Income Splitting: Business case studies from the CIOT

Following publication by the Treasury of draft legislation on “income splitting” (officially "income shifting") HM Revenue & Customs (HMRC) is seeking responses not only the draft legislation but also to the eighteen pages of draft guidance which seeks to try and demonstrate quite how one will quantify the relevant income.

A very basic, and straightforward example of income splitting, might be as follows:

  • Mr Smith is an engineer, he works an average a 40 hour week through a limited company incorporated so that he and his wife each hold 1 ordinary share each.

Continued...

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Comments

If not shareholder OR director OR employee ?

Anonymous | | Permalink

Penny -
Even if that case were caught, what if he were neither a director nor a shareholder: his wife is 100% shareholder and sole director. Also he is not an employee of the company as he receives no remuneration from it. I can't see that he has any 'entitlement' to income from the company, therefore has not foregone any income, therefore this extreme case surely cannot be caught?

What about this one?

Anonymous | | Permalink

Husband is partner in successful firm, wife has negligible income. Husband identifies an opportunity to use his skills outwith the partnership. He sets up limited company with himself as director and wife as 100% shareholder. The company pays only final dividends. Although it is the husband's efforts that generate the income, final dividends have (I believe) to be ratified by shareholders. Can it be said, therefore, that the husband is unable to influence the amount of the income foregone and the rules will therefore not apply? Or will the director's recommendation of the dividend level, even though he cannot approve it, constitute influence for this purpose?

Fair is fair.

Anonymous | | Permalink

In the interests of fairness to all I have edited out the qualifications which Roger has commented on.

Comment

Anonymous | | Permalink

I like this point used by the CIOT in the tax and accounting practice example:

"A&B brought in different qualifications – one an ACA, other a CTA – having a CTA director attracted clients who otherwise would not have used the firm."

That adds nothing to the points they make on the dfficult issues here, but appears to me to be a rather shameless and unsubtle promotion of the CTA qualification by the CIOT.

I am, for your information, qualified as both an ACA and CTA.................

timesheet

Anonymous | | Permalink

I think this means only one thing - small business (who already have enough red tape) will now have to keep a time sheet of who does what
in order to proof the amount of their contribution. Rememeber that the onus of proof is always with the tax payer.

That is of course after spending weeks with all the HMRC submissions, VAT changes, employment legilation, industrial regulation changes etc.

Timesheets

Anonymous | | Permalink

The guidance says that no additional record keeping will be needed which is not too helpful. HMRC will have to rely on those under enquiry to remember who did what and when. This makes me think that if you cannot ascertain the input of say a spouse, someone will then have to estimate input based on, well what?

I think this where it all gets rather interesting. Who could you take to give a comparison for say the work done by a spouse, who is not the main fee earner? You could not do an arms length comparison because that would involve analysis of an entirely different type of worker, or would it? Are spouses entitled to "extra" for say working irregular hours, often putting up with a business run in the spare room, having to act as dogsbody from time to time, and putting up with your mood swings? Would a normal person ever take on such a role, and what is the going rate? From what I can see the role of the non-fee earning sort of spouse is often more akin to some crazy sort of PA.

Then we get to looking at a return on capital investment for this sort of spouse. Should a spouse be entitled to a return in respect of his or her input in terms of goodwill generated and overall prosperity of the business. What about risk? Surely the spouse bears this too? The business may not have a loan secured on the house, but businesses can and do go bust. How much is the lack of job security worth on an arms length basis?

I think, that actually I shall have to write an article on this and develop a costing methodology. I have next to me a book called "Accounting for a better life" which develops a domestic accounting model, it seems I have actually found a use for it.

Don't forget that this "consultation" shows a negative Admins Burden of £200,000, so really it will, actually, really, honestly...save money...

The real intent

NeilW | | Permalink

What it boils down to is simply increasing the cost of using the dividend route such that when you do the costings, including the risk of investigation it will turn out to be 'cheaper' to pay salaries.

As usual with Labour they won't say what they really want up front - which is for people to pay Employment Income.

daveforbes's picture

market rate salaries

daveforbes | | Permalink

If a husband and wife jointly own a limited company and each is paid market rate salary for any work they do for the company, it seems reasonable that any remaining profits should be distributable as a dividend to the shareholders.

