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HM Revenue & Customs (HMRC) is seeking responses not only the draft legislation but also to the eighteen pages of draft guidance which seeks to try and demonstrate quite how one will quantify the relevant income.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. Both are directors, and she is the company secretary. Mrs Smith does no work for the company at all. Mr Smith pays himself a salary to cover his personal allowance and the balance of the £100,000 profits are paid out equally to the shareholders as dividends.
• This is a classic example of “income splitting” between husband and wife, and there is no commercial motive in place here other than to pay as least tax as possible. Mr Smith would never give half his company and half his income to another individual as an arms length transaction or otherwise, he is splitting his income to utilise his wife's basic rate tax bands and allowances. Mrs Smith’s dividends will, under the proposals be assessed as those of her husband.

In practice, most cases will not always be quite so simple. The Treasury have come up with this next example which illustrates how tricky it may be in practice to decide what, if any income is split or shifted:
Appendix B.109 In year one individual 1 and individual 2 form a partnership to provide graphic design services. Each individual introduces £50,000 of capital into the business. Individual 1, who is a graphic designer, carries on the trade of the partnership while individual 2 manages and promotes the business of the partnership. They both work full time and develop the business together. Trading profits for the first three years are £80,000 per year, which are shared equally. In year four, individual 2 does not work for a year and, during that time, individual 1 continues to work in the business providing the graphic design services to customers as before, but also now manages and promotes the business of the partnership on their own. However, profits are still shared equally between individual 1 and individual 2. The trading profits for year four are £80,000, with each partner receiving £40,000. In year five, individual 1 returns to work for the business. The business again makes trading profits of £80,000, which continue to be
shared equally.
The outcome: Maybe, maybe not?
The guidance says that “Income has not been shifted in years one to three, as the arrangements were commercial. Whether individual 2 taking the year off work in year four is sufficient to make the arrangements non-commercial will depend on the facts. Initially the arrangements may appear to be non-commercial because individual 1 has contributed labour and capital while individual 2 has only contributed their capital, and the legislation may apply. However there will be instances where this is not the case and the arrangements would continue to be commercial, so the legislation would not apply. For example, the legislation would not apply when the time off is for maternity or sick leave. The legislation may apply in situations where there is not a commercial rationale for individual 2’s leave that could otherwise justify an individual not working in the
business for a year yet continuing to receive a full share of the profit. In year five, the arrangements are back on a commercial footing and the legislation would not apply.”

A closer look
The unanswered questions here are whether individual 2 should benefit from income in year 4, when his or her capital is in the business, and some of its prosperity is down to his/her input. Does goodwill stand for nothing in these instances? If individual 2 has left to have a baby, that is apparently a commercial decision and there will be no tax charge!

The Chartered Institute of Taxation (CIOT) highlights that fact that income sharing is regarded as perfectly acceptable for unearned income such as rents or interest. It goes on to say that “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.”

With the benefit of experience, the CIOT says that most family companies are genuine joint enterprises and the tax system should recognise this rather than attempt to force arbitrary splitting of the income between different family members. It has produced the following questions and five cases studies based on real businesses to illustrate the problems and difficulties that income splitting creates.

General questions

1. Farming partnerships: How will family farming partnerships be treated? These partnerships often include not only husband and wife, but also other family members, such as an elderly parent, whose active "hands-on" faming involvement may well have decreased over the years. Often their profit sharing ratio may not have changed during this period because of the recognition of the value of their experience, guidance and other skills.
   Will this be acceptable? Would this be acceptable for parents but not for spouses or civil partners under any proposals?
2. Risk: How is risk to which partners and director/shareholders are subjected to be valued? Won't each and every shareholder or partner be subject to the same risk? Will a business with much debt be treated differently to one without, in terms of the risks to which owners are subjected? Does the potential risk change depending on the economy, outlook or trade? For example, are some farming businesses (whether corporate or partnership) currently more at risk (e.g. with avian flu, blue tongue) and therefore to be treated differently now to later if matters improve?
3. Valuing input: How will each owner’s input to the business be valued to determine the figures for self-assessment? Will businesses have to keep detailed records (such as timesheets) to ensure that they cannot be attacked retrospectively when HMRC make enquiries? How will any additional record keeping be justified when looking at the admin burdens of businesses? What disclosure will be needed to ensure no chance of discovery? Is the matter going to have to be re-assessed each and every year, or even part way through a year if circumstances change?
4. Co-habiting partners: Will unmarried co-habiting partners/co-directors be treated differently from spouses or civil partners?

