If you indulge in ’income-shifting’, such as between husbands and wives in business, it seems the taxman will take an increased interest in your affairs from April 2008 - and may well shift a further tax bill your way.
This is prompted by a recent consultative document from HM Treasury and HM Revenue & Customs (HMRC), pointing towards new legislation to take effect from April. The intention is to reverse the effect of the ’Arctic Systems’ decision - a case that involved husband and wife taxation and the dividing up - or ’shifting’ - of business income and profits.
HMRC will expect to see that the participants in a business get a fair reward for their own efforts. So, if two people are involved in the business and one does four times as much ’value’ as the other, that suggests a 4:1 ratio of salary. Salaries should also be near market rates. It does not mean that all profits have to be paid out as salary - profits can be left over and shared equally.
HMRC’s consultative document lays down conditions that make up unacceptable income-shifting:
a. someone (’individual 1’) is party to, or has power over the arrangements, ie how the business has been set up;
b. individual 1 forgoes income which goes to individual 2;
c. individual 1 can control the amount shifted;
d. the income shifted is the distributions of a company or profits of a partnership.
All four conditions must apply and a tax saving must result from the arrangements. Here, HMRC would assess the shifted income as if it still belonged to individual 1.
Take the case of a small com-pany, equally owned by husband and wife, where the husband does all the client work and the wife does the ’back office’ - the situation in the Arctic case. HMRC’s contention is that it is the husband’s business, and so condition a is met. If both just take a small salary, which means significant dividends flow to each party, condition b is met, as some dividend income has been ’forgone’ by husband. They assume that c is met as husband could insist on a bigger salary; d is clearly met. Assuming some of the income would otherwise be taxed on the husband at 40% means there is a tax saving; and HMRC would argue that the husband wouldn’t set up this arrangement with a stranger, so this cannot be excluded under the ’commercial’ get-out.
The result is that this will be an income-shift - and the monies that flowed to the wife over and above reasonable pay for her administration duties will be taxed on the husband, not on her. Arrangements involving children, wider family and friends could also be caught and the asset-backed business that was accepted as outside the HMRC target zone for the Arctic attack is now firmly in the sights of these new rules.
Managing the situation
Factors to take into account in terms of value to the business include capital introduced, such as loan guarantees and other connections that have helped the business. There will also be a need to keep an eye on changing inputs of effort by those involved: one of the HMRC examples points to a situation where one partner stops working for a spell, meaning that the profit sharing should alter, otherwise income-shifting will happen. One hopes that HMRC will make allowances for circumstances such as illness and pregnancy.
Although the consultative document says that HMRC would not expect further documentation to be needed to prove a situation is outside income-shifting, it seems inevitable that businesses will have to get better at documenting how they have valued indivi- duals’ contributions. n
l John Whiting is a past president of The Chartered Institute of Taxation (CIOT) and chairman of the CIOT’s Management of Taxes Sub-committee