AccountingWEB's Business Zone has covered David Drew's EDM on income shifting. What's really interesting though is the reaction of Grant Thornton's George Bull, who has said:
At the heart of this EDM are the same problems for HMRC, [which is] how do you value the contribution of different people in a small business? You end up with the same problem of having to find a statutory method of measuring an individual contribution to a business.
Amazing isn't it? Accountants are meant to be able to measure value, but profess they can't when it suiots them. Accountants are meant to believe in the market, but suggest that there is no market indicator in this case. Do they really believe that, because if they do I have a simple answer. Statute should provide the basis of apportionment if the market does not work.
Perhaps they'd like to reassess their capabilities in that case and work just how the market should indicate value arises. Let's start with these key performance indicators, some or all of which could be used to indicate a basis for apportionment, and none of which need take long to assemble on an annual basis:
1) What does the business do. Who of those sharing its rewards has the training or qualifications to provide that service?
2) How many hours does each participant in reward work for the enterprise each year, approximately?
3) Of the hours worked, what proportion were spent in dealing with customers?
4) Who runs the administration of the business? Administration includes (but not exclusively) billing, accounting, managing correspondence, liaising with suppliers, dealing with accountants, taxation and business regulatory issues. Separate estimates for each category of administration can be given if appropriate.
5) Does each participant in the rewards of the business have their own computer? If not, why not?
6) How many business emails were sent by each participant in the reward of the business each year? Can this be proven by the use of different email addresses?
7) Does each participant in reward have their own business mobile phone? From billing records can it be shown what proportion of business calls were made by each?
8) If the company has a vehicle who usually drives it?
9) Do any of the participants have other employment? If so, how many hours a week do they, on average, spend on that employment?
10) If neither has other employment do either have child care or other care obligations? Do these limit their capacity to work?
Answer these (and in the case of Tax Research LLP my guess is my wife and I could answer these questions, accurately, in less time than it took me to type them) and you'll have a very good overview of who is generating the profits in an enterprise.
That will be true for 97% of all businesses affected by income shifting, in my experience (and I've seen hundreds of this sort of entity in my time). The rest will have to create their own evidence. That's always true of all systems, so the exceptions are not a problem.
Having determined who is generating the profit it's then a matter of assessing the value of the supporting partner's services. I've suggested a de minimis be allowed, which I think is fair. Try to increase that and evidence must be given (and reasonable and supported answers to the above would be a good starting point in supplying relevant evidence). And if the rate to be attributed to support time is to be beyond market rates then again reason must be given for use of a non-standard, out of line with market figure.
Is this fair? Yes.
Is this what accountants do all the time? Yes.
Is it a burden? No.
Are those accountant who say it is not possible to do this simply hiding tax avoidance? You know the answer to that.
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Knowing where to hit it.
A man’s boiler stopped working, so he called in the boiler man to fix it. The boiler man examined the boilder, then took out a big hammer and hit it sharply. The boiler sprang back into life. The boiler man then charged him £50. “That’s outrageous” said the man. “Give me an itemised bill for that”. The boiler man wrote out:
Hitting boiler with hammer: 50p
Knowing where to hit it: £49.50
You are proposing that everyone itemise how much boiler-hitting they do, and be rewarded in proportion. But how do you itemsise the “knowing where to hit it” if these functions are done by different people in the business?
An example would be a web shop. A. responds to customer queries, takes all orders, sorts out payment problems, banks cheqes, boxes up and posts items, handles returns, and spends 30-40 hours a week doing this. Already it seems A. must be entitled to most of the profits.
But suppose it is B. who selects and orders the items to sell, prices them, and writes the short descriptions that go with each? This takes maybe 2hrs/week on average.
If B owns the business and simply employs A. no one is going to question if the profits are 2, 5 or 10 times A’s salary, nor will they dispute B’s right to all of it. But if A and B are married and 50/50 shareholders, B is going to have trouble justifying taking any profit at all.
Now you are probably going to say that “most” businesses are the simple kind where profit can be allocated on measurable work done, and I have described a “hard case”. I don’t agree. It is knowing what to sell, where to sell it, and how to market it that makes or breaks most small businesses.
This whole idea is just not going to work. You want to essentially redefine the notions of profit and shareholding, and change the whole way family businesses organise themselves and why? Just because the Government has suddenly (since Arctic Systems)become worried by the tax “lost” when a husband or wife gets more than their “fair share” of business profits.
But it is not worried when a wife puts half her pension lump sum in her husbands building society account, or he uses his money to buy her a house on which she gets the rent.
It would make more sense to look at this from the other end and ask why a household with one earner bringing in 60K/yr should pay very much more tax than the same household with two earners bringing in £30K each, wherever that income comes from. In the USA, Germany and many other countries tax allowances are fully transferable between spouses. That is a workable solution!
Gareth
That stories been around for longer than the thirty years I’ve been an accountant
But I bet you’ve never met the man who wielded the hammer
As for your A and B – the answer to your question is so obvious it’s absurd. Stuart Rose employs thosands of As. That’s why we know their market rate. Stuart Rose is B. M & S don’t know how to replace him. So, if the market value of A can be stablished (and that’s easy) then B is the residual.
