CPD: Small Businesses – are you a shifter?

If you indulge in ‘income shifting', the taxman is likely to take an increased interest in your affairs from April 2008 - and, as a result, may well contend that a further tax bill will be shifted your way. By John Whiting.

This observation is prompted by a recent consultative document* from HM Treasury and HM Revenue & Customs (HMRC), surrounding new legislation, effective April 2008. 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. However, the impact of the new rules is likely to be felt much more widely than the small husband and wife consultancies at the hub of the Arctic situation.

Where are we now
In the lead up to the Arctic case, HMRC generally agreed that a business (partnerships as well as companies) with assets would be unaffected by this case. A premises-owning business wouldn't be caught by the tax rules since ownership of the shop and stock would be split between the husband and wife and thus couldn't be just a right to income. Equally, if a business without assets - typically a consultancy - paid its owners market salaries and just divided up any remaining profit in line with shareholdings, that would also usually be acceptable.

Arctic showed that if market salaries weren’t paid, that wouldn’t necessarily lead to further tax demands if the company had been set up properly in the first place. The lack of market salaries is the reason why HMRC want to change the rules from April.

Just when you thought it was safe...
HMRC's consultative document includes two pages of new legislation which requires 18 pages to explain and illustrate how it works.

Four conditions are laid down to identify when an unacceptable income shift has taken place:
A. someone (‘individual 1') is party to, or has power over the arrangements, i.e., 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; in addition, a tax saving must result from the arrangements. Here HMRC would assess the shifted income as if it still belonged to individual 1.

The impact: immediate ins and outs
Take the case of a small company, equally owned by husband and wife, where the husband does all the client work and the wife does the ‘back office' - the Arctic situation. 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 husband at 40% means there is a tax saving; and HMRC would argue that husband wouldn't set up this arrangement with a stranger so this can't 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 admin duties will be taxed on the husband, not on her.

One small crumb of comfort is that the typical situation where one spouse gives income-producing assets (say, a deposit account) to the other, so that the latter can receive the income, won't be caught. That will fail condition D.

The wider impact
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.

HMRC's paper suggests that it has ‘identified 65,000 companies where income shifting is likely to be taking place', equating to estimated tax losses of £500 million a year, half of which will be clawed back by the new rules. It goes on to state that ‘the Government is looking to individuals to comply voluntarily without the need for [HMRC] interventions'. In other words, small businesses are going to have to self-assess whether they are caught or not.

Managing the situation
HMRC is going to 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.

There are other factors to take into account and assess in terms of value to the business. These include capital introduced, including perhaps loan guarantees and other connections that have helped the business. Use these factors as ways of enhancing everyone's contribution.

There will 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. This would mean that the profit sharing arrangements ought to alter, else income shifting will be deemed to have happened. 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 individuals' contributions. Some evidence of why the business was set up the way it was - that it was commercial, not tax-motivated - would help.

John Whiting
John Whiting is a past President of The Chartered Institute of Taxation (CIOT) and Chairman of the CIOT's Management of Taxes Sub-Committee.