Given the introduction of a 50 per cent income tax band and the forthcoming increase in the rate of National Insurance contributions, an increasing number of private limited company owners are turning their attention to income-splitting as a means of minimising the impact of these increases.
Typically, this would involve the business owner employing their spouse in the business and paying him/her a salary which would be taxed at a lower rate than that suffered by the director/shareholder partner.
For the salary to be deductible, though, the employee must provide genuine and reasonable services to justify the payment. This, in practice, often limits the extent to which this strategy can be used.
For businesses structured as limited companies, greater savings should be possible by the owner making a gift of shares to his/her spouse and then declaring a dividend. This would also generate NIC savings.
For partnerships or sole traders, bringing the spouse into partnership or sharing profits would also bring about the desired tax-saving result.
Despite the clear tax advantages that are available, because of the publicity given to the Arctic Systems case and the subsequent Government announcement of its intention to neutralise this form of planning, (which did not carry through to legislation – see below) there would still seem to be some uncertainty over whether such planning is effective. This is despite the fact that the law has not actually changed.
In this article, we consider the current position and the current tax planning opportunities.
The Arctic Systems case
In the Arctic Systems case, a husband, Mr Jones, who was the controlling shareholder in a company and the main income producer for that company, transferred shares outright to his wife. HM Revenue & Customs sought to tax the husband on subsequent dividend payments to his wife.
This was on the basis that the transfer amounted to a settlement of the income by him because she did not make sufficient contribution to the business (and the profits that arose) and, instead, the profits were effectively generated by him.
Based on the facts of the case, the House of Lords decided that because the shares gifted were fully participating in both income and capital, and the gift was outright and unconditional, such action was effective for income tax purposes.
This meant that dividend income should be taxed on the recipient, in this case Mrs Jones.
Following this case, it became clear that the Government wanted to make this “income-splitting” planning ineffective and, in that regard, they issued a document setting out how they would change the law.
However, that proposed change in law has still not materialised and this raises the question as to whether this means that a controlling director, in circumstances such as in Arctic Systems, can still undertake planning – even if care should be taken in doing so.
Settlement or not?
The main technical tax issue that arises is whether income-splitting creates a settlement of income from one person to another. This is important as, under UK tax law (in Chapter 5, Part 5 of ITTOIA 2005), if there is a settlement the income would be taxed as still belonging to the controlling shareholder (that is, the settlor of the deemed settlement).
For a settlement to exist there would need to be an element of “bounty”. But even if there is an element of bounty, there will not be a settlement for income tax purposes if the property is gifted on an outright and unconditional basis.
First then it is necessary to determine whether there is a settlement. In order to achieve effective income-splitting, shares would be gifted from the controlling shareholder to his/her spouse, and it is this action which can create a settlement.
The Arctic Systems judgment stated that, in the context of the facts of that case, although the gift of ordinary shares had an element of bounty, it was an outright gift and not a gift solely of income. Therefore, the outright gift exemp- tion in section 626 ITTOIA 2005 applied.
It follows that if there is to be any chance of success with this type of planning, the shares transferred need to be fully participating shares and the gift not made subject to conditions or made in circumstances where the donor will receive a benefit from the property or income or proceeds from that property. While none of those situations existed in the Arctic Systems case, many commentators believe that this exemption could be put at risk if, for example, dividend payments on the gifted shares are put into a joint bank in the names of husband and wife.
This means that, under current tax rules, it would seem to be possible for a controlling director spouse to pass shares to a spouse that give a right to receive dividends with the result that dividends are taxed on that spouse provided the shares also give a right to receive capital, carry full voting rights and do not attach conditions to the gift or enable the donor to derive benefits from the shares given.
Following the Arctic Systems decision, the Government announced consultation on new legislation which would rule out this practice (the so-called income-shifting regime).
This draft legislation was “postponed indefinitely” in the 2008 Pre-Budget Report. This means that the House of Lords’ decision in the Arctic Systems ruling remains effective.
There may, however, be changes afoot as a result of developments in other areas.
The Office of Tax Simplification has publicly acknowledged that income splitting from a private limited company is one of the areas that it is reviewing and therefore proposals for a change in the tax rules may be put forward in the future.
In the meantime, while it is still unclear as to what the eventual outcome will be in terms of new tax rules, currently, it would seem that such planning will work.
Clearly, it is advisable that professional advice is taken before planning strategies are entered, in particular, the shares in question must be fully participating.
Notwithstanding the lack of new legislation, it has recently become clear that HMRC is still enthusiastic about challenging cases which are not within the accepted rules discussed above.
In the case of Patmore v HMRC, a complicated case which the judge eventually decided on the basis of a deemed constructive trust, various transactions took place. This resulted in a husband and wife both ending up owning the shares in a company (but in different percentages and in different classes).
The company declared dividends on the share class owned by the wife, which were shares that were only entitled to income.
HMRC sought to tax the wife’s dividends as her husband’s income under the settlement provisions in section 660A ICTA 1988 (now section 624 ITTOIA 2005 et seq).
The First-tier Tribunal held that, while a decision to only declare a dividend on one class of shares rather than another can be an arrangement caught by the settlement legislation, this only applies where the arrangement involves gratuitous intent.
On the facts of this case, although the arrangement was not commercial, it was also not a gratuitous arrangement. However, to the extent the wife received dividends above her entitlement, then there would be an element of gratuitousness and a settlement. Furthermore, the dividends themselves could not benefit from the outright gift exemption as the property passing was wholly or substantially the right to income.
The conclusion to all this is that, under the law as it stands, these arrangements can work, provided all the conditions are satisfied. Provided arrangements are properly set up so as to pay a dividend to a spouse, the optimum position would exist if the controlling shareholder was currently a higher or additional- rate taxpayer.
If the company could employ their spouse in the business and transfer shares in tax year 2011/12, a salary of £7,225 could be paid with up to £31,725 (net), £35,250 (gross) paid as dividends.
The tax/NIC results of this action are:
(a) the salary of £7,225 would not suffer income tax because it would fall within the personal allowance
(b) the salary of £7,225 would not suffer NICs because it would fall within the primary threshold – but t would still secure important rights to state social security benefits
(c) the dividend would be paid with a 10 per cent tax credit but no higher rate income tax would arise provided the grossed-up dividend income did not cause the spouse to exceed his or her basic-rate tax band.
Indeed, if it was desired to extend the basic-rate tax band and so facilitate an increase in dividend with no higher-rate tax, the receiving spouse could pay a pension contribution.
This would be paid net of income tax relief at source of 20 per cent. The grossed-up pension contribution would extend the basic rate tax band meaning that more income would fall within the basic rate tax band.
In order for his action to be successful:
(i) the spouse must be genuinely employed in the business and perform reasonable services in return for the salary received
(ii) any transfer of shares must be unconditional and give the receiving spouse unrestricted entitlement to the income and capital from those shares and the ability to vote on those shares. The same dividend must be paid on all shares of the same class.
Where strategies involve bringing the spouse in as a partner, then the spouse should be a fully participating partner. The tax savings would then emerge from making an appropriate split of the share of profits.
Don’t forget that professional advice should always be taken and the situation must be kept under control because the tax rules may change in the future.