A Background on Income Shifting

In the Budget report issued on 22 April 2009 the Government confirmed their previous announcement that they would defer introducing legislation on income shifting and would keep the issue ‘under review’. The draft legislation was designed to tackle what the Government sees as the unfair tax advantage gained in some small businesses where the dividends are split between family members.

In essence, the draft legislation required the main shareholder to value the commercial contribution of any second shareholder to the business. Any excess paid to them by dividend over this value would be taxed on the main shareholder.

This proposed new law was put out for consultation in December 2007. Brookson’s view, in common with many others, was that the new legislation:

  • Was unworkable. How can you confidently value the contribution of a second shareholder whose role may be informal and variable?
  • Was unfair. Why should profits from a small business be tackled in this way when a family shareholding in, say, a public company or unit trust, can be split between individuals and the dividends taxed separately?
  • Would lead to more uncertainty for small businesses. There would be no pre-approval mechanism. A business would have to decide how to tax the dividends and then wait to see if there was an HMRC enquiry.

In this case, thankfully, the Government listened to the feedback and acknowledged that they need to take more time before rushing in any new legislation.

Where the ‘Income Shifting’ proposal came from

It is worth going back to why the Government first proposed the ‘Income Shifting’ legislation. The proposal was the direct reaction to the House of Lords judgment against HMRC in the Arctic case.

Arctic Systems was the name given to the tax case of Jones v. Garnett. Mr. & Mrs. Jones were the shareholders in Arctic Systems Ltd. The company essentially earned its income from providing the services and skills of Mr Jones. Mrs Jones also worked in the business but did not provide her services to business customers. Whilst she contributed towards the company’s earning capacity, she did not generate income for the company.

Mr. & Mrs. Jones were paid salaries by the company and had been voted dividends on their equal shareholdings. There was a consequent saving to the Jones’ household as Mrs Jones was not a higher rate taxpayer and dividends are taxed more favourably than salary.

HM Revenue & Customs (previously the Inland Revenue) decided that this was an unfair arrangement purely to save tax, and that the dividend income should all be assessed on Mr Jones (at his top, higher rate of tax). And so they raised an assessment on this basis.

Mr. Jones fought the assessment and the case ended up in the House of Lords.

On 25 July 2007, the House of Lords found in the Jones’ favour. A victory for the taxpayer and HMRC agreed that they would not fight the case any further.

However, on 26 July 2007 the Exchequer Secretary to the Treasury, Angela Eagle made a Written Statement to Parliament:

“The Government acknowledges the judgment given by the House of Lords in the Jones v Garnett (Arctic Systems) case.

The Government is committed to maintaining fairness in the tax system. The case has brought to light the need for the Government to ensure that there is greater clarity in the law regarding its position on the tax treatment of ‘income-splitting’.

Some individuals use non- commercial arrangements (arrangements that they would not reasonably enter into with an arms-length third party) to divert income (which would, in the absence of those arrangements have flowed to them) to others. That minimises their tax liability, and results in an unfair outcome, increasing the tax burden on other tax payers and putting businesses that compete with these individuals at a competitive disadvantage.

It is the Government’s view that individuals involved in these arrangements should pay tax on what is, in substance, their own income and that the legislation should clearly provide for this. The Government will therefore bring forward proposals for changes to legislation to ensure this is the case. In the meantime, HMRC will apply the law as elucidated by the House of Lords and will be providing guidance in due course.

The Government would not want commercial arrangements to be caught by any change to legislation. Consultation should help to ensure this.”

Some 5 months later the new Income Shifting legislation was published for consultation with a proposed implementation date of April 2008, only 4 months later. This implementation was deferred in the 2008 Budget. The subsequent 2008 Pre-Budget Report and 2009 Budget both also made reference to the fact that the issue would be kept under review. Thankfully, the Government have decided to put more thought to the matter before pressing on.

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