It Is Okay To Pay Your Spouse, Right?
Income Shifting & Settlements Legislation.
Splitting remuneration to family members can sometimes be an effective tax saving device. However, any income splitting needs to be done properly otherwise there could be potential HMRC issues around the corner for contractors who haven’t set things up properly.
Many married couples (or civil partners) have made useful tax savings by structuring their affairs to ensure that both spouses use up their personal allowances and basic rate tax bands. In more recent times, this practice has become known as income splitting or income shifting.
For owner-managed companies, this strategy was considered to be a relatively easy one to implement. Typically, the husband could gift or issue an appropriate number of shares to their spouse. The company could then pay sufficient dividends that would result in little or no tax in the hands of that spouse.
HMRC’s predecessor, Inland Revenue, began to resist such arrangements by applying Settlements Legislation. The landmark Arctic Systems case taught us that it was not so easy after all. The case involved an important principle of tax law.
In this case, the husband (Mr Jones) was responsible for earning all the profits on computer consultancy contracts, but drew a minimal salary only. Mr Jones was the sole director and chairman of Arctic Systems, which enabled him to control both the day-to-day and the strategic management of the company.
However, the 50:50 share-owning structure gave the ability to pay large dividends to his wife (Mrs Jones).
The House of Lords had little difficulty in finding that Mr Jones had created a settlement in which his wife had an interest. Mrs Jones had acquired her shares at par (at a considerable under-value) and these “enabled her to receive dividends on the shares which were expected to be paid”.
It was concluded that this was not an arm’s length transaction because “Mr Jones would never have agreed to the transfer of half the issued share capital, carrying with it an expectation of substantial dividends, to a stranger who merely undertook to provide the paid services which Mrs Jones provided”.
It looked like Mr Jones was going to be taxed on the income he had paid to his wife. They appealed.
Although there was a settlement, the Law Lords found in the taxpayer’s favour because they held that the important “outright gifts” exemption for inter-spousal settlements applied.
This exemption had been introduced as part of the independent taxation reforms in 1990, specifically to enable spouses to make outright gifts to each other without fear of the settlement rules being applied.
This valuable escape clause applies where there is an outright gift of assets that does not represent an entire or substantial right to income.
The key conclusion emanating from the Arctic Systems judgement was that, although the shareholding arrangements constituted a settlement, they were exempted under the outright gifts clause.
Thus, as long as a spouse (or civil partner) is given ordinary shares (carrying the normal full range of rights), any dividends paid on the shares should be treated as their income and the settlements legislation would not apply.
Settlements legislation would therefore be applied to any income splitting arrangements that a contractor has with someone who is not their legal spouse i.e. unmarried partner, family member, child, friend etc.
The only way to ensure legal income splitting is by gifting shares to a spouse. Doing it properly can garner significant tax savings: it could be the difference between an effective tax rate of 45% or one of just 20%.
We can, of course, happily advise you on the most tax efficient setup for your current circumstances.