power over the relevant arrangements;
- the first individual forgoes income, and the forgone income is the second individual's for the relevant tax year;
- the first individual has the power to control the amount that is shifted;
- the shifted income consists of distributions of a company or profits of a partnership.
In addition, the tax paid by both individuals must be less than it would have been had they not shifted income - i.e. a tax advantage must have been obtained.
If all of these conditions are met, the shifted income would be treated, for income tax purposes, as income of the first individual only.
The treatment of class 4 National Insurance contributions is to follow the tax treatment where a class 4 liability arises following the shifting of income.
The Treasury suggests that in order to decide if the proposed legislation applies, the business or partnership will have to consider the following questions:
- Is one individual in a position to shift income, with power to control or influence any arrangements?
- 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?
- Does the shifted income consist of distributions from a company (for example, dividends) or a share of partnership profits?
- Has a tax advantage occurred as a result of shifting the income from the first individual to the second individual?
The consultation asks whether the draft legislation meets the Government's aims. It also seeks comments on the draft guidance published alongside the legislation, to ensure that the legislation is clear to businesses and their advisers, and that administrative burdens are minimised.
Comments should be sent by 28 February 2008 to:
James Miller
Income shifting consultation,
Room 2/N2
HM Treasury
1 Horse Guards Road, London SW1A 2HQ
e-mail: incomeshifting.consultation@hm-treasury.gov.uk.
Not happy at all is the message from advisers and professional bodies. The legislation is not clear and the administrative burdens are not minimised.
Francesca Lagerberg of Grant Thornton explains that there are some businesses scenarios that the Government 'does not like because it believes that they give unfair advantages to some people'.
The family-owned business where the higher-rate taxpaying husband gives dividends to his lower-rate taxpaying wife is a classic example. As this cannot happen in the commercial world, the Government thinks it should not happen at all.
However, Ms Lagerberg referred to the 'let out' whereby if there is a sound commercial reason for an arrangement, the legislation will not apply. This, she says is designed so that, for instance, the one-man business which cannot afford an employee, is not caught.
Turning to the examples in the consultation document, Francesca said that these only go so far, and are not realistic. As a result, small businesses and their advisers are likely to be left 'confused'.
Similarly, Anne Redston said that the proposals are 'onerous and uncertain'. Small businesses will have to turn to their advisers for detailed advice, which she feels is an unnecessary burden.
The legislation is 'very wide in scope' and covers all family members, not just spouses, so the corner shop, local takeaway are all likely to be affected.
The proposals 'will be a nightmare for family businesses', said John Brazier of the Professional Contactors Group. 'The Government seems to think that fees paid to big businesses are fine, but fees paid to small businesses are really just income that is shifted.
'This measure will impose a horrific burden on hundreds of thousands of small family businesses, which will make it impossible to self-assess tax bills with any certainty.
'It is also deeply unfair: the Government has been encouraging people to set up businesses under joint ownership for years; now it is hammering the people who have followed their advice.
'A married couple who jointly own a business would have to split its value 50-50 in a divorce; yet while they are married, the Government says they are not entitled to share the profits.'
The CIOT has expressed 'grave concerns' about the implications of the draft legislation.
Vice-president Andrew Hubbard said his organisation accepts income sharing within members of the family unit is an issue which would need to be considered as part of reform of the structure of small businesses, but the CIOT 'regards it as wholly wrong for the Government to deal with this one issue in isolation'.
He added: 'The legislation imposes an arm's-length test and requires taxpayers to work out how much income they have 'foregone' by making a comparison with how the business would have operated had everything been done by independent third parties operating on a fully commercial basis.
'The reality is that family businesses do not and cannot possibly operate on [this] basis.'
(The CIOT has produced a series of case studies to illustrate the problems that arise with income splitting. It can be downloaded as a PDF via the link below.)
The final message to advisers is respond to the consultation: send in examples which demonstrate the uncertainty of the proposals and highlight the extra administrative burden that will be caused.