The other bizarre thing is that it does not apply if you are both higher rate tax payers. Suppose you also had investment income so that your were both higher rate taxpayers. Then it is ok. Move your investment to one for capital growth, deferring income tax to a capital gain down the line, one shareholder may drop out of 40% band - and you are suddenly a "dodgy income splitter"

Consulation Misrepresents

skeeve | | Permalink

In a fair and equitable tax system shouldn't the internals of a company be treated as a black box ? Its quite possible to construct many examples where the proposed consultation is quite plainly stupid.

e.g. Clive and Anne set up a company to sell s/w services. They have a Polish friend Pavel who agrees to work for them for £40k (twice his Polish income) and after many sales calls, they place Pavel at CreditHole Bank, Canary Wharf. The daily rate is £750. The company earns a profit (before CT) of £130k. Clive and Anne have a share each ...
1. Under this legislation is the person who made the ACTUAL sale supposed to take the entire distribution ?

2. If Clive makes the sale, but Anne is the s/w engineer instead of Pavel, how is the ultimate profit to be distributed ? (This is the black box - the inputs and outputs are no different to the Clive/Anne/Pavel - yet this is caught by the legislation.

Limited Companies are an ENTITY in their own right. There is nothing (yet) in law to prevent any two people from enjoying the legal right to co-own a company. (In fact if the legislation is skewed against married/civil partners then its almost certainly a breach of their EU Human Rights).

If the government want to raise more revenue there are two distinct obvious things they can do:

1. Abolish the small companies tax rate.
2. Remove the ability for Limited company owners to receive any form of benefit - e.g. Family Tax Credit.

It seems fairly obvious that the 0% CT rate completely screwed with tax predictions at the lower end of the business market and if they want to now discourage incorporation, use a scapel instead of a blunt hammer.

The consultation is extremely biased - it suggests e.g. that "0" tax is raised on a £60k income split between two partners, versus £6k for a single owner, versus £15.5k for a Sole Trader. In reality the situation is £13200, £15k and £15.5k - because the compiler's appear to be unable to compute the CT contribution.

Income splitting

Anonymous | | Permalink

What amazes me about all the examples the IR give is the naivety about how they are run. If I'm not mistaken all the profits were extracted from the example companies each year - nice and handy for simplistic calculations that the IR want to achieve but this just doesn't happen in practice.

I have a small family company that has significant retained profit over the years, because you just don't know what tomorrow or the next few years may bring. It thus generates significant interest income - not earned by any particular person - so the questions are these

- how should income splitting apply to profts earned say a decade ago?and
- should non-earned profits be subject to income splitting? If so how?

I fear that the legislation will be as well targeted as the other recent cock-ups like IR35 and S660 - a lot of heartache and soul-searching for the poor businessman which most likely will achieve zip after implementation.

Part A

notmy realname | | Permalink

Getting away from the rights or wrong of this, on a very practical level I simply don’t see what the actual “shift” computation should be. I think this is the angle to go at rather than worrying about measuring the worth, its hard enough to do the math even if the “worth” is quantifiable.

Ie even if we know (presumably using some detailed prescriptive list of what hours are ‘allowable’ and what hours are not backup up by a daily timesheet) how many hours are worked and even if we some how accurately know what is an appropriate rate of pay for each type of work undertaken.

The guidance still doesn’t actually help us compute the “income shift”.

Let us assume the company make £100k profit. No other salaries. Pays CT of £20k. Net profit £80k. Profits split equally, £40k each and paid out for simplicity. A works 1,000 hours in the year, at a rate of £20 per hour ie £20,000. B works 1,000 hours at a rate of £30 per hour, ie £30,000.

Now are the dividends split 50:50 (both worked 1,000 hours), or are they split 40:60 (in line with relative ‘market’ rates) or are they split 20:60. If its 20:60 this doesn’t make any sense to me as the £20k is a net figure, the £20k salary is a gross quoted salary.

Had the company paid A £20,000 it would have incurred NI of (say) £2,500 and paid less CT, so net profits to distribute of £62,500.

A would (with a salary) received around £15,000 net salaried income. So does this mean we should split this £62,500/£15,000 rather than £60/20? If so what happens to the ‘missing’ £2,500 (this could of course go either way depending on the relative tax rates).

Or should it be £65,000/£15,000, or £60,000/£20,000, or £60,000/£40,000 or £30,000/£30,000?

From the guidance notes it would appear ALL of the above are possible answers.