Hard? Not at all. I just solved it in seconds.
And of course, I agree with you – all income shofting should be subject to these rules, bit just that from ‘self employed earnings’.
Now, where’s the difficulty?
Richard
Hi Richard,
Two points:
1) How can you put a value the support one spouse gives to another, e.g. when the working partner comes home and sounds off to his wife about what a bad day he’s had?
2) The list you suggest would add additional red-tape burdens to businesses that are already struggling to keep up with huge tomes of legislation.
I would support your argument that small businesses be run as LLPs unless there’s a genuine reason to be anything else. Then the partnership’s profits would be taxed, not the money taken out by the partners – and no need for any additional burdens or trying to put a figure on something that’s priceless.
M
I’m confused.
I’d love to be able to agree with you on this Richard. Indeed in my own simplistic way I originally had no problem with the income shifting proposals. I thought the onus would be on HMRC to prove that disproportionate income sharing had taken place and that in the absence of the most blatant ‘shifting’ they would be unable to do so and there would be few problems.
I was wrong. I now accept that the admin burden required to defend challenges of income shifting would be enormous. Let’s just take some of your examples above:
– Counting all emails sent from each email address?
– Reviewing mobile phone records to distinguish business and non-business calls?
– deciding and justifying whether to focus on relative amounts of customer contact time or some other measure of value to the business?
– arguing that only one computer is required as the 2 (or 3 or 4) people involved in the business access it at different times due to their different roles.
The person who wields the hammer in the old value pricing story is normally the accountant or any other knowledge professional. However it could be the spouse who shares some knowledge or experience that enables the main worker to solve a problem or secure a big order and make more money than would otherwise have been possible.
If your secretary (wife or otherwise) were to offer an idea, suggestion or introduction that leads to a big commission you might want to pay her a bonus. If it happens more frequently you might choose to fairly share your business profits to reflect the value of her input to your business and to encourage her to contribute more often. You might not do this of course. Plenty of other people would do so and regardless of marital status, roles, responsibilities and time spent on the business each year.
In your reply to Gareth Williams you seem to suggest that a Company Chairman would not warrant a share of business profits (out of what’s left after rewarding the ‘worker’) commensurate with experience and value. Why does the person putting in the physical labour get the biggest allocation in your example?
I don’t follow why you think it would always be easy and obvious as to how the profits should be shared. And then there’s the issue of how to share profits in years where roles have changed from those in the years when losses arose. Without statutory allocations we would be left with the need to document and record all of the above to justify allocations used in the accounts and such records would be susceptible to challenge and debate.
As I say, on reflection I accepted that the income shifting rules were not workable. I remain unclear as to why you think that accountants (and, by definition HMRC with whom they would have to negotiate) are well placed to assess such values.
I would also add that not all accountants are well placed to assess values. I’m aware of specialist corporate financiers who do this when advising on buying and selling companies. Also fiscal ‘share valuation’ experts – a rare skill across the general population of accountants. But that’s it.
Mark
Richard
I think that means in english that A should get a “market rate” and what is left must be profit due to B.
I am glad you are not adopting as simplistic an approach as the HMRC in their recent consultation, where they consider that if a consultancy makes a profit of £60,000 from one fee earner, then all the profit is “clearly” his. (They don’t stop to ask what the market rate salary for that work might be, or why the fee charged is more than this).
But the difficulty in my example is that in reality, where A and B are married, what to buy and how to advertise it are discussed over breakfast. Who is to say where most of the real creative input comes from?
Given the same facts, namely the hours worked by A and B and the concrete tasks completed, it would be possible to justify almost any income split, depending on where you think the profit came from.
It seems to me there are two possibilities: either go with the revenue approach and take into account only quantifiable work. (but we agree that is wrong); Or allow business partners to agree between them how to split profits (which is where we are now).
There would be more logic in suggesting that _salaries_ should be paid at market rates for quantifiable work, while allowing _profits_ to be distributed in the traditional way. But that is going to come a cropper in real life too. How do you value a family member who is avaliable at a moments notice to take the till in a shop while the “full-time” shop keeper deals with some other urgent matter? Are they paid for the 30 minutes they were on the till? Or the 12 hour period they were available to do so? You can’t pay for that kind of involvement “at arms length”.
It is folly to try to pick apart the contribution of spouses in a business. That was understood by the Government that put the spouses exemption in the settlements legislation, and by the courts that upheld it. It does not appear to be understood by the present Government.
M
I’m sorry to disagree with you.
When my wife was an employee (which she is not any longer) she came home and most certainly came home and sounded off about the bad day she’d had. Actually, she still does that now she’s a partner in a GP surgery. Do you know, it’s never once occurred to me to ask for payment? And it’s also impossible for any employee to do that. So why give the self employed an advantage not available to others, without evidential support?
