New laws prohibit family firms' tax gain
The government has published draft legislation to stop a "tax advantage" thousands of 'husband and wife' businesses currently obtain by sharing their income via dividends.
From April, any tax advantage that may have been gained by family members or married couples in companies and partnerships "shifting" income in the form of distributions or a share of profits will be countered by new anti-avoidance legislation.
Drafted by HM Treasury in conjunction with HMRC, the new rules would not apply if there was a "genuine commercial arrangement" and HMRC believes tax reduction was "not the main or one of the main purposes" of the arrangement.
Otherwise the rules will apply where one person 'shifts' trade or business income to another, with the effect being that less income tax is paid.
Experts say the rules, which are under consultation, extend beyond the target of 'husband and wife' firms to all small firms where the arrangement was not at "arm's-length."
"In theory this might seem fair, but the reality is that family businesses do not and cannot possibly operate on a fully arms length basis," said Andrew Hubbard, vice chairman of the CIOT.
"One spouse might be the main income generator but he/she may well be totally unable to run the business without the full support of their spouse.
"Measured purely in hours that spouse's input may not appear to be significant, but that is not the reality of the situation. The support of the spouse may well be the difference between the business succeeding and failing."
Under the legislation, taxpayers must detail how much income they have 'foregone' by making a comparison with how the business would have operated, had all their work been done independently on a fully commercial basis.
If they fail to provide enough evidence to HMRC of how they pay themselves, company directors will face fines. Estimates suggest this could net the department £1bn in tax.
Yet in the legislation, "tax advantage" is not defined, though in accompanying notes the Treasury said the term is intended to cover a "wide variety of situations".
These include but are not exclusive to "the relief from tax, repayment of tax, the reduction in the amount of a charge to tax, and the reduction in the assessment of tax."
Last night the Charted Institute of Taxation pointed out that income sharing, or 'splitting' as the government prefers, is "perfectly acceptable" for unearned income such as rents or interest.
They said: "It is very difficult indeed to see the logic of permitting income sharing in these contexts but not in the case of family businesses, which are the life blood of the economy."
Justifying the rules, the Treasury explained: "Following the House of Lords decision , it is now clear that the settlements legislation is not sufficient to address all cases of income shifting.
"The government is committed to ensuring that, with clear and modern legislation, such cases can be dealt with effectively and that clarity can be given to businesses and their advisers."
"Therefore the government is proposing to introduce new legislation effective from 6 April 2008, focused specifically on income shifting arrangements that make use of companies or partnerships to gain a tax advantage."
Roger Sinclair, legal consultant at Egos Ltd, said that as currently drafted, the legislation departs from "commercial reality."
He told CUK: "It fails to pay any regard to the fact that carrying on business outside the world of employment - not only the individuals concerned - but also their families, must accept the burden of a whole range of risks not faced by the families of those who are simply employed - precisely because of the non-commercial nature of the relationships between them."
John Brazier, managing director of the Professional Contractors Group, agreed, saying the new rules would be a "nightmare" for smaller businesses.
He described the legislation as a "horrific burden on hundreds of thousands of small family businesses, which will make it impossible to self-assess tax bills with any certainty."
The freelance trade group has estimated that the legislation, which effectively overturns the Lords' decision, could hurt the tax practice of up to 300,000 micro firms.
Mr Brazier added: "The Government has been encouraging people to set up businesses under joint ownership for years; now they are hammering the people who have followed their advice.
"A married couple who jointly own a business would have to split its value 50-50 in a divorce; yet while they are married, the Government says they are not entitled to share the profits.
"Following on from the Arctic Systems case, IR35, the MSC rules, CGT changes and the rise in corporation tax, this is another kick in the teeth for small businesses in the UK."
But the Institute of Directors says the government has a legitimate concern about spouses agreeing to share income from a family business in order to save tax.
"It was inevitable that some changes to the law would be proposed following the Revenue's overwhelming defeat in Jones v Garnett," the IoD said.
"The problem is the state of the draft legislation. The consultation document presents it as only likely to apply rarely (paragraph 1.16). But the legislation is put together in a way that will make it all too easy for the Revenue to demand extra tax.
"Taxpayers will have to satisfy all of the conditions on commerciality set out in section 681E in order to be safe from the legislation. Fall at any one hurdle, and you are at risk."
Asked if he intended to respond to the consultation, one legal advisor said he wouldn't help the government "get it right" when the spirit of the legislation was so wholly wrong.