In that case, the House of Lords had to decide if it was legitimate for a husband and wife to share the dividends from their family company equally, despite the fact that the income of the business was “earned” by the husband, an IT consultant.
The Lords came down on the side of the taxpayers, saying among other things that the way the legislation operated was “workable and fair”, and pointing out the potential problems that would arise if HMRC’s line of reasoning was followed. HMRC had contended that, by not taking a salary from the company at a market rate, the husband was enabling the company to pay larger dividends on its shares, and thus he was “shifting” income to his wife (who only paid tax at the basic rate).
They wanted to tax him on this “shifted” income. The Lords made the point that a “market rate” of salary was a very subjective matter and could lead to endless arguments between HMRC and taxpayers.
At the time of the Lords’ judgement, there were some spiteful comments from the Treasury saying that they would legislate to stop “income shifting”, and now we have the result.
The draft legislation is scheduled for inclusion in the 2008 Finance Bill and will take effect from 6 April 2008. What it says is that:
If you are able to “influence” how a company or a partnership distributes its profits, AND
You use your influence in such a way that income passes to anyone to whom it would not have passed if you were dealing with them “at arms length” , AND
As a result, less tax is paid, THEN
You must declare the “shifted” income on your tax return, and the person to whom it was “shifted” must not declare it on theirs.
If this law is passed, chaos will ensue. Just think of the problems:
One way to “shift” income, as set out in the consultation document, is to pay yourself less than a “market rate” of salary, as described in the Arctic Systems case above. But what is a “market rate”? My practice is based in Cornwall and Devon where average earnings are significantly lower than in other parts of the country, so will a “market rate” there be lower than in London? What about some of my clients who have their company’s registered office in Cornwall, but mostly work in London – which rate do they have to pay themselves?
What about confidentiality? Say I deal with a company but other accountants deal with some of the directors. In order to know if less tax has been paid as a result of the company’s policy on salaries and dividends (one of the conditions for the law to bite), I need to know what the directors’ other income for the year is, and if they use a different firm of accountants, that is none of my business – and if I ask the question, by implication I am disclosing the income of the directors I do deal with (because if they were not paying tax at 40% the “shifting” would not matter).
What does “influence” mean? It is a new word in tax law and as such will need to be defined by court decisions before we get any certainty. I can think of one client, a company, where the parents no longer own any shares personally but their children (the shareholders) do exactly what Mum and Dad tell them. Do Mum and Dad “influence” the company’s policy?
This is another example of “guess what I’m thinking” legislation (the most recent before this was the law on CGT losses which I dealt with in November’s Tax Insider). It will give Tax Inspectors (or “Officers” as they now seem to be calling themselves) the opportunity to intimidate taxpayers into changing their policy on distributing profits from the family company, with the alternative of a long and expensive dispute about the meaning of the legislation.
The other possibility is that nothing will happen. At a time when HMRC is haemorrhaging staff, cannot operate basic security precautions to protect taxpayers’ personal data, and is unable to administer the system as it exists – it recently took three months and a formal complaint to get them to make a simple change to my own PAYE code – they are hardly going to thank their masters for giving them yet more complex and ambiguous legislation to enforce.