CUK’s contractor guide to s660, income shifting Part 1

Q: Is s660, s660A or the Settlements Legislation the same as the Family Business Tax (FBT)? And how did the FBT come about?
 

A: The proposed Family Business Tax is not the same as s660A Income and Corporate Taxes Act, or ICTA (1988) – which is now under s624 of The Income Tax Trading and Other Income Act (2005), or ITTOIA.

The reason there was consultation on introducing an FBT is that HM Revenue & Customs lost the case they brought on s660A – the Arctic Systems Case (Jones V Garnett).  The House of Lords finally decided in favour of the Jones’ in 2007.

In their response to the House of Lords decision, the following ministerial statement was made:

“The Government acknowledges the judgement given by the House of Lords in the Jones v Garnett (Arctic Systems) case.

The Government is committed to maintaining fairness in the tax system. The case has brought to light the need for the Government to ensure that there is greater clarity in the law regarding its position on the tax treatment of “income splitting”.

Some individuals use non commercial arrangements (arrangements that they would not reasonably enter into with an arms-length third party) to divert income (which would, in the absence of those arrangements have flowed to them) to others. That minimises their tax liability, and results in an unfair outcome, increasing the tax burden on other tax payers and putting businesses that compete with these individuals at a competitive disadvantage.

It is the Government’s view that individuals involved in these arrangements should pay tax on what is, in substance, their own income and that the legislation should clearly provide for this. The Government will therefore bring forward proposals for changes to legislation to ensure this is the case. In the meantime, HMRC will apply the law as elucidated by the House of Lords and will be providing guidance in due course.

The Government would not want commercial arrangements to be caught by any change to legislation. Consultation should help to ensure this.”

Hence the consultation for an FBT (covering what the government called ‘income shifting’ arrangements).

As CUK readers will be aware, Alistair Darling announced in his Pre-Budget Report on 24 November 2008, that the proposed FBT would not be introduced in the Finance Bill 2009 as previously planned.

It was to be “kept under review”, although no mention of it was made at all in his last Budget in March 2010.

However, time moves on. The new (coalition) government has created the Office of Tax Simplification (OTS).  One of the directors of the OTS, John Whiting, recently revealed in an interview that his team were looking at “income splitting” alongside other controversial taxes on businesses, such as National Insurance and IR35. So clearly it is back on the agenda, although he acknowledged that it is “pretty difficult to do”.

The OTS was tasked by the current chancellor George Osborne “to carry out a review of all tax reliefs by Budget 2011, identifying changes that can be made to simplify the tax system”.

An interim report was produced in December and, no doubt, they are on target to fulfil their instructions by March.  Whether this will lead to immediate legislation is far from clear. The tax profession believes that this is an impossible deadline for something so complex, but the government does seem to have the will to make significant changes.

Q: What factors, in terms of how I run my business with my spouse, indicate that I may get caught by s660, or the proposed (but shelved) family business tax?

Turning to the specific issues of s660A, particular difficulty arises where a company is formed and the income generated is really from the work of one of the spouses but the profits are shared between them.  Typical arrangements are where the income generating spouse takes a small, ‘uncommercial’ salary thereby maximising the dividend that is shared with the other spouse, usually 50:50.

The settlements legislation normally applies where the individual in receipt of the income is the spouse or civil partner of the settlor (unless such a gift is outright and unconditional, and of the capital and income from that share). 

Q: Do I have to be married to a person of the opposite sex who I run my business with in order to be caught by s660 (now s624)? In other words, is it only ‘husband and wife’ firms that need to be careful under the settlements legislation, or do I still need to be wary even if I run a jointly owned company with a business partner, or a civil partner.

The settlements legislation is broad enough to cover arrangements involving cohabitees. In these circumstances the settlements legislation would normally apply where the settlor has retained some “reversionary interest” over the shares that have been issued or given to the cohabitee (for instance a right to acquire the shares back or the right to enjoy proceeds from, or the income from, the shares given away).

For example, if the non-working cohabite receives a dividend that is paid into a joint bank account, or is used to pay the joint mortgage, then the working cohabite has retained an interest.  In this situation, it would be very difficult to exclude any benefit going back to the working cohabitee.

Q: Has the taxman’s loss in the Arctic Systems case made the settlements legislation less of an issue for companies with a similar structure to the IT consultancy? If not, is there any general guidance about how I reduce the potential for being caught by the legislation?

A: The Revenue has sought to identify s660 cases notwithstanding the loss in the Arctic Systems case.  The best way to be sure of avoiding an issue is to make the jointly owned company, or partnership, as commercial an arrangement as possible.

The Revenue acknowledge that where the business has real substance with employees, premises etc, and the profit earning is not just down to one shareholder, then s660A should not apply.  In other cases there are some simple steps that can be put in place to provide some protection:

  • Avoid having differing classes of shares.  Preferably, all shares should have the same income, capital and voting rights.
  • Where possible both parties should contribute to the company’s business and there should be evidence of this.
  • Both parties should subscribe for shares from their own resources and introduce real value.
  • Dividend waivers should be avoided.
  • Each arrangement needs to be looked at on its own merits and taxpayers who are married or are civil partners or are cohabiting who are looking to establish a joint business should seek expert advice. 

In terms of more definitive guidance, maybe there will be a proposal for a modified FBT in the 2011 Budget, on March 23rd, which will clarify matters and remove uncertainty for affected businesses.

Answers, as told to CUK, by Mike Hayes, Principal at Kingston Smith LLP, a chartered accountancy firm.

Editor’s Note: This is part one of a three-part guide, designed to provide contractors with an expert opinion on their most frequently asked questions about s660 and income shifting – the Family Business Tax. Part 2 will look at how a tax liability is calculated under s660/s624 and Part 3 will focus on how the FBT could be made fairer and workable. 

- CUK’s contractor guide to s660, income shifting Part 2

Wednesday 9th March 2011