Tax Doctor:
Mark McLaughlin
ATII ATT TEP

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June 2003

Q:

In a previous 'Tax Doctor' (Tax Doctor 4), you mentioned that it can be possible for a small family company to spread income between husband and wife in order to reduce their overall tax bill. For example, shares could be gifted from one spouse (paying higher rate tax) to the other spouse (who is not), enabling dividends to be paid to both spouses.

However, I have subsequently read a newspaper article about the Inland Revenue attacking such arrangements. I am concerned because I propose to gift some shares to my wife. Should I now abandon this idea?

A:

There has been some speculation in the press recently that owners of small, family companies are being made the subject of enquiries by the Inland Revenue, where for example shares have been transferred between spouses or from parent to child.

'Settlements'

There is tax avoidance legislation concerning 'settlements'. This legislation is intended to prevent an individual from achieving tax savings by diverting income to another person who is liable to tax at a lower rate, or who is not liable to tax at all. The term 'settlements' is frequently associated with trusts. However, the settlements legislation can apply to certain gifts between individuals, normally family members.

It is not uncommon for shares in a small family company to be transferred from one spouse to another. The donor spouse will invariably be a higher rate taxpayer, while the recipient spouse will have a lower (or no) income. The company then pays dividends on the shares, possibly utilising the donee spouse's personal allowances and basic rate tax band. An overall tax saving is achieved, because the gifting spouse would otherwise be liable to higher rate tax on that dividend income.

It is understood that the Revenue are selecting a small number cases for enquiry each year where the settlements legislation may be in point because company shares have been transferred in this way. The legislation can apply in other situations as well, e.g. if company dividends are waived by one shareholder to enable another shareholder (who pays a lower rate of tax) to receive a higher dividend. It can also apply in partnership situations, for example where a higher rate tax paying spouse appoints the other (possibly non-working spouse) as a partner.

In short, the settlements legislation can apply where an individual enters into an arrangement to divert income to someone else, thereby achieving a tax saving. However, in addition certain other criteria need to be established, i.e. if there is some element of 'bounty' (i.e. a gratuitous benefit is conferred), or if the arrangement is not commercial, or if it is not at 'arm's length', or (in the case of gifts between spouses) if the gift is wholly or substantially a right to income.

Let out?

There is a very important potential let-out from the settlement provisions, relating to gifts by one spouse to the other, which can help in the context of gifts of shares. This exclusion applies if a gift is made outright (i.e. with no strings attached), if it carries the right to the whole of the income from it, and if the gift is not wholly or substantially a right to income. This would seem to cover the situation where a spouse gifts ordinary shares to the other spouse unconditionally, and the recipient spouse receives all the dividends from the gifted shares.

Unfortunately, even if these conditions are satisfied, this arrangement could still be challenged. The Revenue may argue that unless the company has sufficient fixed assets, the shares are wholly or mainly a right to income (i.e. dividends), and are therefore caught by the settlements legislation. It has to be said that this approach is somewhat controversial, and has been met with criticism by some tax professionals. However, unless there is a change in the Revenue's view, or unless it is successfully challenged in the Courts, it would be unwise to ignore it.

In response to the query, it would therefore be advisable firstly to look at the company's capital assets. Is the fixed capital value of the company significant (say, more than 25 per cent overall)? If so, chances are that shares can be gifted to your wife without a successful challenge by the Revenue.

The Revenue have provided detailed guidance on the settlements legislation, in Issue 64 of its publication 'Tax Bulletin', including 15 examples of situations illustrating when the settlements provisions would and would not apply. One example given is where a spouse owns all the shares in a manufacturing company employing 10 people, and owning a small factory, a high street shop, tools, fixtures and fittings and 3 delivery vehicles. A gift of 50% of the company's ordinary shares is made to the other spouse, who receives dividends from them. In this situation, the Revenue would not seek to apply the settlements legislation, because the outright gift of shares cannot be regarded as wholly or substantially a right to income, in view of the capital value of the shares represented by the company's fixed assets.

Tax Bulletin Issue 64 can be downloaded by visiting the Revenue's website: http://www.inlandrevenue.gov.uk/bulletins/tb64.htm#a.

Mark McLaughlin

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