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Readers' Forum - Careful credits

28 July 2005
Issue: 4018 / Categories:

Careful credits

I wonder if readers can offer any thoughts on the following scenario. A new business starts, there being four partners, comprising two married couples, who are Mr and Mrs A and Mr and Mrs B. Mr and Mrs A have two grown-up children and Mr and Mrs B have three school age children who are still living at home. Let us say that the partnership makes £60,000 profit. If the profit were to be split equally four ways, each partner would have £15,000 profit, each couple having £30,000 profit. Mr and Mrs B would not be entitled to working tax credit.

Careful credits

I wonder if readers can offer any thoughts on the following scenario. A new business starts, there being four partners, comprising two married couples, who are Mr and Mrs A and Mr and Mrs B. Mr and Mrs A have two grown-up children and Mr and Mrs B have three school age children who are still living at home. Let us say that the partnership makes £60,000 profit. If the profit were to be split equally four ways, each partner would have £15,000 profit, each couple having £30,000 profit. Mr and Mrs B would not be entitled to working tax credit.
But the partners can split the profit on any basis which they all agree. Let us now suppose that they agree to split the profits as to £23,000 each for Mr and Mrs A and £7,000 each for Mr and Mrs B. If so, then the tax and Class 4 National Insurance burden should remain the same, but Mr and Mrs B will now be eligible for working tax credit.
My question is as follows. If I fail to advise Mr and Mrs A and Mr and Mrs B that it is open for them to agree to split profits on this basis, thus maintaining the tax burden unchanged, but otherwise creating a situation where working tax credit is due, am I exposing myself to a future risk of a negligence claim?
Query T16,650                                         — Fair Shares.

Fair Shares has two sets of clients operating in partnership producing a profit of about £60,000 between the two families. Mr and Mrs A are not eligible for child tax credit or working tax credit as they have grown up children.
Their partners, Mr and Mrs B are eligible for both child tax credit and working tax credit, but with a family income of £30,000, the abatement of the tax credits is such that Mr and Mrs B only receive the family element of the child tax credit.
However, if the profit of the partnership was split differently, so that Mr and Mrs B only had a combined profit share of £14,000, the abatement would be greatly reduced and Mr and Mrs B would receive a greater amount of child tax credit and possibly some working tax credit, depending on their circumstances.
We are not told if Mr and Mrs A and Mr and Mrs B are related, but quite possibly they are not. If they have no connection other than business, why would Mr and Mrs B want to give up £16,000 of profit less tax and Class 4 National Insurance, in order to receive, at most, 37% of £16,000 in extra tax credits? The figure of 37% is the rate at which the reduced abatement is applied. Mr and Mrs B could take the same drawings as before, but their capital accounts will have been depleted.
If Mr or Mrs B is one of the grown up children of Mr and Mrs A and so they are related, the proposal may make some sense. But a further difficulty comes if the two sets of partners want to redress the balance at a later date. If they are not related, Mr and Mrs A might take a profit share of £14,000 next year with Mr and Mrs B taking a profit share of £46,000. Mr and Mrs B would only receive the family element of the child tax credit next year, but their capital accounts will have been replenished; in this way they could receive a higher level of tax credit in alternate years.
On the other hand, if the two families are related, the profit split might be left as proposed, but Mr and Mrs A would make 'gifts' to Mr and Mrs B in the form of transfers between capital accounts.
However, the bottom line is that these proposals are going to fall foul of Regulation 15 of The Tax Credits (Definition and Calculation of Income) Regulations SI 2002 No 2006. If a claimant has deprived himself of income for the purpose of increasing the amount of tax credit, he is treated as having that income. In HMRC's Tax Credit Technical Manual at reference TCTM04903 it states that increasing entitlement to tax credit may not be a claimant's main motive, but it must be a significant motive.
In this instance the whole purpose of changing the profit shares is to increase entitlement to tax credit and so Regulation 15 will apply. As a consequence, Mr and Mrs B will be deemed to have income of £30,000. Failing to advise a client of a plan that does not have the desired effect will not result in an adviser being the subject of a successful negligence claim.                                               — Hodgy.


I have a rather nasty feeling that this is one of those suggestions that, perhaps a couple of years down the line and after the dust has settled, one might be filing under the heading of 'well, it seemed like a good idea at the time'!
The first thought is why would a husband and wife each be willing to give up £8,000 of income to become entitled to a lower amount of tax credits. They would not, would they, so presumably something else is going on here; most probably a 'side agreement', that Mr and Mrs A will 'feed' the increased income back to Mr and Mrs B. For this reason, I would guess that there would most likely be some family relationship between Mr and Mrs A and Mr and Mrs B, because the next thought in a situation like this is the likelihood of one party deciding to keep their gains, in which case the other party would stand little chance of recovering the monies.
Call me cynical, but I — and I suspect the HMRC — would think this could best be described as a 'sham' transaction.
Things could theoretically then start to get a little bit 'nasty'. Regardless of the fact that Mr and Mrs A have presumably paid an increased tax liability, Mr and Mrs B have paid a reduced liability and if we have crossed the line (if it still exists) from avoidance to evasion, then we are into money laundering and reports to the National Criminal Intelligence Service, possible HMRC investigations, interest and penalty charges, aggrieved clients, etc. etc. Fair Shares does not want to go there.
We have not yet got to the small matter of The Tax Credits (Definition and Calculation of Income) Regulations SI 2002 No 2006. Regulation 15 states that 'if a claimant has deprived himself of income for the purpose of securing entitlement to, or increasing the amount of, a tax credit, he is treated as having that income'.
HMRC's Tax Credit Technical Manual (at paragraph TCTM04903) states as follows.

 'Deprivation occurs if a claimant gives up, or transfers to another person, an income which was received, or due to be received, to gain or increase entitlement to tax credits.
'For example, a claimant may, by a deed of gift, transfer entitlement to an occupational pension to someone else.
'Purpose of disposal of the income
'The claimant may have more than one reason for disposing of the income, only one of which is to obtain tax credit or more tax credit. Securing or increasing entitlement to tax credit may not be a claimant's main motive but it must be a significant one.'

There is also the potential for Regulation 17 to apply. This states that if work is done by the claimant for someone who can afford to pay for it, and who either does not pay, or pays less than the going rate, then the claimant is deemed to have received the going rate for the work.
If there is a valid commercial reason for the change in profit-sharing ratios; e.g. Mr and Mrs B might be reducing their involvement in the business (perhaps they are going to be spending more time teaching their children at home), then Fair Shares should point out that their tax credit entitlement will change. Without such a valid reason, I would suggest that rather than exposing himself to a possible negligence claim for not suggesting a scheme such as this, Fair Shares could end up with a negligence claim for suggesting the scheme.                             — Brubeck.

Extract from reply by Zibultong:
The flaw in this thesis is that TA 1988, s 660A can be called in aid by HMRC to counteract the artificial attribution of profit shares in this type of case. While this has always been possible on the authority of Crossland v Hawkins 39 TC 493 and CIR v Mills [1974] STC 130, Mr Justice Park's judgment in the recent case of Jones v Garnett [2005] EWHC 849 (Ch) has highlighted this issue. It follows that, far from being negligent in failing to advise these clients to adopt such an arrangement, Fair Shares could well be culpable if he were to advocate it.

Issue: 4018 / Categories:
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