TAX PLANNING WITH SHARES AND SPOUSES – AVOID THE TRAPS!

Many “one-man” companies, and indeed many “close” companies within the OMB/SME sector, utilise their directors’ tax free allowances by paying them a small salary, usually up to the primary threshold, so as to incur no PAYE or NICs but still maintain entitlement to state benefits and the state pension. The company gets corporation tax relief on the salaries, and earnings are then topped up by dividends.

Directors can duplicate this process with a spouse, gaining tax relief on two salaries provided the spouse does a worthwhile job within the company and is a bona fide employee of the company. Provided the company pays enough secondary Employer’s NICs, the Employment Allowance of £4K per annum then becomes available to offset such secondary NICs. The same scenario applies for other relatives, provided the rules are adhered to.

Tax Planning with Shares – Available Options?

With reference to spouses specifically, by transferring ordinary company shares from one spouse to the other in a “no gain no loss” transfer with no capital gains tax to pay, both spouses can then  withdraw excess profits as dividends, enjoying lower tax rates and no NICS. Shareholders are not legally required to perform company duties to “earn” dividends.

Playing by the rules

Anti-avoidance rules are in place [Part 5 ITA 2005] which provide that if a spouse’s income arises from a “settlement”, it is deemed to be the income of the other spouse, thereby counter-acting the original reasons for the share transfer. If one spouse receives income for activities carried out by the other, this rule therefore applies.

These rules do NOT apply [under Sec 626 ITA 2005] in the following cases:

1. The couple is unmarried or co-habiting.
2. Married couples where the income arises from an “outright gift” from one spouse to the other – i.e. this gift is not subject to conditions nor reclaimable.

There are two additional conditions for the exception to apply, namely:

1. The gift “must carry a right to the whole of the income, AND
2. The gift “is not wholly or substantially a right to income”.

Example Case : Husband and Wife Company

In the historic case Garnett V Jones (2007) – i.e. the “Arctic Systems” case, the House of Lords scrutinised the exception criteria in detail, as HMRC had attacked the spousal dividends income as a “settlement” , that should be taxable under Sec 624 ITA 2005 on the husband as the real fee earner for the company.

Mr Jones [J] argued that the transfer of the ordinary share capital to his wife was an “outright gift” and therefore the settlement rule under Sec 626 ITA 2005 didn’t apply. The Lords ruled in his favour and J won his case, and even though the gifting of the shares represented a “settlement”, the exception did in the end apply as the shares were ordinary shares, therefore constituting an “outright gift”.

Alphabet share schemes – a few relevant tax points

Companies may distribute so-called “alphabet shares” to key individuals, which restrict shareholders voting rights, and/or their right of income to dividends, or capital on a winding up, based on performance targets of either the individuals themselves, or the company as a whole. Gifting or issuing such shares to such key individuals could be argued by HMRC to be “substantially a right to income”, and therefore would NOT meet the criteria for exemption,  so Sec 626 ITA 2005 would apply.

Rank “Pari Passu”

If however shares were issued under an alphabet share scheme – i.e. the ordinary share capital of the company was subdivided into Class A, B and C shares – where the only difference between the share classes was their right to dividends [e.g. with various performance conditions attached] and full minority voting rights still applied, then HMRC would NOT be able to attack this arrangement as a “settlement”.

In this way key individuals, including spouses, could actively participate in the company and have minority voting rights that did not practically interfere with Board level decision making, and yet still derive dividends from distributable profits in a tax efficient way, based perhaps on pre-existing conditions or company performance targets being met.

Dividend waivers

If one spouse receives a variable second income, a 50:50 split is obviously no longer tax efficient, and adjusting their shareholding is an inadequate and impractical solution. Theoretically dividends could be “waived” to allow the other spouse to withdraw more dividends.

Such a “dividend waiver” must be a properly executed and sealed legal document, signed at witnessed in an appropriate manner, and lodged with the company.

Furthermore, the waiver must be in place before the dividend is paid to be valid and effective, a fact that is often ignored if tax planning is done “on the hoof”.

It is no secret that HMRC do not like, and are highly suspicious of, such dividend waivers, and will frequently challenge such devices if they are not made with any genuine commercial benefit in mind.

 So beware – the traps for the unwary are waiting for those that do not seek professional advice in advance!

Nick Dean ATII CTA