Income shifting legislation: fair share?

While it is very easy to complain about new tax legislation, it is hard not to suspect that the government had deliberately planned to saddle us with more complex legislation to explain to incredulous clients.

Delaying the implementation of the income shifting proposals until 6 April 2009 is a very welcome concession and I hope that further consultation will yield results. Some of the practical issues to be addressed are highlighted below:

Salary cannot be shifted

Consider Mr & Mrs X, 50:50 shareholders in a small trading company. Mr X works full-time in the business and Mrs X only works 10 hours per week in the business performing administrative duties. The business makes annual profits of £60,000 (before salaries). Mr & Mrs X each take an annual salary of £25,000 from the business. The remainder of the profit (after tax liabilities) is distributed equally to Mr & Mrs X in the form of dividends.

Clearly, these are not normal commercial arrangements. Mr X has, arguably, foregone some of the dividend income to which he is entitled, but he has also foregone salary as he makes a greater contribution to the business than Mrs X in terms of the number of hours worked and the value of his work to the business.

However, under the wording of the draft legislation, while it is possible to reallocate some of the dividends received by Mrs X to Mr X for tax purposes, it is not possible to reallocate any of her salary payment ­ shifted income must be either distributions of a company or profits of a partnership.

Statements in the original consultation document make it clear that the government intends the legislation to apply only to business arrangements. However, the wording of the draft legislation could be read as applying to a property letting ‘business’ carried on in partnership. This should be tidied up to ensure that only trading businesses are covered by the rules.

When does it start

The new legislation will apply to shifted income taxable in tax years 2009/10 onwards. The legislation will apply to:

• Company distributions received on or after 6 April 2009; and

• Partnership profits subject to tax in the tax years 2009/10 onwards.

Under the normal basis period rules, profits of a partnership earned in respect of an accounting period ending in the year to 5 April 2010 will be treated as taxable in the tax year 2009/10. So, in the case of a partnership with an accounting period ending on 30 April 2009, all of the profits from this period will be subject to the income shifting rules.

What is a spouse worth?

The biggest problem that taxpayers will face under the new regime is determining the value of the contribution that each co-owner makes to the business to self-assess any income shifting adjustment. The original consultation document suggested that business owners consider: the work done; the amount of capital invested; and the amount of risk taken.

The examples given in the consultation document are simple. As has been well documented, family businesses often work on very fluid lines with spouses ‘mucking in’ as necessary to run the business. This makes the quantification of their contributions to the business a real burden.

There is also the small matter of proving that each spouse has been paid a market rate return for their efforts and investment. For someone who owns and runs their own business it will be almost impossible to ascertain ‘the going rate’ for their services.

HM Revenue & Customs says that the legislation will not increase the administrative burden for most family businesses as it will only challenge ‘abusive’ arrangements, but, as always, what constitutes abuse will be defined by inspectors, and interpretations may vary.

Unless the government has a radical change of heart, some form of legi slation to block income shifting is inevitable. I hope that the above issues, and many others, can be fully resolved so that the proposed legislation can be re-drafted quickly.

Family businesses need to see and comprehend the new rules for 2009/10 well in advance so that another last minute rush to put appropriate arrangements in place can be avoided. Sadly, I foresee many difficult conversations with small business clients over the next few years.

Lisa Macpherson is the national director of tax at PKF

www.pkf.co.uk

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