Sunday, 9 December 2007

Income shifting: the Government’s paper published in December 2007.

The document “Income Shifting: a consultation of draft legislation”

is the Government’s response to the defeat of HM Revenue& Customs in the Arctic Systems case, Jones v Garnett, which concerned a “husband and wife” company where the wife received a substantial distribution of profit as dividend by virtue of the share in the company for which she had subscribed. The Revenue had sought to assess the husband on the wife’s share of the income under settlements legislation dating from the 1930s.

Despite the so-called consultation period, this is another example of legislation on the hoof, which is likely to be bad legislation, difficult to understand for tax payers, difficult to interpret for advisers because of the grey areas likely to be thrown up and pretty impossible for HMRC to police. I can see many enquiries initiated on scant evidence, vast amount of taxpayers’ money being wasted, and lots of professional fees incurred without much increase in the tax uptake by HMRC.

Firstly, the consultation period is all too short and ends on 28th February 2008 only shortly before the next Budget and at best a couple of months before publication of the 2008 Finance Bill. At least one recent consultation, that before last year’s “interventions” contacting taxpayers over the telephone or in writing concerning supposed problems in their Returns indicated that HMRC had already made up its mind and that engaging the professions, CCAB or otherwise, was in reality a sham. This is of course as a result of politically driven policy and reflects the attitude of Ministers and their political appointees. I do not wish this to be seen as another example of Revenue-bashing. It just seems to me that in being expected to implement ill thought out legislation and indeed to understand their duties at all in this respect, the HMRC on the ground are almost as much victims of policy as the vast majority of basically honest small business owners and their poor advisers, and it does show how out of touch our political masters are.

The document avoids mention of married couples, families or civil partnerships as specific targets, whereas surely these are the classes of individuals at which the new legislation is aimed. This is quite extraordinary in my view.

We cannot expect that there will be much reasoned opposition when the Finance Bill is discussed. Debate is often curtailed and MPs’ eyes probably glaze over when tax is mentioned, except in the context of headline tax rates, which we know disguise the true burden of taxation (vide the FA 2007 cut in the basic rate of income tax from 2008-09, which essentially will make no difference at all to the majority of individual taxpayers with the loss of the starting rate of 10%; indeed there are some who will be worse off).

In the context of lack of reasoned debate, one suspects that few politicians will get past page 4 of “Income Shifting: a consultation of draft legislation” where Box 1.1: Examples of income shifting” (the only one illustrating the circumstances of a married couple) suggests that Nina, by paying all her profit through dividends to herself rather than half to Charlie, her non-working husband, has avoided paying income tax of £6,039, and if she had been a sole trader she would have paid £15,414 for 2007-08. Well, yes, but the example fails to mention that the company would still have paid 20% corporation tax, viz. £12,000 tax however the profits had been distributed as dividends.

Whilst I am of course cherry-picking the nonsense here, this example is in the introduction, and is disingenuous – yes, it is spin and disguises the reality, which is that £12,000 tax has been paid as opposed to nothing, which this example appears to suggest.

In Part 3 of the document there are a number of examples of what will be deemed income shifting as well as some that will not. Of course this is far beyond where the politicians will read. One can see the logic of some (in Treasury terms anyway and assuming that they are starting from a reasonable premise just for a moment), but there are worrying misunderstandings about the way life works and indeed the way families work (OK, an out-dated concept).

Example B (P.24) says:

B.74 This example illustrates a scenario that would be covered by the income-shifting legislation. Despite each partner providing equal labour for the business, a tax advantage is obtained through a division of income between the partners that does not reflect what they would be entitled to in a normal commercial arrangement. This is because of the differing levels of capital they have introduced to the business.

B.75 Individual 1 and individual 2 form a partnership and start trading as a local grocery. Individual 1 introduces £200,000 of capital into the business, which is used to acquire the shop premises and stock. Individual 1 and individual 2 both work full time in the business and develop it together. Neither individual 1 nor individual 2 bring any special skills into the business. Trading profits for the year are £80,000, which are split between individual 1 and individual 2 equally (i.e. each partner receives £40,000).

