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Income shifting - guide for contractors

''Income shifting'' is a term coined by the Treasury with the objective of getting contractors, and other small businesses, to pay more tax on company profit.

The idea is based on the notion that at many family companies one spouse does all the work and the other spouse doesn't. Each partners receives a share of the company profits and pays tax individually. So the partner who does all the earning supposedly 'shifts' half the income to the partner who does nothing, and both partners pay less combined personal tax as a result.

HMRC proposed draft legislation for the finance bill 2009, but it never came to fruition. Contractors who are currently not caught by IR35 and split dividends with their spouse would be particularly hard hit by any re-emergence of income shifting legislation.

Income shifting is based on profit / dividend division

For most companies income is taken in the form of dividends and not salary. This strategy of dividing up the dividend income is one that has been accepted as legitimate since World War II-- it is only the Government, which seems to have a real antipathy to small business in general and contractors in particular, which has tried to take steps to restrict it.

All businesses employ tax planning strategies to limit their tax liability, which are fine provided they are on the right side of the law. Dividing up dividend income in this way is entirely respectable, but HMRC decided to try and take action in 2007 - and failed.

Revenge for Arctic Systems

The first action taken by the Treasury proved to be cruel and unusual punishment. HMRC attacked a small family business called Arctic Systems and tried to force the couple who owned it to pay back taxes on the basis that income was being 'shifted' from the principal earner, a computer consultant, to the spouse who ran the business and kept the books.

The theory was that the computer consultant was the only real earner. HMRC dragged the couple through the courts for six years until finally the Law Lords ruled against HMRC in 2007.

Treasury income shifting proposal ridiculed

Immediately after the court case was lost, Labour's junior Treasury minister Angela Eagle announced that changes would be made in the law so that ''income shifting'' could be penalised.

The Government announced its proposed law with the 2008 Budget, and the bill, as it was elaborated by the Treasury, was received with ridicule by every tax expert and tax organisation in the country.

It was called ''unworkable,'' ''badly drafted,'' ''impossible to implement'' by organisations like the Chartered Institute of Taxation and the Institute for Chartered Accountants. Despite the ridicule and outcry the Government suffered from the proposal, they still intended to put it through.

So how was it supposed to work?

So, how did this proposal supposedly work for the typical family company that the Government was targeting?

Let's say a couple--husband and wife for example, but it could be any two partners-- forms a company, and each owns 50% of the shares. The company provides consultancy services, perhaps in IT or engineering for example. Let's say the husband goes out into the field and provides the consultancy work, while the wife works in the business doing all the admin work, answering phones, and general other background tasks to make is possible for the husband to do the consulting.

They each take a small salary, and after expenses and corporation taxes they're left with a profit which is distributed as dividends to the shareholders. Both husband and wife pay tax on their personal income. At the time of the proposals the dividend tax regime was such that any dividends under the basic rate threshold (£34,000 at the time) were not taxed - meaning a full £68,000 were not taxed further, because the money was split between the two partners.

The Treasury then claims that the wife contributes nothing!

Now, let's suppose that the wife were not a shareholder. This would mean the husband takes all the dividends, and then has to pay further tax on them.

The Treasury claimed that the wife wasn't really 'adding value' to the business, and so had no right to receive dividends. What the new legislation proposed was that the small business owners would have had to ''prove'' that the supposed non-earner adds enough value to the business to merit the dividend payment.

What, asks the Treasury, would be the value of the wife's services if they were paid for on the open market, that is, if the company had to hire someone else to perform them?

As one tax expert after another showed, providing a value for the wife's services is practically impossible--the technical term for such a valuation is an ''arms-length'' value.

It was painfully clear that, in a family business, each partner contributes a great deal more than what can be shown on a paper valuation. The wife, in our example, may help make sales when answering calls, or may provide practical advice, help build a network of contacts, help when clients call up with issues to be resolved and the husband isn't there.

The example given by many experts is the family farm, where, at one time or another, husband, wife, children, and even aunts and uncles all pitch in to keep the place going. How do you put a value on that?

HMRC's (Non) consultation period

The Government refused throughout the consultation period to modify or clarify the proposals sufficiently. The result was that thousands of small businesses would have had difficulty in managing their taxes. Worse, an additional burden of administration and paperwork would have been placed on the shoulders of contractors and family companies of all kinds.

The Government finally understood the proposals were riddled with holes, and they did not go into the Finance Bill 2009.

Updated: Monday, 26 June 2017

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