He transferred rental income to his mother. What are the consequences?

The case of my client, Mr. Jan, who has recently faced many personal problems, perfectly illustrates the importance of adhering to tax regulations, especially concerning rental income from properties outside the UK. In this article, we will examine the mistakes Mr. Jan made and their potential consequences, focusing on issues related to rental income, tax penalties, connected persons, and the use of family foundations.

Mr. Jan owns properties in both Poland and the UK, and the rental income from the property in Poland was transferred to his mother's account, who used these funds to pay off his debts. Although Mr. Jan initially declared that the property generated no income, it turned out that income was indeed being earned but was deposited into a different account.

Issues related to rental income

Under UK tax law, the responsibility for taxing rental income rests with the property owner, even if the income physically goes into another person's account. In a situation where income is transferred to Mr. Jan's mother's account, the tax liability still applies to Mr. Jan, as he is the property owner. Such situations are regulated by Income Tax (Trading and Other Income) Act 2005, which clearly states that rental income from a property received by a third party can be challenged if the purpose is to avoid taxation. Additionally, transferring income from one's assets to another person is cautioned against by income tax anti-avoidance legislation (ITA 2007).

Using family foundations as a solution

If Mr. Jan wished to formally transfer income to another person, he could do so by establishing a Trust, which allows for such actions legally. Trust is a legal structure where property income is formally attributed to another person, thereby allowing for the avoidance of tax-related issues. In Poland, the equivalent of a Trust is a Family Foundation, however, this is a relatively new solution in Poland. For HMRC to accept such a division of interests, appropriate documentation is required, such as a trust deed (trust deed) or declaration of trust (declaration of trust).

Why is giving the income to your mother not a suitable solution?

A simple example

To better understand this situation, let's imagine that Mr. Jan asks his employer to transfer his salary to his son's account instead of his own. Although the money physically goes into his son's account, Mr. Jan actually performed the work, so the income belongs to him, and he should pay tax on it. The same applies to rental income from property – even if the money goes into his mother's account, Mr. Jan is responsible for taxing it because he is the true owner of the property.

Family Connections and the Necessity of Arm's Length Transactions

In transactions between connected persons, such as Mr. Jan and his mother, it is important to remember that all operations should take place at arm's length. This means that if a property is rented to a family member, they must pay market rent. If this does not happen, HMRC may consider the income to be artificially understated, and taxes should be calculated based on the market value. This is regulated by a provision contained in the legislation TCGA 1992, which clearly defines the rules regarding transactions between connected persons.

GAAR Anti-Abuse Rules

If HMRC determines that Mr. Jan attempted to avoid tax by transferring income to his mother, it may apply the anti-abuse provisions of GAAR (General Anti-Abuse Rule). Even if the money physically went into his mother's account but was used to pay off his obligations, HMRC may consider Mr. Jan to be the actual beneficiary, if only because ownership was not transferred to his mother. This is mentioned in ITA 2007, which provisions aim to prevent income tax avoidance by transferring the right to income to other persons without actually transferring the assets from which that income arises. In short, transferor (the transferring person) may still be liable to pay tax, even if the income formally goes to another person, unless specific exclusion conditions are met.

Additionally, under legislation TMA 1970, HMRC can investigate up to 12 years back for unpaid taxes related to income earned outside the UK.

How might the authorities discover such income? Primarily through the exchange of information between tax offices, thanks to the CRS system, as well as through tips from "well-meaning" individuals. Interestingly, during my research for you on property rental in Poland, I came across an article, which actually encourages and instructs on how to file such a report. I'll leave that without comment!

Consequences of Concealing Income

Concealing rental income can lead to high financial penalties. If Mr. Jan does not voluntarily declare his income, HMRC may impose on him penalties of up to 100% of the unpaid tax, if it determines that the actions were deliberate and concealed. To avoid such a situation, Mr. Jan should consider voluntarily disclosing his income through the process of Tax Disclosure. This will allow him to regularize all his tax affairs and minimize potential penalties.

My recommendation was, for Jan to sort out his tax situation as soon as possible by declaring all rental income, even if it was transferred to his mother's account. It's also worth considering setting up a formal Family Foundation to avoid such problems in the future. Currently, by voluntarily disclosing income, Jan can reduce potential penalties and also benefit from tax reliefs, such as Property Allowance, which can reduce his liabilities to HMRC.