The law relating to ‘settlements’ can impact upon arrangements to provide tax-efficient dividend income for the shareholders of some owner-managed companies.
When an asset is placed within a trust, it is termed as being ‘settled’. ‘Settlement’ itself is not defined in tax law, but the legislation relevant to income derived from a settlement is to be found in ITTOIA 2005, Pt 5, Ch 5. Section 620 defines a settlement widely as including ‘any disposition, trust, covenant, agreement, arrangement or transfer of assets’.
Therefore within owner-managed companies a ‘settlement’ situation may present itself when an individual enters into an ‘arrangement’ of diverting income one to another, resulting in a tax advantage.
An example of such an arrangement might begin with a company set up with a nominal share capital, owned jointly between husband and wife (or by people living together, or closely connected by personal or family ties), where one of the parties is taxed at a lower tax rate than the other (or not subject to tax). In this situation it would seem tax-efficient for one spouse to gift or issue an appropriate number of shares to their non-taxpaying or lower rate taxpaying spouse. The company would then pay sufficient dividends that would result in little or no tax in the hands of that spouse.
However, such an arrangement will be questioned especially if one of the owners works full-time in the business (or does most of the work) and the other's involvement is much less - all that has to be shown is a definite plan to use a company's shares to divert income. In instances where the settlements legislation is found to apply, the arrangement is deemed null and void, with all of the income being treated as that of the ‘settlor’.
There is an exemption for outright gifts to spouses (under ITTOIA 2005, s 626), but the exemption only applies if both of the following conditions are present:
- The gift carries the right to the whole of the income arising; and
- The property is not wholly or substantially a right to income.
Where this exemption does not apply, a transfer of shares to a spouse is likely to be treated as a ‘settlement’ even though there is no formal agreement or trust document.
The settlement ‘tests’
Tax cases using similar arrangements are becoming increasingly common. The main case under this heading is that of Jones v Garnett [2007] UKHL 35 (colloquially known as the ‘Arctic Systems’ case) which was decided by answering two questions:
1. Is the arrangement one which might realistically have been entered into by parties acting at arms-length?
2. For arrangements between spouses - is the gift an outright gift and not wholly or substantially a gift of income?
In the Arctic Systems case, the House of Lords concluded that the arrangement was indeed a settlement under ITTOIA 2005, s 624 and could not have been seen as 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”. However, Mr Jones won his case under the ‘spousal exemption’ in s 626, as there had been an actual transfer of shares and his wife was entitled to substantially more than just income as holder of the company’s ordinary shares.
The ‘stranger/arm’s length’ point was also used in the case of Patmore v HMRC [2010] SFTD 1124. In that case, the defendant argued that the arrangement between the two spouses had been one that could have been entered into by two strangers. In the end, on the specific circumstances of the case, the judge decided that the defendant did not satisfy either of the two questions, but then went further by returning to a question originally mooted in the Arctic Systems case – that of ‘bounty’, namely ‘the benefit provided by the settlor which would have not been provided in an arm’s length transaction’. The judge considered how much each spouse had contributed to the company and whether any excess of contribution had been received, rather than just looking at the legal ownership of the shares.
Calculations were key - a table of all dividends paid was presented showing that 41.7% of the total dividends had been paid to Mrs Patmore, despite holding only 12 shares of the 110 issued. Importantly, the couple had remortgaged their home to finance the purchase of the shares. The judge held that as Mrs Patmore was responsible for half of the financing she was entitled to half of the income, 41.7% was less than she was entitled to, and as such the judge ruled that the shares were not settled on her and it was not a ‘bounteous arrangement’.
The judge went further and ruled that there was a constructive trust in place, saying that although one spouse owned a greater proportion of the shares in number, some of the husband’s holding should be treated as being beneficially held in trust for his wife such that there was no intention of any gifts being made.
Dividend waivers
Arrangements for dividend waivers arise where the shareholder voluntarily gives up entitlement to their share of the dividend, allowing the distributable profits to be divided between the remaining shareholders in the proportion of their holdings. An arrangement that frequently attracts HMRC’s interest is where each spouse owns shares in a family owned company, but one spouse ‘waives’ their right to the income. HMRC’s argument is that the waiver indirectly provided funds for a ‘settlement’ on the receiving spouse.
The case of Donovan and Anor v Revenue & Customs [2014] UKFTT 48 (TC) set the ground rules for such arrangements by looking at the commercial reality of dividend waivers. A key factor in the decision was whether the arrangement was one into which the defendants would have entered into with a third party at arm's length.
The facts of the case were broadly that Mr Donovan and Mr McLaren each had a 50% shareholding in the company. A 10% shareholding was then allotted to each of their wives, who were basic rate taxpayers. Each year the husbands entered into dividend waivers such that the wives received a disproportionate share of the income.
HMRC contended that the settlements legislation applied such that all of the dividend income was taxable on the appellants as settlors. The appellants countered this argument saying that the waivers had no tax avoidance motive but rather, were a commercial decision to ensure that the company maintained workable reserves and cash balances to fund the purchase of the company's freehold premises. Further, that the allotment of the shares to their wives represented an exempt gift falling within the s 626 exception.
The tribunal ruled in favour of HMRC deciding that the ‘irresistible inference’ from the facts was that the directors waived dividends as part of a set plan to ensure that dividend income became payable to their wives and as such this constituted an arrangement under the settlements legislation. They found no evidence that the share allotments in favour of the wives were gifts. The dividend waivers themselves could not be ‘outright gifts’ because by their very nature such waivers are only a transfer of income and as such the ‘inter-spousal’ outright gifts exemption could not apply.
Practical Tip:
It is clear that husband and wife businesses need to take great care when allocating shares between them. HMRC often look at the pattern of dividend waivers made regularly to determine whether there has been a diversion of income. The use of different classes of shares to pay separate levels of dividend may be something to consider.
