24 December 2007

The Jones v Garnett case, known as “Arctic Systems”, has understandably achieved a high profile in recent months. It is after all, a case HMRC lost in the House of Lords. In the aftermath HMRC have, as anticipated, published their consultation paper on what they have termed ‘Income Shifting’.

Jones v Garnett – HMRC responds
It has been common for many years for shares in family businesses to be split between family members so that profits of the company, distributed by way of dividend, are shared between individuals. The new legislation seeks to remove any tax advantage which might arise from this arrangement.

The case summarised
Mr Jones had set up a company and given half the shares to his wife. Mr Jones was the main income generator, with Mrs Jones providing administrative support to the company. The profits were shared equally between them through the payments of dividends. HMRC sought to tax all the dividends on Mr Jones using the long-existing ‘settlements’ legislation, but were unsuccessful.
Immediately after the House of Lords judgment was issued, the Treasury issued a statement confirming they would seek to introduce new legislation to tackle the issue. A consultation paper on the proposed legislation was issued on 6 December.

The Treasury’s proposal
The legislation, intended to take effect from 6th April 2008, seeks to identify where ‘income shifting’ has taken place. This is defined as where one person shifts business income to another with the result that less income tax is paid overall.

Where income shifting has taken place, the legislation requires that any tax advantage is removed by the income being taxed on the first individual.

The rules do not apply where there is a legitimate commercial reason for the income split, or if HMRC accepts that tax mitigation was not one of the main purposes of the arrangement.

Issues arising from the consultation paper
The consultation paper states clearly what its aims are however, as always, the difficulty is in the practicalities of applying the legislation in real life. Brookson has considered the proposals and their implications carefully and identified some key issues.

The proposals in practice
The key issue for business owners is to assess whether income shifting has taken place. The next issue, if the answer is yes, is to work out how to value the ‘shift’.

The proposed rules bring in a significant degree of uncertainty and therefore judgment to the process. Where the second shareholder makes a contribution to the running of the business, the legislation accepts that it is right that the distributions reflect the contribution that both individuals have made. However family businesses, by their nature, are normally run as a partnership and may have little formality in how things are done. The contribution of the second shareholder may not be directly related to the trade of the business, but the business may not run without them. Support can be provided in many ways such as administration and paperwork, taking messages, enabling the main shareholder to carry on the business in a way they could not on their own.

The legislation allows the value of this work to be taken into account when considering if income shifting has taken place. The responsibility for assessing the value of the contribution is given to the main shareholder. There is a specific requirement to demonstrate the nature and extent of the work done by the second shareholder. Examples in the consultation paper are given as “timesheets, board minutes and any research done on the market rates of pay for the duties”. Furthermore, this assessment of the income shift has to be done for each tax year.

HMRC reserve the right to request this documentation and use it in any enquiry into income shifting. However, there is no detailed guidance proposed. This leaves the tax payer in the position of having to exercise considerable judgment year on year on their tax return, without any degree of certainty of the outcome should there be an enquiry.

HMRC acknowledge this difficulty in the consultation process but provide no further guidance, merely stating that they expect “individuals, together with their advisors, to use their own judgment in working out the level of shifted income”.

Is the consultation proposal fair?
The proposals only apply where the main individual has the power to control the amount of income that is shifted. This means that the individual must have control over how future profits are earned or distributed.

Therefore, if an individual holds shares in an unconnected quoted company and transfers half to their spouse, the transfer is outside the scope of the legislation and dividends are still split between them for tax purposes, as previously.

This situation potentially provides a better tax outcome for wealthy individuals, utilising their spouse’s basic rate tax allowance to transfer some of their investments and income which arises from them, as opposed to an individual setting up a new business, with all the risk that this involves for them and their family.

The impact on small businesses
This legislation will undoubtedly hit small family businesses hardest; those who have recently faced the impact of the managed service company legislation, changes to capital gains tax and the increase in corporation tax rates. Brookson believe this is a sector that generates huge value for the economy. The Government should be seeking to support them rather than continually changing the rules and adding complexity to their business lives.

Income Shifting - Advice to Brookson Customers
What should you do now?

The Government is proposing to introduce the legislation from 6th April 2008. At present it is a draft only, although given the political climate around the Arctic case we believe it is likely that something similar will be introduced as law.

Until 6th April 2008, the position is as it was after the Arctic judgment. For full details see the document Brookson Respond to Arctic System Ruling in the news section of our website.

Unusually for Brookson we feel you should hold back on this one. We recommend that no changes be made as a direct result of the proposed legislation until the final version is available and the position is more certain. We will continue to review the information and when the implications from the final draft are assessed, we will support you through the practicalities of the legislation.

In the meantime, if you would like to examine the proposals yourself, you can click here to access a PDF on the draft legislation from the HMRC website.

If the legislation comes in as drafted, what is Brookson’s advice?
• Value the second shareholder contribution

Where a business has a second shareholder who is not directly involved in the trade of the company, it will be the responsibility of the first shareholder to assess the value of their contribution to the business. Any profits distributed to them in excess of this value will be taxed on the first shareholder.

For example, a business makes £60,000 profit and distributes this equally between its two shareholders. The contribution of the second shareholder is valued at £10,000. The legislation deems that income of £20,000 (i.e. £30,000 less £10,000) has been shifted from the first to the second shareholder. As a result the first shareholder is taxed on £50,000 of dividends (i.e. £30,000 plus £20,000).

The key, therefore, is to clearly identify and value the contribution of the second shareholder. Brookson will be providing more detailed guidance in this area over the next couple of months to help you in documenting the true value of the second shareholder input.

• Look at the ownership of other assets in the family

The income shifting legislation does not catch investments in unconnected assets (e.g. quoted companies). If the result of the calculation above leaves your spouse with an unused basic rate band, consider if splitting the ownership of other assets might redress the position.

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