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Substance of the argument

Last week, I restated some tax planning fundamentals for couples but I

also sounded a warning that there are some traps to be aware of, especially

where the objective is the transfer of earned income where one or both of

the couple have control over the means of producing the income.

Before rushing to make such transfers, it is important to remember that,

in order for the payment to be deductible for the payer (regardless of

whether that payer is a company, an individual or partnership), the same

Schedule D rules apply and the payment must be incurred “wholly and

exclusively for the purposes of the trade, profession or vocation”. The

importance of this cannot be overstated.

Non-deductibility for the payer will mean not only that the income remains

assessable (in effect) in the higher tax base but that the income will also

be assessable on the recipient. Now this may well mean that no additional

tax liability is triggered if the recipient is a non-taxpayer but no

improvement in the taxsituation of the couple will have been achieved.

Thus, it is important to ensure that deductibility is secured. In order to

do this, it is important that, broadly speaking, the work carried out is

commensurate with the payment made.

Of course, in addition to this, the payment should actually be made in

respect of an employment that formally exists. In other words, the payment

should be made in form as well as substance.

Where the paying business is a partnership then, where the payments to the

spouse are more substantial and there is some concern over deductibility,

consideration may be given to bringing the spouse into the partnership. If

this is considered, it is worth remembering that the new partner must be

admitted properly into the partnership.

The Inland Revenue&#39s attitude to this is indicated in its Inspectors&#39

Manual 263. In particular, it states that: “It is worth emphasising that

the partnership is not a sham merely because of it is set up to save

tax…Cases which are worth investigation…are more likely to be

found among those in which there is no current partnership deed.”

It is important that the partnership should be one not only in substance

but also in form. Turning quickly to the “substance” part of the “substance

over form” consideration, perhaps more worryingly, there has been evidence

recently that the Revenue has sought to impose the provisions of section

660A ICTA 1988. This would be on the grounds that there has been a

settlement of income which is not exempt from the anti-avoidance provisions

on the grounds that it is between a husband and wife.

The Revenue could, in these circumstances, argue that if the spouse does

not substantially work in and contribute to the partnership, then the

income that the spouse is entitled to by virtue of the partnership interest

is nothing more than a settlement of that income by the substantially

involved partner and the spouse&#39s profit share would be assessed on the

substantially involved partner.

This risk is thought to be less when the spouse is a partner from the

commencement of the partnership but it is one that needs to be taken into

account nevertheless.

Where the business considering the move is a limited company and where

there is concern over the deductibility of the proposed payment, then

another way around this may be for the recipient spouse to become a

shareholder and receive dividends which will not be chargeable on the

“wholly and exclusively” grounds. Where this route is considered, thought

should also often be given to issuing a different class of share that

perhaps carries restricted rights, for example, shares that carry the right

to dividends only since it is an ability to pay dividends that gives rise

to the desire to issue shares.

If such shares are considered, one needs to take into account the

potential for a similar attack being made by the Revenue as was described

above in respect of the partnership idea, namely, that there has been an

effective settlement of income. This attack can be pre-empted, of course,

by ensuring that the shares participate in more than just dividends.

It is, of course, impossible to transfer or assign rights under approved

pension arrangements. This makes it essential to create pension rights for

each of a couple so that the income generated from the pension fund is

properly split so as to maximise use of tax allowances and lower tax bands

in retirement.

This means that when considering payments of income to each of a couple

from a business, it is also important to consider pension arrangements for

them. Generally speaking, pension contribution capability (occupational or

personal) is determined by the amount of money available to make a

contribution and the salary/profit level of each of the couple.

The big exception to this rule is the ability for a contribution to be

made to a stakeholder pension arrangement in respect of an individual

regardless of that individual&#39s salary level provided the amount of the

contribution does not exceed £3,600 gross or £2,808 net of

basic-rate tax each tax year.

The tax-effectiveness of making such a contribution where the funds used

to make it, if not used in this way, will have been taxed at a personal or

corporate tax rate, makes the attraction even greater.

Of course, going back to my original point, the fact that the pension

arrangement will then belong to the person who has made the contribution or

had the contribution made on his or her behalf will mean that the income

generated from the resulting pension fund will be assessable on that

person. This will possible give scope for the use of that person&#39s personal

allowance in retirement so that the pension may well be wholly or

substantially free of tax.

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