If you indulge in ‘income shifting’, it seems the taxman is likely to take an increased interest in your affairs from next April.

This is prompted by a recent consultative document from HM Treasury and HM Revenue & Customs, pointing towards new legislation from April 2008. The intention is to reverse the effect of the ‘Arctic Systems’ decision - a case that involved husband and wife taxation and the dividing up - shifting - of business income and profits.

Where are we now?

In the lead up to the Arctic case, HMRC generally agreed that a business (partnerships as well as companies) with assets was unaffected by this case. A premises-owning business would not be caught by the tax rules - ownership of the shop and stock would be split between husband and wife and so could not be just a right to income. If a business without assets paid its owners market salaries and just divided up any remaining profit in line with shareholdings, that would also usually be acceptable.

Arctic showed that if market salaries were not paid, that would not lead to further tax demands if it had been set up properly. And the lack of market salaries is the reason why HMRC wants to change the rules from April.

Just when you thought it was safe... HMRC’s consultative document includes two pages of new legislation which requires 18 pages to explain and illustrate how it works.

Four conditions are laid down to identify when an unacceptable income shift has taken place:

i) someone (‘individual x’) is party to, or has power over the arrangements, ie how the business has been set up

ii) individual x forgoes income which goes to individual y

iii) individual x can control the amount shifted

iv) the income shifted is the distribution of a company or profits of a partnership

All four conditions must apply; in addition, a tax saving must result from the arrangements. Here HMRC would assess the shifted income as if it still belonged to individual x.

The wider impact

Arrangements involving children, wider family and friends could also be caught and the asset-backed business that was accepted as outside the HMRC target zone for the Arctic attack is firmly in the sights of these new rules.

HMRC’s paper suggests that it has “identified 65,000 companies where income shifting is likely to be taking place” and talks in terms of tax losses of £500 million a year, half of which will be clawed back by the new rules. It goes on to say “the government is looking to individuals to comply voluntarily without the need for [HMRC] interventions”. In other words, small businesses are going to have to self assess whether they are caught or not.

Managing the situation

HMRC are going to expect to see that the participants in a business get a fair reward for their own efforts. So, if two people are involved in the business and one provides four times as much ‘value’ as the other, that suggests a 4:1 ratio of salary. Salaries should also be near market rates. It does not mean that all profits have to be paid out as salary - profits can be left over and shared equally.

There are other factors to take into account and assess in terms of value to the business. That would include capital introduced, including perhaps loan guarantees and other connections that have helped the business. There will also be a need to keep an eye on changing inputs by those involved.

Although the consultative document says that HMRC would not expect further documentation to be needed to prove a situation is outside income shifting, it seems inevitable that businesses will have to get better at documenting how they have valued individuals’ contributions.

John Whiting is a past president of The Chartered Institute of Taxation.