HM Revenue and Customs (HMRC) have unveiled proposals on ‘income shifting’ (their term) following their robust defeat in the recent ‘Arctic Systems’ case. Needless to say, the professions have greeted these with a pronounced lack of enthusiasm.
The use of joint shareholdings in ‘husband and wife’ companies and the payment of dividends rather than salaries is a well-known technique for minimising the tax burden on a family business. The practical benefit of paying dividends rather than salary is the saving of employer’s and employee’s National Insurance Contributions.
The proposals are, in simplified terms, that HMRC will regard income as being shifted when:
- a person is a party to or has power over the split of income;
- that person forgoes income and the income forgone becomes the income of another person; and
- the income shifted is by way of company distribution or partnership profit share for the year and the overall tax liability paid by the parties for the tax year is less than it would be had the arrangement not subsisted.
Where income shifting occurs, it will be the responsibility of the persons concerned to enter on their tax returns the amount of income shifted and the practical effect will be that the ‘saving’ in tax will be collected by a charge on the person forgoing income. The interesting point here is that it would appear that it will be possible for someone to be assessed to tax on income they have not received (indeed, which they have no legal right to receive) – this begs the question of what might happen, for example, in a relationship in which there is a legal arrangement (i.e. because of the shareholdings or a partnership agreement) existing which created the income shifting tax benefit and the people involved are not on good terms!
The first issue here is that the proposals will include partnerships, not just companies. This is an important point as there are many family partnerships in which the partners’ shares of income do not match their contributions to the business. The proposals are not intended to apply only to families, but could catch any arrangement where there is a significant mismatch between the contribution to the business by an individual and their ‘fully taxable’ income from it.
The second issue is that it does appear that the proposals could catch any arrangement where salary is suppressed by a shareholder who makes a bigger contribution to the business than the others who receive dividends.
In practical terms, this will mean that it will be necessary for all businesses to know – and be able to justify – who does what for the business and to pay a market rate for the job done, so it may well be a case of ‘timesheets for all’.
For businesses, it is sensible to consider the likely impact of the proposals and have a strategy in place. For many, the most likely outcome is an increase in their tax burden.
Legislation enacting the proposals is expected to take effect in April 2009.
Partner Note
The ICAEW’s Tax Guide on Income Shifting is excellent reading for those with an interest in the matter. See http://www.icaew.com/index.cfm?route=153518.