Income Shifting Legislation

Following last week's verdict in the Arctic Systems family tax case, the Government announced its intention not to back down, but to introduce new legislation aimed at clamping down on family owned companies where dividends are "split" and shared to parties who are demed to be "non-commercial" partners.

In the Arctic Systems case, HMRC had argued that Mr Jones had not drawn an adequate salary and because he was solely responsible for the income generated by the couples' company, he should have received a greater share of the profits. Being a higher-rate taxpayer than Mrs Jones, it claimed he would then have been subject to tax at a higher rate.

Ministerial Statement

In a ministerial statement, Exchequer Secretary to the Treasury, Angela Eagle, announced the intention to legislate:

"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".

So, what does this mean for small businesses?

The House of Lords' decision in favour of Geoff and Diana Jones of Arctic Systems in their battle with HM Revenue & Customs should spark a wholesale review of small business taxation, Peter Penneycard, PKF Partner and National Director of Tax, argues.

Penneycard said that HMRC is not going to let the matter rest there - its next move is likely to be a push for changes to legislation to prevent all small company owners using what is a long-standing practice to their advantage. Unfortunately, while HMRC may increase their tax take, this is likely to make starting a new business less attractive and damage entrepreneurial spirit within the UK.

The Chartered Institute of Taxation (CIOT) and ICAEW Tax Faculty are asking the Government to take their time and reflect on the decision before rushing to legislate.

Francesca Lagerberg, Chairman of the Technical Committee of the ICAEW Tax Faculty, says:

"The Government is looking to review situations where family members are involved together in a business. It appears that the tax authorities will seek to separate out 'commercial' situations from those where it believes dividends are being passed to lower rate taxpayers primarily to keep down the tax bill. The reality is that most businesses do not fall into such neat categories. There is a danger that rushed legislation will result in unworkable legislation, plunging thousands of taxpayers into yet more uncertainty about their tax position. There is no 'quick fix' formula that we think could work. There is now an urgent need for full and detailed consideration of the small business tax regime, which should include a detailed understanding of the businesses and the issues involved and full consultation, which should be completed before any measures are announced."

Professional Contractors Group chairman David Ramsden commented:

"When husbands and wives began to be taxed independently in the 1980s, it was always intended that they should be encouraged to go into business together in this way. We question why the Government suddenly wishes to jeopardise the UK's vibrant small business sector by reversing this well-established policy."