Tax Doctor:
Mark McLaughlin
ATII ATT TEP

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January 2003

Q:

As a director and shareholder in a small limited company, I am in the 40% tax bracket. However, my wife has zero income. Is there a tax-efficient way to spread income (i.e. payments of bonuses and share dividends) between us?

A:

I assume that, as your wife "has zero income", she is not an employee or shareholder in the company. I also assume that your 40% tax rate arises solely from income extracted from the company, and not partly from investments (e.g. bank interest or property rental income). To the extent that higher rate tax arises from investment income, it should be possible to use some or all of your wife's personal allowances and/or starting/basic rate tax bands by transferring investments to your wife.

With regard to income from your company, two possibilities spring to mind.

Firstly, does your wife do any work for the company, or could she? If so, it may be possible for the company to employ your wife and pay her a salary. However, the salary should be justifiable in relation to the duties she performs, and comparable to the wages paid to any employees who perform the same or similar tasks for the company. Otherwise, the payments may be subject to challenge from the Inland Revenue, who could contend that the salary paid to your wife is actually 'disguised' income attributable to you. In addition, bear in mind that your wife will acquire all the rights of an employee, such as the National Minimum Wage for the number of hours worked.

Secondly, if your wife became a shareholder in the company, it may be possible for dividends to be paid to her. However, great care needs to be taken to avoid unnecessary tax liabilities. For example, if the company issues shares to your wife while she is an employee, she will be liable to tax on the market value of the issued shares.

As the purpose of this tax planning exercise is to increase your wife's income and reduce your own income taxable at 40%, perhaps the most straightforward method of achieving this objective is to make a gift of shares to her. However, in order to be effective for tax purposes, there should be an outright gift between spouses of an income-producing asset (such as shares), which must carry a right to the whole of the underlying income (i.e. dividends). In addition, the gifted shares must not wholly or substantially represent a right to income.

In other words, the gift of shares to your wife should be made 'with no strings attached', your wife must be free to enjoy the dividend income as she sees fit, and there should be no change in rights attaching to the shares, such as voting or liquidation rights.

The Inland Revenue are alive to the tax planning possibilities of husbands and wives re-arranging their shareholdings in this way, and anti-avoidance legislation exists to prevent the donor spouse continuing to benefit from gifted assets such as shares. In addition, if the company does not have a track record of paying dividends but then starts paying them following the share transfer, this may attract unwanted attention and a potential challenge by the Revenue.

Entire books have been written on the subject of tax planning for family companies, and there are various other potential planning strategies that have not been mentioned. Professional advice is essential, particularly when contemplating share transfers between spouses. However, if properly handled, substantial tax savings can be achieved.

Mark McLaughlin

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