B.76 The new legislation would apply in this case because income has been shifted. The profit share received by individual 1 and individual 2 do not reflect the balance of labour and capital put into the business. The arrangement whereby individual 2 is entitled to an equal share of the profits and a return on capital of the business even though individual 2 has not contributed any capital appears to be non-commercial. Individual 1 has forgone income that individual 1 may have otherwise received in relation to the capital contribution (i.e. a return on individual 1’s capital).

I hope you will forgive any stereotyping in the next paragraph or so, but suppose Mr. Patel is given £200,000 by his father. He works in a grocer’s shop for a while, where he meets Mrs Patel to be, the daughter of the owner. They get married, and Mr. Patel uses his £200K to by a decent corner shop business. They have some acumen which they have acquired selling goods for others, but neither has a special skill which could be defined, beyond an eye for business. They run their shop as a partnership, sharing the profits equally; after all they both work hard and the shop is open from 7AM selling newspapers, sweets and the dreaded tobacco products until 11 at night when they might sell a little alcohol.

Is it really fair that because Mr. Patel originally bought the shop and business with his money, he should be taxed on a larger share of the profit than his wife? After all, they work so hard and probably could not manage individually with the long hours and having during slack periods to pay someone at least the minimum wage. Again, is this fair? HMRC thinks it is. I don’t.

Mrs. Giles-Hunter inherits a farm from her father. She has been running the farm for some time effectively as an employee before her father’s death, but it is very large and a great deal of work. At the Young Farmer’s Ball she met a young man named Hunter, who is experienced in farming, but being the second son will not inherit his father’s farm. They get married, and move into Mrs. Giles-Hunter’s farmhouse, and they run her farm together with a formal partnership agreement. They both have equal skill as farmers through experience, they increase their profits (no mean feat these days) and they share the fruits (the profits) equally. Because it is Mrs. Giles-Hunter’s farm and for legal reasons she cannot give half of the land to her husband, should a larger share of income be attributed to her because essentially the business is based on her capital?

Are we really going to deny families proper reward for their joint endeavours, which are in many instances what bind them together as a unit? My last example might cause some difficulties under the current rules and of course one might try to separate the land from the buildings, machinery and goodwill for the exercise, but to try to assess one person unequally when the other works equally hard seems nonsensical and out of touch.

The paper says that the income shifting legislation does not mean that businesses will have to maintain additional records, yet from the farm to the corner shop, one might think that timesheets would have to be completed to show the amount of work contributed by individual partners or directors. Without them there may be a large problem in that HMRC enquiries especially for the less well represented deem taxpayers guilty until proved innocent. Of course HMRC largely relies on professional advisers to do the self-assessment job for them, notwithstanding the relative contempt shown for these advisers and their conduct in the higher echelons of HMRC (and I have pretty much heard this attitude from the horse’s mouth).

In reality professional advisers will be better placed to implement the new rules then HMRC, which will continue to bark up many wrong trees, and one really has to wonder whether their projected tax yields even if true will show the Treasury any profit given the costs of recovery if HMRC has any significant involvement through the enquiry system. The general cost assessment contains a number of arbitrary statements without justification of the basis. There is of course no talk of redistributing the presumed increased yield amongst other cash-strapped taxpayers.

The new raft of legislation will not be based on “fairness”, and “the right amount of tax”, two favourite Treasury mantras, or on preserving family unity and values. Rather we see old-fashioned paranoia exhibited by out of touch Civil Servants and politicians who have forgotten that what drives Britain, “the nation of shopkeepers” is a continuing sense of talent and entrepreneurship which is overlooked in the current climate of low taxes for big business only, and the Stalinist attempt to regulate the lives of every individual who dares to have expectations of rewards for their efforts.

Adam Smith would be sorry to discover that the Government is no longer influenced by shopkeepers. Indeed it has rather taken against them.

© Jon Stow 2007

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