1. Husband & Wife (H & W) partnership – taxicab business

• W used personal inheritance to acquire original Hackney Plate and vehicle.
• H drove the taxicab and W carried out the office work, e.g. completed the paperwork, took telephone messages or requests and operated radio.
• After several months W expanded the business by negotiating regular contract hires with a local council and some schools for transporting disabled children. The business turnover doubled in the period.
• H was then involved in a car crash and initially the roles were swapped temporarily, whilst he recuperated and was unable to drive.
• Unfortunately, as a result of complications following the accident H had both legs amputated and could only work in the office (not driving) – so W took over driving permanently.
• Business folded within 2.5yrs due to H’s lack of ability to generate new work and W’s perceived lack of driving ability. Proceeds of sale split equally – even though assets originally purchased by W.

  Questions:

  1. How do you value the original capital input?
  2. How do you value the input in the first few months where H did most of work?
  3. How to value input of the new work generated by W?
  4. How do you value the input following H’s accident?
  5. Basically, how do you value the changing input over time, which was not foreseen and affected by the accident?

2. Husband and wife (H & W) partnership and company shareholders - builders and developers - sharing profits equally

• Partnership: In the past H&W have bought land and built houses which were sold and they also bought land that they sold on to another developer after obtaining planning permission. One of their biggest projects was to purchase a dilapidated factory site which they turned into 35 small industrial units. They retained ownership of the units which are let and H&W are assessed on the rental income.
• Company: H&W are also equal shareholders in a company which bought land in 1990 and obtained planning permission for hi-tech industrial units. Once the company had put in the infrastructure it marketed the serviced plots for sale. Some plots were sold, but then the bottom dropped out of the market and they eventually built warehouses on the remaining plots which the company continues to own and let out to tenants.
• Both: When the building work was in progress (both partnership and company) H would have been on site getting his hands dirty and managing the sub-contractors. W was involved in every decision regarding which land to buy and was involved in all discussions with the bank, solicitors and surveyors. W was responsible for designing the show houses and she also got her hands dirty doing the landscaping. The partnership won a prestigious award for its design and presentation of the former factory site.
• Immediately after the dilapidated factory site was acquired in the early 1990s there was a severe recession and the partners were in serious financial difficulty; everything they owned was in hock to the bank and they lived with that uncertainty for a number of years.

  Questions:

  1. How should the rents from the small industrial units be shared given the fact that husband may have spent more hours on the refurbishment, but the wife had a major input into the award winning design and landscaping of the site and she was joint and severally liable for all the very substantial debts?
  2. How should the dividends from what is now an investment company be shared given that husband spent more time on the day to day project management when the warehouses were being constructed, but the original intention had been to sell serviced building plots and the wife played an equal part in the acquisition of the land and the obtaining of planning permission.
  3. In short how do you measure the split of current income which derives from many years' history involving twists and turns which were affected by factors beyond the control of the individuals concerned?

Husband and wife (H & W) partnership – training consultancy business

• H&W have been in partnership since 2000 and have always split profits equally - business of training consultancy.
• At first, while their child was very young, W did all "back-room" work, including the accounts and general admin (prior to the partnership being formed W was paid a wage for this).
• Gradually W's direct business involvement has increased - by taking on the business development and marketing, and by gradually starting to do a proportion of the "fee-earning" consultancy work.
• H still does the majority of the "fee-earning" consultancy work, but the proportion undertaken by each varies according to the demands of clients - and (as the majority of the work involves travel) they never go away at the same time, so that one of them is always there for their child.

