Farm Finance: Income shifting offers security

It’s not uncommon for farm businesses to shift income among individuals for tax purposes. For instance, many farms’ books have traditionally structured the salaries and dividends received from the business among the individuals involved.

The idea has been to maximise the benefit of personal allowances and lower-rate tax bands, particularly where a spouse has little other income and would therefore pay tax at a lower rate than the farmer. But, HM Revenue & Customs says this income should not be shifted and should be taxed as the income of the main breadwinner who really earns it.

Earlier this year, HMRC announced that its new rules on this practice were to be postponed from April 2008 until April 2009 – giving farmers, accountants and tax advisers a welcome opportunity to analyse what these regulations might mean. However, the chancellor announced in his pre-Budget Report that the legislation would now be held under review – it is not clear when it will now take effect. However the threat remains real and a dedicated assault on income sharing is now just around the corner, so who will be affected – and how?

Background

First, what is income shifting? To set the scene properly, we need to return to December 2007 when the government published draft legislation to address its concerns regarding this issue. This is defined by HMRC as an individual’s ability “to dissociate themselves from income that they would have received in order that the income is taxed in the hands of another individual at a lower rate”.

The proposed legislation comes in response to the taxpayer’s victory in the well-documented Arctic Systems tax case. HMRC brought the case against a small husband-and-wife IT services firm for shifting income mainly generated by Mr Jones’s skills as an IT specialist to Mrs Jones, who worked in an administrative capacity for their company.

The couple paid themselves a low salary and distributed most of the company’s income equally between them using dividends. Mrs Jones paid tax on those dividends at a lower rate than Mr Jones. As a result, they saved on the potential Income Tax and National Insurance bill, which would have resulted if Mr Jones had paid himself the majority of the money he earned as a salary. The House of Lords found they were acting legally and HMRC lost. However, the Treasury considered the arrangement to be “tax avoidance” and announced draft legislation to combat the practice.

Impact of the proposed legislation

The proposed legislation will affect the many family companies and partnerships in the farming and rural sector that seek to shift income between spouses or other family members. It is difficult to plan precisely for the impact of the new post-2009 regime, as there are no detailed provisions available. These are unlikely to be announced before the Budget in spring 2009. However, there are some steps businesses can take based on general principles.

Those running companies and partnerships will need to identify if they could fall under the new legislation. It is targeting those owner-managed businesses that draw on the skill and expertise of predominantly one person, but which, to some extent, use family members and friends, perhaps in less skilled roles.

The original draft legislation set out four conditions, all of which must be met for the legislation to apply.

  • Condition A – that the individual is party to or has power over the relevant arrangements
  • Condition B – Individual 1 forgoes income and the forgone income is individual 2’s for the relevant year
  • Condition C – Individual 1 has the power to control the amount that is shifted
  • Condition D – the shifted income consists of distributions of a company or profits from a partnership

In addition, the tax paid by individual 1 and individual 2 must be less than it would have been, had they not shifted the income.

The effect of the legislation will be to undo any tax benefit gained by those who are deemed to have shifted income. Taxpayers will be required to assess the benefit obtained and to calculate their tax bill as if they had not obtained such a benefit. There will also be a requirement for each party involved to provide full details of the other, in order that HMRC may enquire into both sides of the arrangement.

Farmers will therefore need to look at the structure of their business and the roles of those involved and assess whether there is a justifiable reason for what they are paid and whether the legislation might apply.

There is still time to review circumstances to ensure appropriate arrangements are in force before it becomes clear when the new legislation will take effect. Any legislation is likely to mean a sudden change, so it is important that any appropriate action is taken to comply with the anticipated new regime.

  • Mike Harrison is partner in the landed estates team at chartered accountant Saffery Champness