Income shifting - how it might affect you

The Arctic Systems case has been much talked about over recent years. The case involved a husband and wife who owned a company 50/50 and, broadly, took the profits out by way of dividends. HMRC attempted to tax the dividends solely on the husband, as he was performing most of the work which generated the profits of Arctic Systems.

Following HMRC’s defeat in this case, the government has published draft legislation to prevent a tax advantage being gained through what has become known as ‘income shifting’. This legislation will apply from 6 April 2008 to:

• company distributions, usually dividends, and
• profits from a partnership.

It is broadly designed to address the Arctic Systems sort of situation, where one spouse or civil partner generates most of the business profits but the other gets a proportion of the profit and saves tax into the bargain!

However, the proposed legislation is rather wider than this and refers to an individual who shifts income to another individual. To be caught by the legislation three other conditions have to apply:

• the individual who is shifting income is party to an arrangement or understanding, or can control or influence such an arrangement or an understanding
• that individual forgoes income (directly or indirectly), as it has been shifted to the other individual, and
• the individual who is shifting the income has the power to control or influence the amount of the income shifted.

If these conditions are met, the individual who has shifted the income will pay the tax and any national insurance due on the income shifted.

Situations not caught

The legislation will not apply to:

• genuine commercial arrangements
• arrangements that are the same as those that would have been entered into in dealing with an unconnected party on an arm’s length basis
• general investment income, such as dividends from a plc
• situations where gaining a tax advantage is not the main or one of the main purposes of the arrangements
• situations where, even though income has been shifted, there is no tax advantage gained.

The proposed rules are very widely drafted and will catch many owner-managed businesses involving husbands, wives and other family members, as well as businesses run by non-family members, leaving many with a substantially higher tax bill.

We will, of course, be reviewing your tax position before April. We will advise you of any necessary action which you should take to mitigate the effect of the new rules.

If you have any questions or concerns in the meantime, please do not hesitate to contact us.