As many contractors are aware there are substantial tax savings to be made by divvying up the dividends between spouses/civil partners to ensure that both parties fully utilise their personal allowance and basic rate band. Over the years this has come to be known as income splitting or income shifting.
Marilyn is a 50% shareholder in her husband’s company, Monroe Ltd. During 2014/15 she received a dividend of £37,600 which was her only source of income. Effectively the dividend is received free of tax thus:
|Gross dividend (£37,600 + £4,177 tax credit (10%))||£41,777|
|Less: personal allowance||(£10,000)|
The basic rate band is £31,865 therefore no tax is due as dividends will only become taxable at higher rates.
This case should be etched on freelancers’ minds as it was a landmark victory for contractors and family businesses and established an important principle of tax law.
Mr Jones was sole director and earned all the profits for the company yet drew a minimal salary, He held shares jointly with his wife, enabling large dividends to be paid to Mrs Jones.
The House of Lords confirmed that Mr Jones had created a settlement in which his spouse had an interest.
Mrs Jones had subscribed for the shares at par which was considered to be not an arm’s length transaction because Mr Jones would never have agreed to transfer 50% of the issued share capital to a third party on the same basis as a family member.
It is important to remember that the case was not won on the settlement issue. The dividends were generated by Mr Jones’s efforts, so he was the settlor and as the income was payable to his wife, he was treated as having retained an interest in the dividend income.
Whilst there was a settlement the ‘outright gifts’ exemption came to the Jones’s rescue. This allows spouses/civil partners to make outright gifts to each other without any consequences of the settlements legislation. However there has to be an outright gift of assets that do not represent an entire or substantial right to income.
The Lords held that the ordinary shares held by Mrs Jones carried more than just a right to income but a whole raft of rights, such as attendance and voting at meetings, rights to capital growth on a sale and return of capital on winding up.
Non-voting preference shares will fall foul of the Settlements legislation. This is because the rights of the shares are restricted and they essentially represent a right to income.
In the case of Young v Pearce (1996), spouses were given these very same shares and the High Court deemed that they did not come within the spousal exemption.
Establishing different classes of shares which rank equally may work. However, HMRC will seek to apply the settlement rules where the level of dividend on one class of share could not be achieved without a bounteous arrangement to pay no or minimal dividends on the other share classes.
Although dividend waivers are a legitimate mechanism for shareholders to allow a company to retain additional profits, problems will arise where waivers are used to provide a spouse with greater dividends. There have been a number of cases where waivers have been caught by the Settlements legislation.
In their Trusts Settlements & Estates Manual (TSEM), HMRC set out factors that may indicate that the Settlements legislation applies:
The issue or transfer of shares or dividend waivers in favour of an unmarried minor (under the age of 18) will be caught by the parental settlement rules contained within the Settlements legislation.
What about other family members though? Can the Settlements legislation apply to these relatives or other third parties, such as good friends? Well, HMRC seem to infer, in their TSEM, that the rules can apply but Sir Andrew Park took a very different view when the Arctic Systems case reached the High Court in 2005. He said that if Mr Jones’s sister had been the other shareholder then the legislation could not have applied,
Income splitting does work provided the pitfalls mentioned above are avoided and it makes perfect sense to use this legitimate piece of tax planning whilst you still can.