However, the Tax Faculty warns: "Unfortunately, we fear that many commercial arrangements will be caught because the proposals are very widely drafted. They will catch many owner-managed businesses involving husbands and wives and other family members.
"The difficulty will be working out whether they are caught by the definition of income shifting or not, which will lead to yet more uncertainty for many small businesses."
The Government introduced its income shifting proposals after it was defeated in the Arctic Systems House of Lords case. Income shifting is the process by which an individual transfers part of their income (from dividends or partnership profits) to another person who is subject to a lower rate of tax. The Government intends to tax the shifted income as if it had been received by the higher tax payer.
The new rules will come into effect in April 2008 after a consultation period. They have been widely criticised as being too complex and leaving significant areas of uncertainty. The Tax Faculty has attempted to clarify the proposals, with a proviso that the proposals are merely a consultation.
It says: "Very broadly, the rules will apply where under ‘relevant arrangements’ dividends or partnership profits are shifted from one individual (individual 1) to another individual (individual 2).
"The changes are meant only to affect those who transfer dividends or profits and as a consequence move income from a higher to a lower rate taxpayer. The rules will apply where all of the following conditions are met:
- Condition A – individual 1 is party to or has power over the relevant arrangements;
- Condition B – individual 1 forgoes income, and the income forgone is individual 2’s for the relevant tax year;
- Condition C – individual 1 has the power to control the amount that is shifted; and
- Condition D – the shifted income consists of distributions of a company or profits of a partnership.
"...Where the rules apply, the income is treated as forming part of the income of the individual shifting the income and not the income of the other individual."
It advises that accountants and advisers should start preparing their clients for the change. It suggests that they should start to review all clients and classify them as follows:
- i) Particularly serious cases which will definitely be caught by the proposed rules.
- ii) Cases where, with supporting documentation, it seems probable that you can support the status quo.
- iii) Clients who are definitely not affected by the proposals.
It takes 'an extreme example', where a husband and wife owning a company in which the husband does all the work, but the shares are owned 50:50. The profits of £60,000 are usually paid out as dividends. If the income shifting rules are applied, the whole of the £60,000 of dividends would be taxed on the husband, with the result that some or all of the income shifted will be taxed at a higher rate.
If this company has considerable reserves built up over the past few years, the Tax Faculty says that it would be worth giving serious consideration to extracting these reserves before the rules change on April 6 2008. As it is a company, the dividend must not only declared, but also actually distributed before April 6 2008.
The Tax Faculty advises accountants: "You may decide that it is necessary to make actual changes to the profit sharing arrangements between partners or owners of a company so as to reflect more accurately the commercial nature of their relationships to the business. This will of course entail costs. At this stage you may prefer to see how the proposals develop before taking action, but it would nevertheless be good practice to advise clients that this might be necessary in the near future."
In other cases where there may be a potential problem, but the adviser considers that the client’s position could be justified, the Tax Faculty says that it may be enough for the time being to write to clients explaining that the rules may change and that their adviser will be reviewing their case in the light of the changes, if the changes are likely to affect them.
It also says that advisers may wish to advise clients that they should begin to document the work they carry out or other contributions made by the family members (or connected parties) to the business.
The full guidance is available on the ICAEW's Tax Faculty website.
Shout99 has followed the events relating to Section 660 and income shifting. You can also read more about the background to this case and the issues at stake in Shout99's Section 660/Income shifting resource centre.
Shout99 members are invited to submit their practical experiences as part of a response to the Government's consultation process (See: Practical examples needed of income shifting difficulties - Shout99, Dec 2007).
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Susie Hughes © Shout99 2008