Second, I have suggested a de minimis payment be allowed in a shared ownership business in my proposal – which I think is generous but would save lots of hassle and would be a fair compromise in many if not most cases. So no red tape at all would be required to justify a payment at all in some cases.
BUT, if people want to do something different, why shouldn’t they be asked to keep records to justify payment? Isn’t that what we do for all other taxable transactions?
Finally, that list is very, very easy to prepare. Not all would be needed, I’d suggest, just enough to suggest what was happening to justify a claim. In 97% of cases it would take half an hour or less to do this. But that’s because in 97% of cases a de minimis payment would be all that could be justified, I suspect.
In that case, what is the real problem?
Richard
Mark
I just don’t get this ‘burden’ thing.
We have accepted we need to keep private apprtionment records. That might require an analysis of phone records. It might require an analysis of computer usage. It does require justifictaion of the ‘use of house as office’charge. And so on.
What I’m suggesting is no more onerous than any of these things. What is the problem?
What too is the problem in assuming that in 98% of businesses payment is made for graft, not inspiration. Graft is the basis on which 98% of small businesses are actually paid – be it an hourly rate, day rate, opening hours or whatever. As a proxy for the normal basis for charging graft is a very good one. So let’s use it. Accountants do, after all, all the time!
But of course if a partnership wants to show that this is inappropriate, that’s fine. Make a note (it need not be long) or better still, prepare a minute, and then justify a changed allocation to reflect real contribution. It would be amazingly difficult for the Revenue to argue with this IF the resulting bonus was a fair reflection of profit generated from the idea and not the consequent execution of it – and reasonable estimates of this will always be acceptable, I’m certain.
What cannot be done with any ease is to reflect this in a limited company, at least unless a salary is paid, which mysteriously no one wants to do for NIC reasons. Dividends cannot be distorted for this purpose annually without real problems arising. But my suggestion of using an LLP for this purpose does allow for this – which is exactly why I recommend it. I am answering your need, not creating an impediment to its resolution in making the suggestion I have put forward.
As for accountants being unable to measure financial value – if they can’t then we have real, and much bigger problems to face as a profession. I suspect the public would rightly laugh at such an excuse.
Richard
Richard, as HMRC, is addressing the wrong point.
It is not for the gov’t to determine how a business should apportion its profits nor how salaries should be determined.
The gov’t may put a certain tax regime in place
but it should think it through before implementing it and once it place it should play by the rules.
The divorce courts seem happy enough to take 50% or more of a man’s assets and hand them to his ex-spouse, regardless of her contribution.
Mr Davies
I am sorry, that does not wash. Governments also create the strcutures in which small business opoerates. Law protects the property rights of the sole trader. Partnerships only exist under law. Companies and LLPs are entirely statutory constructs. As such to argue it cannot regulate how rewards are paid from them is wrong.
The argument on divorce is also wholly erroneous and irrelevant: that allocates post tax reward. We’re talking pre-tax here.
Richard
Gareth
I think we’re much closer than you think – read my paper.
I recognise a three way split. An LLP could pay interest on capital as part 1. It can pay for what is, in effect labour input. I also allow for a profit split – and it is this by the way that most ‘partners’ do earn in these enterprises, and I suggest a de minimis allowance.
What I really do not agree on is that there is enormous value attributable in most acses to the ’emergency’ cover that most seem to claim commonplace – let alone for the loyal wife sitting at hime by the phone in this day and age! If this is coomonplace, labour reward for it can be paid. If it isn’t, then it’s part of what I allocate as a de minimis reward for help. I also think profit is rare in small business if I am candid. Most make labour rates – and that’s true of most accountancy firms, for a start.
In other words, exceptions are being forund to try and block progress in 98% of cases. I think the 2% will always be able to document their exceptions if they want to.
Others can argue the ratio – but my opinion is based on fact of seeing hundreds of small enterprises over many years.
What I do remain worried about is that accountants are arguing as they do for one reason only – that limited companies generate them much better fees than LLPs. That has to be true – LLPs are much easier to run. In that case, I am worried that accountants are not being candid in this debate.
Richard
Hi Richard,
Perhaps I made my point a bit clumsily – I was trying to say that as, for example, support from a spouse can’t be valued, far less paid for, it’s very difficult to quantify the contribution of each partner/director.
How much is your suggested de minimis, please?
M
M
I say this in my paper proposing this:
That a part of the income of any small business be attributable to management activity including administration. This might be 10% of turnover up to a turnover limit of £200,000 with a flat £20,000 being allowed for enterprises above that size unless they wish to argue their case for another sum. This sum can be allocated as the reward for enterprise to members as those members see fit so long as all members who participate in the reward for labour effort expended receive a share of not less
than 1/(1 + n)% where n is the number of members.
So, for example, where there are two partners only one of whom supplies services to clients and the turnover is £100,000 then £10,000 may be allocated to management activity, the partner supplying client services must receive £3,333 but the
balance could be paid to another member without question being asked. That member could also get interest on their capital.
R
Thanks Richard. I’ve commented further on your more recent blog on this topic