  Question

  1. It seems quite clear that W's involvement in recent years could be commercially justified as being equal. In the same way, is it right to suggest that it would not have been equal in the earlier years of the partnership? W was, as a Partner, even then jointly and severally liable, and her "background" role enabled H to go out and accept work which ensured that the partnership was a commercial success. If they had split the back-room and other elements equally, no doubt W would have been out fee-earning at a much earlier stage - but the fact that they chose a traditional route should not devalue her input into the partnership.

Limited company - Tax and accounting practice

• Shares owned equally by two working directors, A&B (each married to other spouses) who set the practice up from ‘day one’ as a limited company.
• For commercial reasons, from the outset, they paid each other identical salaries and, having identical shareholdings, took identical profits. They decided that remunerating each other or splitting shares in proportion to the value of their input to the business would be divisive and engender a lack of trust.
• A&B lent the company different amounts to provide some working capital.
• A&B brought in different qualifications – one an accountant, the other a trust tax expert – he attracted clients who otherwise would not have used the firm.
• A&B had different skill sets in terms of IT knowledge (vital in a small business with own IT network and no IT dept), management skills, organisational skills, marketing, design and networking skills.
• A&B had different backgrounds – A had been in practice for entire career whereas B had spent a period lecturing and had developed presentation skills.
• Each had different contacts many of whom became clients – B brought in far more than A.
• A was able to deal with all the internal accounting without having to pay for staff from day one.
• A’s husband was an IT consultant and was able to provide her tips on running the IT network before an IT contractor was affordable. She dealt with the firm’s IT network (with some external assistance).
• B dealt with designing brochures, personnel matters, writing press releases, client newsletters and maintaining the website.
• B worked full time (approx 40 hrs per week), A part-time (approx 20 hours per week at the start which increased to 30 hrs per week), due to family commitments.
• Each took different and variable amounts of holidays, dependent on workloads and family commitments – these varied from year to year.
• B was able to delay taking salary when cash flow tight in early days.
  B had more time off sick, yet A often had to leave early for parents’ meetings etc.
• A lived near to the office so was able to be the key holder, check the mail during Christmas shutdown, pop back to meet clients out of hours etc.
• 2 years into the business (three years ago) both business partners separated from their spouses and moved in with each other ‘as husband and wife’ and continued in the practice, then subsequently became civil partners.

  Questions

  1. Is the period after becoming ‘life partners’ treated differently to before?
  2. Is the situation different again when they became civil partners?
  3. Is to do so discriminating against couples?
  4. How do you value their varied input, which changes from day to day and is dependent on many circumstances, not always within their control?

Husband and wife partnership incorporated – plumbing and fireplace business

• H was in partnership with another partner X, who wanted to retire. X had run the shop whilst H installed fireplaces and carried out plumbing work.
• W acquired 50% of business at a commercial rate from X and started work in shop dealing with customers and paperwork.
• Within 6 months they incorporated the business, with shares owned 50:50.
• W expanded business considerably through her vast contacts and extended the range of goods sold in the shop to other related items.
• W negotiated better deals with suppliers.
• Within 18 months of her joining the business turnover had more than doubled and profits had almost tripled.
• Two years later W was diagnosed with a serious illness and had considerable amounts of time off work, whilst an assistant was employed in the shop. Takings and profit dropped but were still above level before W joining the business.
• Due to illness, they decided to sell the shop and work from an office at home, having built up a reputation locally, which they maintained through personal contacts and advertising. Turnover fell further, but profits only fell slightly (due to reduction in overheads) but again still above earlier level.

  Questions:

  1. How do you value their varied input, which changed over time, as input varied due to knowledge of business, skills, contacts and hours input?
  2. Does value input have to be valued differently during period of increasing illness?

If you have some equally baffling case studies, let us know below or by emailing; [email protected] or better still, submit them to HMRC as part of the consultation process.

Useful links:
Income shifting: a consultation document