Small Businesses: Blow for family-run firms as tax loophole is closed

Family-run companies were dealt a blow when the Government proposed draft legislation to close the "income shifting" loophole, which allows spouses to transfer between them the personal allowances and basic rate tax bands relating to business income, reducing their overall bills.

The crackdown follows a landmark case in July involving husband-and-wife team Geoff and Diana Jones. The House of Lords dismissed an appeal by HM Revenue and Customs and said the couple, who run the IT company Arctic Systems, would not be taxed on dividends that Mr Jones paid to his wife.

This gave the legal all-clear to a tax-saving arrangement used by thousands of husband-and-wife business partnerships. Using legislation known as "settlement provisions", HMRC argued that the scheme was not permitted under existing laws. It said the dividend being paid by Mrs Jones was in fact income which should have been taxed at her husband's tax rate, and sought to reclaim the difference. The Lords dismissed this and said the couple had been paying the correct tax.

However, just one day after the ruling, ministers announced their intention to legislate. Mr Darling confirmed this yesterday and proposed to draft rules which would take effect from 6 April.

"The Government recognises the contribution that small businesses make to the economy and that business owners should profit from the success of their business," he said. "But we believe it is unfair for one person to arrange their affairs so that their income is diverted to a second person, subject to a lower tax rate, to obtain a tax advantage."

The vast majority of people could not shift their incomes and the procedure "ran counter" to the principle of independent taxation, Mr Darling added. The new rules will work alongside the existing legislation for business deductions and settlements, and will seek to remove the tax advantage obtained from income shifting. They will apply only when income is in the form of distributions from a company (dividends) or partnership profits.

Stephen Herring, a tax partner at accountants BDO Stoy Hayward, said: "It is disappointing that the Chancellor has not introduced legislation enabling all taxpayers to transfer personal allowances and tax bands to their spouses. This is already permitted in both Eire and the US.

"The principle would then apply that households paid the same tax, regardless of how income was divided between spouses."