This is prompted by a recent consultative document  from HM Treasury and HM Revenue & Customs (HMRC), pointing towards new legislation to take effect from April 2008. The intention is to reverse the effect of the 'Arctic Systems' decision. 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. Many hundreds of thousands of small businesses will have to take stock of their way of conducting themselves in the coming months and many may need to set up some defences against this new problem.

Background

To understand this new problem properly, a recap on the Arctic Systems case is necessary, though no doubt most readers will recollect at least some of the situation.

Geoff and Diana Jones formed Arctic Systems Ltd to be the vehicle for Geoff acting as an IT consultant. Diana managed the 'back office' and generally supported what Geoff did. No doubt he would say that he couldn't do what he did without her support. They both took modest salaries and the balance, after corporation tax, was paid out in dividends. Diana got a significant amount and that, combined with her small salary, used up her personal tax allowance and lower income tax bands. Compared with all the income going to Geoff, there was a tax saving of about £7,000 a year, due to income not being taxed at the full 40% rate.

The Jones' arrangement was widely practised and generally thought routine by tax professionals. Mrs Jones had her own ordinary share in Arctic Systems Ltd, after all. But HMRC objected and argued they fell foul of some old settlements legislation, in particular a provision that precluded an arrangement that was 'solely or mainly a transfer of a right to income'. The upshot was a lengthy series of arguments and a case that wound its way to the House of Lords where the Joneses won. HMRC's contention failed as what was involved was a share - with a bundle of rights - not just income, vindicating the long-held view of the tax profession.

However, the day after the Arctic Systems decision, HMRC, in what smacked of 'bad loser' guise, announced that they would be bringing forward a change in rules to tackle what they termed 'income shifting'. And that is what appeared on 6 December.

Taking stock - where are we now

Before examining the new proposals, it is as well to assess the current position.

In the lead up to the Arctic case, HMRC generally agreed that a business (and all these discussions apply to partnerships as well as companies, though most examples are in terms of a small company) with an asset base was unaffected. So a shop-owning business couldn't be caught by their settlements arguments - ownership of the shop and stock would be split between husband and wife and so couldn't be just a right to income. Also, if a business without an asset base - typically a consultancy - paid its owners market salaries and just divided up any remaining profit in line with shareholdings, that would usually be acceptable.

Arctic showed that if market salaries weren't paid, that wouldn't lead to the settlements legislation applying if it had been set up properly. A gift of preference shares in an established business would be caught, as shown by an earlier case. But many small businesses could sleep somewhat more easily taxwise.

That relaxed doze is now to be disturbed.

Just when you thought it was safe etc....

HMRC's new consultative document includes two pages of new legislation which then takes 18 pages to explain and illustrate how it is meant to work. The tone is set in the preamble which talks in terms of

• individuals being taxed on their income independently of others
• much focus on the system needing to be fair
• consequently a need to stop the tax system being 'undermined' by income shifting/splitting

The document points to a growth in recent years of trading through companies and notes reasons for this such as clients preferring to transact with a corporate body. Somewhat disingenuously, the fact that a major promoter of corporate structures was the government itself with the short-lived nil rate of corporation tax for the smallest companies is ignored.

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, ie 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 - and those arrangements must be other than genuine commercial arrangements of the sort that would be effected by people not connected with each other.

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 as it would basically be the husband's business, 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 wife over and above reasonable pay for her admin duties will be taxed on husband, not on her.

A 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

These new rules won't just apply to husband and wife situations, though that is undoubtedly the main target. Arrangements involving children, wider family and friends could all be caught but a lack of close family connection should help establish that the arrangements are excluded from income shifting as being in the 'commercial arrangements/not connected' category - though business arrangements between friends could still be caught.

The asset-backed business that was accepted as outside the HMRC target zone for the Arctic attack is firmly in the sights of these new rules.

HMRC's paper suggests that they have 'identified 65,000 companies where income shifting is likely to be taking place' and talk in terms of tax losses of £500m a year, half of which will be clawed back by the new rules. They go on to say 'the Government is looking to individuals to comply voluntarily [with the new rules] 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 are 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. That would include

• capital introduced, including perhaps loan guarantees
• other connections that have helped the business

There will be a need to keep an eye on changing inputs by those involved: one of the HMRC examples points to a situation where one partner stops working for a spell meaning that the profit sharing should alter, else income shifting will be in point. One hopes that they 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.

It does seem that a large proportion of the country's smallest businesses are going to have to review their arrangements before April 2008 when these new rules are going start. Although they are, strictly, only proposals, there seems little doubt that they will be introduced and in a similar format to the drafts now circulated. Many will conclude their arrangements will still pass muster; many will have to take action to document and/or change their arrangements.

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.