If the answer to this question is that these rules don’t apply as both work on the business full time (ie its 50:50), how does this change if the hours worked where 1,200 and 800 for example? Or 1,500 and 500? And is this fair? And when do we go from an “hours worked” basis to a “minority open market rate” basis? Given the fact that most business are more than the sum of their parts the "bounce" from one to the other is going to be very significant when you go over the wire and stray from a commercial relationship to "shifting income" in the eyes of HMRC.

Part B

notmy realname | | Permalink

.........

What happens if A works 2,000 hour but is “worth” only £10 hour (support and marketing role), but B due to a long term illness works just 100 hours but is “worth” £200 per hour (advisory role)? Is this now an equal partnership (50:50) or an unequal one (hours worked) given they make £60,000 (ie more than their individual inputs) before CT. So this would be either, 15:33 (A’s net market salary and B taking the balance as the “brains”), 20:28 (A’s gross market salary and B taking the balance) 24:24 (Straight partnership), 28:20 (A taking the lions shares as the most hours, and B taking the gross market rate) or 33:15 (A taking lions share, and B net market rate) depending on which way you look at it.

What happens is B only works 50 hours, or does 200 hours? Or spends half their time on admin tasks?

There just doesn't seem any way of computing it fairly other than a very broad brush manner and leaving it to HMRC to challenge it.

What if?

Anonymous | | Permalink

I think, James, that you just get in a muddle...

In all seriousness, I think you have to review each business as it comes and this is one area where a broad brush approach may have you reaching for the phone about PI cover.

Check out this seasonal tale Costing the Spouse it has some interesting ideas about costing out the family workforce.

Profits pre 2008

Anonymous | | Permalink

Still haven't read anywhere how you account for retained profit in the company post next April.

Say company OldCo has significant built up reserves from retained profit over many years of trading (incidentally without ant timesheets etc,) which in turn generates its own non-laboured interest income. How can this be accounted for within the income shifting regs past next April.?

E.g. dividend x declared from old reserves - is this subject to income shifting, or dividend y declared from new interest on old reserves.

I just can't see how you draw a line in the sand next April because companies have been in existence long before then and unlike the HMCE examples do actually keep profit back.

How does this square with Company Law ?

skeeve | | Permalink

Company law states that distributions must be made in proportion to the share holdings of the company "investors".

The income shifting legislation seems to try to run rough-shod over this. It will be impossible to make a dividend distribution comfortably without certainty about the "income-shifting" situation.

If on the other you somehow manage to value according to the income-shifting legislation and this results in uneven splits - then this will fall foul of company law on distributions.

As the TaxZone Costing the Spouse indicates this is an impossible situation.

unworkable and unclear

notmy realname | | Permalink

Just seems completely unworkable.

Going back to one of the points below, if the open market rate of salary is £20,000, do you take £15k of net dividend (net of tax as an employee), £20k gross, or perhaps the £20k is the gross dividend ie £20k dividend = £18k net.

Huge differences in tax there for the other HR tax payer (£5k=£2k in tax). The consultation document doesn't even mention this important computation issue that I could see, nor does CIOT.

Re the Scrooge story, I thought that was just sarcasm rather than a practical guide on how to deal with it!

Spouse skills

Anonymous | | Permalink

An apparently simple case. 50/50 H&W company. H is a qualified engineer, company gains contracts which H fulfills as a named consultant.

However, these contracts are in China, and would not have been gained without W's input as she is Chinese and able to provide translation services as and when needed. Translation is not needed very much, and is rarely explicitly charged, but the contracts would not have been gained, and the income would be zero, without the language skills being available. How much do you value W's contribution for income-shifting purposes? Zero (she doesn't directly earn any fees) or 50% (she is equally responsible for gaining the contracts) ?

Reply to Steve re profits pre 2008. See draft legislation subsection (2) bottom of p.12 of consultation document. These would not have "formed part of the income of Individual 2 for the tax year 2008-09 or a later tax year" so would be excluded from the income-splitting amendment. Interesting question whether reserves could be accumulated over a period of years post-2008 and then paid out to individuals 1 and 2 in subsequent years, whether as dividends or salary, and escape these rules. 681B (4) (b) suggests that this might be possible because it introduces the comcept of "the relevant tax year" - i.e. perhaps the effect of the legislation could be mitigated by "time-shifting" the payment to individual 2.