What is Income Shifting?

Income Shifting is the process of structuring the ownership of a business so that the controlling party can distribute income to another individual in order to gain a tax advantage.

An Example

Jeremy and Sarah are a married couple. Jeremy wishes to start up a business as a freelance architect. He sets this up, involving Sarah in the structure of the business although she does not play any role in it. Jeremy and Sarah each buy 50 shares in an off-the-shelf company. The business makes £60,000 of profit in its first year and in order to reduce his tax liability Jeremy decides to distribute all of the profit to the shareholders, Sarah and himself, as dividends. They each receive £30,000 in dividends although Sarah has not contributed directly to the generation of the business's income. 

There is no income tax charge on the dividends received because neither individual is a higher rates taxpayer. If Jeremy had paid all the dividends to himself he would have had a tax liability of £6,039. Jeremy has organised his business in such a way as to shift part of the income that he would have otherwise received to Sarah in order to gain a tax advantage and is hence caught by the income shifting provisions.                

This example assumes that neither Nina nor Charlie has any other income and the calculations of tax are based on 2007-08 tax rates. 

The proposed legislation

The introduction of the legislation has been postponed. Based on the current consultative document income shifting will have been deemed to occur when the following conditions have been met:

1)  One individual is in a position to shift income with power to control or influence how the profits 
     from the business are distributed.

2)  That individual has forgone income that formed part of the second individuals income within an  
     arrangement that would not be entered into at arms length.   

3)  The shifted income consists of distributions from a company such as dividends.

4)  A tax advantage has occurred s a result of shifting the income from the first individual to the  
     second individual. 

Another Example

Jim and Ian form a company, each owning fifty £1 Ordinary Shares. The business of the company is to provide the personal services of Jim. Ian spends around five hours a week on back office duties for the business. In the first year they each receive a salary of £5,000 and dividends of £30,000. The salary received by Ian is considered to be the market rate given the nature of the work done and the time spent doing it. Jim has £20,000 of capital invested in the business which would otherwise attracted a return of 10% a year if invested elsewhere (i.e. £2,000). The shifted income is £28,000 (i.e. £35,000 less £5,000 salary less £2,000 return). 

Scope of the proposed legislation

Where the income an individual receives reflects fairly and reasonably what other individuals would be entitled to receive in a normal commercial arrangement, then he will not be caught by the income shifting legislation. Where the market rate is not applied to the services of the participators or the company is not structured correctly then problems may occur under the proposed legislation.  
 
Further Information

For more detailed information click on the image below:




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