HMRC is aware that it is not uncommon for an individual to set up a limited company and then introduce another individual as a second shareholder, who in a small business is often a spouse, partner or other household member of the first individual. They accept that there are often legitimate commercial reasons for doing so, for example the second individual contributes labour or capital to the business. In these situations the Government believes that it is right for the distributions from the company to reflect the contribution that both individuals have made.

However, where the second individual has little or no involvement in the business, but the income is distributed such that the first individual forgoes income which can then be distributed to the second individual and taxed at a lower rate, then in this situation HMRC considers that income has been “shifted” from the first individual to the second.

HMRC believe a similar outcome can arise if two or more individuals decide to establish a business in partnership form (including a Limited Liability Partnership). By agreeing to a particular allocation of the partnership profit, the first individual can again forgo income so that it is taxed on the second individual at a lower rate.

Therefore, in order to establish the correct treatment in these situations, it will be necessary to consider:

Is Individual 1 in a position to shift income, with power to control or influence any arrangements? In other words, can Individual 1 decide or secure how the profits from the business are distributed? (HMRC’s Condition A)
Has that individual forgone income that formed part of the second individual’s income within an arrangement that would not be entered into at arm’s length? (Condition B)
Does the shifted income consist of distributions from a company (for example, dividends) or a share of partnership profits? (Condition C)
Has a tax advantage occurred as a result of shifting the income form the first individual to the second individual? (Condition D)

The effect of the proposed legislation is that where a distribution made from a business represents shifted income, the individual who has forgone that income should include it on their self-assessment return at the end of the relevant year, for income tax purposes. To determine whether the Income Shifting legislation may apply to you consideration must be given to the four Conditions. Yet, unlike the Settlements Legislation, income shifting will apply if income is shifted from one individual to another; there is no requirement for the individual to have retained an interest in the income. Essentially, this widens the scope of HMRC powers.

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