Dividends To Spouses: The ‘Settlements’ Rules

Lee Sharpe looks at anti-avoidance rules affecting giving up dividends in favour of your better half.

Readers will no doubt be aware that it is perfectly acceptable (and potentially quite tax-efficient) to pay a wage to a family member, such as one’s spouse. However, there are limitations. 

For example, the payment must be commensurate with the work done for the business, and should not be excessive. This can potentially impose practical constraints if (say) the spouse is already working full-time elsewhere. Also, wages can carry a significant cost in terms of employees’ and employers’ National Insurance contributions (NICs); the more so, the larger the payment. 

We shall look at dividends as an alternative, and outline some of the important issues to consider when making dividend payments to spouses – in particular, the ‘settlements’ regime and waiving dividends.

As noted above, dividends are free of NICs and so can be quite efficient. The (relatively) new dividend regime (introduced from April 2016) means that dividend income taxable at the higher rates of 32.5% or 38.1% can be quite painful, although still more efficient than the salary alternative. 

So, if the spouse has unused tax-free personal allowance, dividend ‘allowance’ and/or basic rate band where dividends are taxed at only 7.5%, the tax cost can be significantly reduced.

Charlotte owns her own company, and habitually takes a modest salary of £8,000, plus a dividend of £80,000. Her personal tax bill has risen markedly since the introduction of the new dividend regime in 2016/17. 

Based on those income figures, her tax bill will be around £16,000 in 2018/19, with the majority being attributable to the 32.5% now being charged on that part of her dividend income being taxed at higher rates.  Charlotte’s spouse, John, has no other income, so if half of Charlotte’s dividend were paid to John instead, such that they took £40,000 each, the total income tax bill would fall to just around £5,000 for the couple – an overall saving of more than £10,000 for the year. 

Firstly, you need to have shares in the company, in order to be paid a dividend (this is something I had to point out to an accountant quite recently, so perhaps it’s not as obvious as one might have thought).

By default, the dividends are paid out in proportion to each respective holding. If one shareholder has twice the number of shares held by another, he or she will expect twice the dividend income. 

It is possible to waive entitlement to some or all of the dividends that would normally be paid on one’s holding. This therefore changes the apportionment of dividend income. However, married couples (or civil partners) need to exercise caution as regards dividend waivers, as set out below, thanks to the ‘settlements’ legislation.

The settlements anti-avoidance legislation (now at ITTOIA 2005, s 619 and following) was designed to counter scenarios broadly where one party officially deprives himself of income in favour of another, but still actually benefits from that income. 

The legislation is primarily aimed at someone giving up income in favour of their spouse or young children, so the spouse/child is taxed on income which really still belongs to the person making the settlement – the ‘settlor’ (the legislation can apply more widely, but in those relatively rare cases involving more distant parties, HMRC might struggle to prove how the settlor might still benefit). Where the settlements anti-avoidance legislation is triggered, the income is taxed on the original settlor, and not on the official recipient.

Clearly, if Charlotte is doing all the work in the company but John is getting some of the dividend income, and Charlotte will still benefit from a dividend paid to John as they are married, then they are at risk of the settlements anti-avoidance legislation being triggered, in which case Charlotte would be taxable on both her and John’s dividend income. HMRC certainly thought so, when they fought the Arctic Systems case all the way to the House of Lords. 

The taxpayers finally won the Arctic Systems case when it was heard by the Lords (formally, Jones v Garnett [2007] UKHL 35). It was held that there was indeed a settlement, but it was of more than just income, from one spouse (or civil partner) to the other. Essentially, when the spouse received the shares in the company, she received a right to dividend income, and to vote as a shareholder, and to assets on a winding up of the company, etc. 

There is a specific exemption from the settlements anti-avoidance legislation (at ITTOIA 2005 s 626), which covers those outright gifts between spouses that are not only (substantively) gifts of income. This exemption allows married couples to arrange their affairs and income-generating assets in a tax-efficient manner, so long as it is not a diversion only of income from one spouse to the other. 

The judgment found that ownership of ordinary voting shares amounted to significantly more than just a right to income, so the exemption applied, and the settlements anti-avoidance legislation could not be invoked to put all the income back into the hands of the settlor spouse.

So, in our example, if Charlotte gives some of her shares to John, this may be a settlement, but it will not trigger the anti-avoidance legislation.

Following on from the above example, let’s say that a year later, in 2019/20, John receives income of £200,000 from other sources. 

As John will then be exposed to the highest rates of tax on any further income, it would be better if Charlotte took all of her company’s dividend income instead, in 2019/20. To do this, John could waive any entitlement to a 2019/20 dividend from Charlotte’s company, so Charlotte would become the only recipient. But does the spousal exemption still apply when dividends are waived?

The matter is not free from doubt, but the tax courts have found in HMRC’s favour, on this point – using the example of the First Tier Tribunal case Donovan and McLaren v HMRC [2014] UKFTT 048 (TC), and Buck v HMRC [2008] SpC 716. Essentially, the tribunal held that where one spouse waives a dividend in favour of the other spouse, then that is a settlement, and it is only of income – the dividend. To put it another way:

The above example has been used to illustrate that shares can be arranged between spouses and civil partners so as to yield dividend income in a tax-efficient manner. But readers should be aware that HMRC may well challenge dividend waivers between spouses (but the Donovan case, as a First-tier Tribunal case, does not set a binding precedent that must be followed, although tribunal judges will pay heed to previous similar cases). Simply put, arranging company shares between a couple is fine, but messing around with dividend waivers between them runs a real risk of HMRC challenge.

The act of transferring shares has lots of tax implications, not least for capital gains tax, employment-related securities and inheritance tax. Advice should always be sought before transferring shares, or waiving dividends.