PKF accountants and business advisers are warning family businesses to take immediate action to review the way they take money out of their businesses.

This follows the publication of HM Revenue and Customs’s (HMRC) Income shifting: a consultation on draft legislation.

Peter Harrup, tax partner, said, “If this draft legislation is enacted as it stands, many family businesses will have to keep much better records to prove that they are not shifting business income between family members to save tax.“

Following its loss of the Jones v Garnett case on the settlements legislation, the Government had announced its intention to address income splitting, or shifting between married couples and family members.

In the Jones v Garnett case, better known as the Artic Systems case, the House of Lords ruled that although Mr Jones has diverted some of the profits derived from his work for their jointly owned company to his wife, the settlements legislation did not allow HMRC to tax this on him because of a specific clause that exempted such transfers between spouses.

Harrup said that it has fortunately taken a sensible approach and left those rules alone: the new legislation stands on its own and will only affect income derived from companies and partnerships.

Start keeping records

The new rules will allow HMRC to challenge income shifting for all payments made after 5 April 2008. Harrup points out, however, that many businesses have accounting years that will end after 5 April 2008. They need to start keeping good records now to be able to defend salary and dividend payments made later in their accounting year.

The key problem is that HMRC has not set out just what records it considers sufficient to prove that the main earner in a family business is getting a market rate return for his work and cash investment. Harrup questioned how much research and paperwork a family business will have to do to keep HMRC happy.

While many families will seek to extract as much cash from their businesses as they can before 5 April, care must be taken by company owners: it is illegal to pay out dividends that exceed the company’s distributable reserves,” he added.

Still advantageous 

Harrup said that some thought that the Government would also try to level the playing field between small companies and the self-employed. He, therefore, calls it surprising that it has not taken this opportunity to address the issue of national insurance contributions and dividends.

Ignoring the income shifting issue, for now, Harrup said that it is still advantageous to set up a company and pay yourself in dividends because of the NIC savings.

“We have known that the tax-saving options for family business owners were going to be reduced, but I am concerned that this solution to the Government’s problem gives those families a paperwork headache as well as higher tax bills,” Harrup concluded.

Through the consultation process, PKF will demand that HMRC sets out hard and fast guidelines on exactly what papers are needed to establish the market rate of return for each person involved in the business.

Related links

• Income Shifting: A consultation on proposed legislation
• PKF

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