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Mark McLaughlin CTA (Fellow) ATT TEP provides a brief overview of the proposed new rules on income shifting.

Mark McLaughlin

Unfit for purpose

The President of the Chartered Institute of Taxation, Rob Ellerby, recently protested to the Government in a strongly-worded letter that the proposed new rules on ‘income shifting’ were not “fit for purpose”. Upon reviewing the draft legislation and HMRC’s guidance notes, in my opinion it is difficult to reach an alternative view.

The proposals swiftly followed HMRC’s defeat in the House of Lords in the ‘Arctic Systems’ case. The draft legislation is relatively short for such wide-ranging proposals – six sections in total. Such brevity could be seen as a good thing, but in fact it is not. The legislation is open to interpretation, and HMRC have taken the opportunity to produce a consultation document of around 40 pages with draft guidance on their interpretation of how the rules work. There is a worrying trend developing of short but widely-drafted legislation supported by lengthy HMRC guidance (the targeted anti-avoidance rule on capital losses and guidance arguably being an even more disturbing instance). The guidance does not carry the force of law, but HMRC will no doubt seek to apply it in practice as though it represents the law.

When the rules will apply

The proposed rules will apply if four conditions (A to D) are satisfied. Note that all four conditions must be satisfied or otherwise the income shifting rules cannot apply. These conditions can broadly be summarised as follows:

Condition A - An individual (1) is a party to, or has power over, ‘relevant arrangements’ (see below);

Condition B – Individual 1 forgoes income (see below), which becomes income of another individual (2) for the relevant tax year;

Condition C – Individual 1 has power over the amount shifted; and

Condition D – The shifted income comprises company distributions or partnership profits.

Individual 1 ‘forgoes income’ if he or she would be entitled to the income, or might reasonably be expected to receive the income based on the work that they have done. ‘Relevant arrangements’ are generally defined in terms of being non-commercial, where it would be “reasonable” to conclude that saving tax was a main purpose. This is an area where potential problems are sure to arise. For example, what is ‘reasonable’?

What is ‘Arm’s length’?

There are rules to determine if arrangements are ‘commercial’ or not, whereby three conditions must be satisfied. The first condition is a business purpose test, and the second relates to companies with investment business. The third condition will cause problems. It provides that the arrangements must be on ‘arm’s length’ terms. But what is ‘arm’s length’? Such questions call for judgement and opinion, which are likely to result in uncertainty and possible disagreement with HMRC. If caught by the new rules, the shifted income will effectively be treated as that of Individual 1.
 

Practical points

The following are some key practical points to come out of the proposed legislation and guidance:

• Husbands, wives and civil partners are potentially ‘caught’. However, the rules have wider scope. Owner-managed businesses run by other family and close friends may also be affected.
• The rules apply to shifted dividends or profits of 2008/09 and later years. However, they are likely to impact upon undistributed income of earlier years.
• The rules will only apply if the income shifting produces a tax saving. So if (say) husband and wife are already higher rate taxpayers, the rules cannot apply to any income shifted between them.
• Salaries are not subject to the income shifting rules. The new provisions only apply if company distributions or partnership profits are shifted.

Prepare for the worst!

The consultation period for the income shifting rules ended on 28 February 2008. It seems unlikely that the Government will do a ‘u-turn’ on the proposals, but the absence of a response may lead to the conclusion that advisers are in agreement with the income shifting rules – are you among them? In addition, advisers of potentially affected clients should be thinking now about how they will need to act in their clients’ best interests under the new rules. In other words, hope for the best – but prepare for the worst!

Please contact me if you wish to discuss the income shifting rules, or have any queries on their possible application. 

The above is taken from 'Practice Update' a free bi-monthly e-Newsletter for professional advisers. Firms can order a copy by e-mail (tax@markmclaughlin.co.uk).