Meg Saksida looks at whether income can be spread tax-efficiently between family members.
Imagine you are an additional-rate taxpayer and have three school-aged children who earn no income. If only you could gift the children some of your investments, thus diverting to them a proportion of your interest and dividends.
The thinking would be that the children could then use their personal allowances, savings-rate band and savings and dividend allowances to cover the income. Each child could receive tax-free up to £18,570 in interest income (i.e., £12,570 covered by the personal allowance, £5,000 by the savings-rate band, £1,000 personal savings allowance or nil rate) and up to £1,000 in dividend income (the dividend allowance or nil rate of £1,000). The total income potentially diverted for the three children would be £58,710, saving tax for an additional-rate taxpayer of £26,420.
That’s ‘settled’!
However, this is not possible due to anti-avoidance legislation in the form of the ‘settlements’ rules. The settlements provisions broadly state that if gross income of over £100 is either paid, made available to, or belongs to a child, and that income has been produced through an income-producing asset that originated from mum or dad, the income generated will be taxed on the parent rather than the child. This will also include income generated by a cash ISA opened by a 16/17-year-old with the capital funded by the parents but not funds invested in a junior ISA or a child trust fund account (a now discontinued scheme).
A settlement is a broader definition than a trust. A settlement can be inferred by a trust-type relationship where the formalities of a trust are absent. These provisions are called the settlement rules because the child is deemed to be the trustee of an asset settled on them by their ‘settlor’ parent.
A ‘child’ is one that is neither married nor in a civil partnership and under 18 years old. Children can be stepchildren, adopted children, children from a previous marriage and children of one’s civil partner.
Further legislation to watch
Not only will a direct gift of the income-producing asset by the parent to the child be taxed on the parent under the settlements rules, but so too may an indirect gift. A settlement could therefore be made by the parent through someone other than them gifting the income-producing asset.
Thus, in the above example, instead of our additional-rate taxpayer gifting the income-producing assets directly to their three children, they could gift them to their brother on the basis that their brother would then gift the assets to the children. Although the children did not receive the assets directly from one of their parents, this plan would reflect ‘an arrangement’ where the settlor (the parent) retains an interest in the settlement (see HMRC’s Trusts, Settlements and Estates manual at TSEM4300).
When do the settlement rules not apply?
If the income was generated from a trust, which was already a settlor-interested trust, meaning that the settlor (parent) is taxable on all the income at their own rate anyway, the settlement rules on the payment of income to a child are not relevant. If the child is classified as a vulnerable person, these rules will not bite if income is paid by trustees to the child. A vulnerable person will include a disabled person and a child who has had at least one of their parents die.
Practical tip
If the child is married or in a civil partnership, the rules won’t bite. Furthermore, although the rules prevent parents from gifting income-generating assets to their children, the siblings, grandparents and other relatives of the child may be able to (as long as these are not part of an arrangement with assets gifted first to the relative by the parents).
