Income shifting and settlements: will HMRC finally catch up with the Joneses?

Our prediction

The most that can be expected here is consultation on yet another 'targeted' anti-avoidance rule.

Ever since HMRC (then the Inland Revenue) lost the case of Garnett v Jones in the House of Lords Revenue & Customs, Revenue & Customs have been looking for ways to stop owners of family businesses sharing income around their families instead of seeing it taxed only on the business's principal earner.

The decision in Jones v Garnett on 25 July 2007 confirmed that a wife's dividends from a company that she and her husband jointly owned to exploit his earning potential was not taxable on the husband.

In that year's Pre-Budget Report anti income-shifting (AIS) rules were announced but after public scrutiny they were widely derided as both inequitable and impracticable and withdrawn.

It is still the Government's stated intention to introduce 'new, improved' AIS MkII but this was delayed in 2008, ostensibly due to the onset of the recession but also, it is suspected, because the issue stubbornly resists removal from the 'too difficult' pile.

Now that we are officially out of recession will AIS raise its head again? There is arguably more incentive for the Treasury to reopen this issue since income shifting has the potential to erode the effectiveness of the 50% additional income tax rate. However, past experience shows that this is an area of great complexity and one in which there will not be the political consensus required to produce legislation before the General Election. So the Budget may contain bold statements of intent but the only practical outcome is likely to be the announcement of further consultation, conveniently keeping the issue on a back burner yet again.

Jones v Garnett confirmed that most income shifting arrangements within families constitute settlements.

The decision depended on the precise application of existing tax rules which caught most family arrangements.

The most obvious 'loophole' relates to settlements that are outright gifts between spouses which
are not only gifts of income. Provided that the gift is one that gives the recipient spouse or civil partner something more than simply a right to income (e.g. a share in the rights and responsibilities of ownership, participation in business decisions and the potential to receive a capital profit, where appropriate), the income cannot be imputed back to the donor spouse or civil partner.

Under the current the top tax rate of 40% the maximum benefit is: 

  £6,475 @ 20% =  1,295
£37,400 @ 40% =  7,480
                                £8,775

But under the new additional rate there is a further potential marginal saving of £22,480 if the second spouse has no other income.

Calculation:

Saving to 'main earner', £150,000 @ 50% = £75,000

Tax paid by second spouse (no personal allowances)

  £37,400 @ 20% =   7,480
£112,600 @ 40% = 45,040
                                   -52,520
                                  £22,480 
     
Removing the exclusion for outright gifts to spouses would be simple but potentially inequitable.

Adding an anti-avoidance rule would add complexity which in itself could act as a deterrent even to legitimate income sharing.

The original AIS proposals went far beyond arrangements between spouses and civil partners and potentially swept up arrangements that were outside the existing settlement rules which are already extremely wide but rely on there being an existing settlor who creates the arrangements. Those proposals would have had the potential to sweep up any case where any family made use of any pre-existing arrangement or business structure for their advantage. If something similar is reintroduced the potential for complexity, unfairness and uncertainty is simply mind-boggling.