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In his Pre-Budget Statement on Monday Alistair Darling quietly dumped legislation intended to outlaw income splitting arrangements among individuals that would have effectively forced small, family-run businesses to pay more tax.

For some years now the Labour government has tried to take action against income splitting arrangements which it considers “unacceptable tax avoidance”. Leaving aside the legal fact that tax avoidance is legal and that it is tax evasion which is illegal, the burden of their complaint is that too many small companies (an estimated 85,000) operate by generating income using one partner’s efforts and skills and then split the profit between both partners, so as to reduce the total tax that is payable.

The sort of situation they object to is where one spouse runs a business and generates the income but pays the other spouse a salary and/or dividend for doing little or no work in the business. By doing this a husband and wife could pay much less tax between them because they can both of their personal tax allowances and shift income otherwise taxable 40% from one spouse to the other where it is taxable at 20%. HMRC (Her Majesties Revenue & Customs) estimate the loss to the Treasury at some £250 Million a year.

Unfortunately for the government the Courts don’t agree with them that this is illegal or even “unacceptable”. For some years HMRC pursued a claim against Geoff and Diana Jones who ran a small IT company called Artic Systems Limited. HMRC wanted Artic to pay some £8,000 in tax which they (HMRC) claimed had been avoided by means of the income splitting arrangements detailed above.

This case (commonly called “the Artic Systems case”) went all the way through the legal system finally ending up in the House of Lords where, in July of last year, the Law Lords ruled against HMRC effectively agreeing that this means of tax avoidance was perfectly legal. HM Treasury immediately announced it would legislate to close this “loophole” – as they term it – with a view to having the new law on the statute books by April 2008.

In drafting the legislation HMRC set out four tests which inspectors would look for to establish whether income splitting was taking place. First they would identify firms where one individual has enough control over a business to decide how to distribute profits. Then they would look to see if the individual was paying themselves a big enough salary for their efforts. Next they would check to see whether dividends were being used to shift income to others. Finally, they would identify and quantify any tax advantage resulting from the arrangements.

However it was the view of many accountants and lawyers that any attempt to prevent income splitting by attributing profits of a family business to individual shareholders would be bound to fail.

For example the principle of paying tax on the proportion of the output from a business directly associated with one partner runs contrary to current Matrimonial law, where husbands and wives can make claim to equal shares in the family wealth even where one partner could argue that he or she generated the wealth.

It was also pointed out that in practical terms in order to defend themselves against HMRC accusations, businesses would be required to keep detailed records of hours worked, something that they are explicitly exempt from having to do under the Working Time Directive as directors/business owners. The amount of time and red tape involved would be massive and would affect thousands of companies who are not in any way involved in income splitting.

However, as one has come to expect from this Labour government, they pressed on regardless despite being told by lawyers that it was probably going to be impossible to draft legislation that would be effective in the Courts.

The fear was that the Treasury would simply pass a law that saying that “It is illegal to split your income” leaving individual businesses to decide whether what they were doing was income splitting or not and risking fines and prosecution if HMRC ever investigated the company.

Remember HMRC no longer have to give a reason for any tax investigation, they can do so entirely at random by sticking a pin into a list of names or, more usually by looking for certain types of business structure or trade. It is simple for anyone to access public records showing the ownership structure of any company and with this information HMRC could decide to investigate a sample of companies with husband and wife owners.

But, no more. The legislation was initially expected in April 2008 but was delayed when they realised how complicated it was and was announced for April 2009. But in an embarrassing U-turn Mr Darling has “indefinitely” postponed any legislation. Let’s hope this ill-conceived idea sinks without trace.

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