From me to you!

Peter Rayney explores the tax savings offered by spousal dividends from owner-managed companies. 

Married couples (and civil partners) can make useful tax savings by structuring their affairs so as to ensure that both spouses use up their personal allowances and basic rate tax bands. For owner-managed companies, one partner would typically arrange to gift or issue an appropriate number of shares to their spouse. The company could then pay sufficient dividends to the spouse with minimal tax liability.  

As an illustration, it is possible for a spouse (with no other taxable income) to receive a dividend of (say) £50,000 in 2021/22 at a tax cost of only £2,657 (see example below). 

Example: Dividend to spouse 

Karen owns 20 ‘B’ £1 ordinary shares in her husband’s company – Close To You Ltd. Her ‘B’ shares carried commensurate voting, income distribution, and capital rights. 

During 2021/22, she received a dividend of 50,000 and had no other income. Karen would only pay £2,657 dividend income tax – an overall effective rate of some 5%, as shown below:  

 
* In 2022/23, the basic rate of dividend tax increases to 8.75% (due to the addition of the 1.25% health and social care levy, which is added to all the dividend tax rates). This means that for 2022/23, the dividend tax rates will be 8.75% (basic rate), 33.75% (higher rate) and 39.35% (additional rate). 

Arctic Systems: the ‘settlement issue’ 

The landmark ‘Arctic Systems’ case (Jones v Garnett [2007] UKHL 35) demonstrated that this type of ‘income shifting’ strategy is far from being straightforward. Although Mr Jones eventually won his long-running squabble with HMRC, the case had to go all the way to the (then) House of Lords for a definitive ruling.  

The Arctic Systems case involved an important principle of tax law. It asked whether HMRC could overturn the payment of dividends to a spouse and treat them as her husband’s income for tax purposes (thus negating the tax savings)?  

In Arctic Systems, Mr Jones was responsible for earning all the company’s profits on computer consultancy contracts but drew only a minimal salary. He was the sole director and chairman 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 (within ITTOIA 2005, s 620 (1)). Mrs Jones had acquired her shares at par (at a considerable undervalue) and these shares ‘enabled her to receive dividends on the shares which were expected to be paid’.  

This was not an arms' 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’.  

Consequently, the necessary ‘element of bounty’ for the arrangement to be a ‘settlement’ existed (see (what is now) ITTOIA 2005, s 624). Since the dividends were funded by Mr Jones’ work, he was the settlor of the settlement. Mr Jones was treated as having a requisite interest in the dividend income since it was payable to his spouse.  

We should just reflect on this point since it is often misunderstood in practice. Mr Jones did not win on the ‘settlement’ point. Arctic Systems confirms that any gratuitous transfer or issue of shares to a spouse is likely to be treated as a settlement. There will, of course, be cases where shares are provided on a sufficiently commercially defensible basis so as not to constitute a settlement, as illustrated in Patmore v HMRC [2010] TC 00619.  

The vital ‘outright gift’ exemption 

The Law Lords found in the Joneses favour because they held that the important ‘outright gifts’ exemption (in what is now ITTOIA 2005, s 626) for inter-spousal settlements applied. This valuable ‘escape clause’ applies where there is an outright gift of assets that do not represent an entire or substantial right to income.  

In Arctic Systems, the Law Lords held that the ordinary shares provided to Mrs Jones were more than a pure right to income – they had a bundle of rights, including the right to attend and vote at general meetings, rights to capital growth on a sale, and to obtain a return of capital on a winding up.  

Thus, provided a spouse (or civil partner) is provided with ordinary shares (carrying the normal full range of rights), any dividends paid on the shares should be treated as their income. The settlements legislation would not apply because the ‘outright gifts’ exemption should be available.  

Avoid ‘dodgy’ preference shares 

The conclusion reached in Arctic Systems may well have been different if Mrs Jones was given (say) non-voting preference shares instead. The taxpayers in Young v Pearce [1996] STC 743 had previously come ‘unstuck’ on this point.  

In Young, the High Court held that non-voting preference shares carrying a coupon of 30% of the company’s net profit (which would be paid if agreed by the Board) were wholly or substantially a right to income (since the other rights were minimal). The company’s arrangements to provide spouses with the non-voting preference shares constituted a settlement, but this was not protected by the outright gifts exemption since they were, essentially, mainly a right to dividend income. 

Thus, in practice, the safest way to avoid this trap is to avoid restricting the rights of the shares issued to a spouse (e.g., in terms of voting power or capital returns, etc.). 

Dividend waivers can be problematic 

Dividend waivers are a legitimate way for one or more shareholders to waive their dividend entitlement in order to retain additional profits within the company. However, tax problems can occur when waivers are used to distribute funds to shareholders on a disproportionate basis. 

The broad conclusion is that the issue or transfer of ordinary shares to a spouse and the payment of dividends to them should be safe from HMRC challenge. However, this will not be the case where dividend waivers have been used to provide a spouse with ‘excessive’ dividends. By this, I mean a dividend payment to a spouse that exceeds their pro rata entitlement to the company’s profits or retained reserves. 

However, dividend waivers are capable of falling within the settlement rules (see HMRC’s Trusts Settlements & Estates manual (at TSEM4225). These principles were illustrated in Donovan and McLaren v HMRC [2014] UKFTT 048 (TC). The key facts were as follows: 

• Mr D and Mr M each had a 50% shareholding in Victory Fire Ltd (VFL). In 2001, they agreed to issue a 10% shareholding in VFL to each of their wives. 

• Dividends were subsequently paid to the four shareholders. However, Mr D and Mr M made annual dividend waivers, enabling their wives to receive a larger share of the total dividend than would have been due by reference to their 10% holdings (based on the amount of the distributable profits available).  

A comparison between the dividend entitlements and the actual dividend payments over the relevant years showed the following: 

 
The First-tier Tribunal (FTT) found that the dividend waivers would never have been made if the directors had been dealing with a third party at arm's length. The ‘arrangements’ therefore involved an element of bounty that was sufficient to create a settlement within ITTOIA 2005, s 620. Furthermore, the wives clearly benefited from the dividend waivers since they received more than their pro-rata dividend entitlement. The dividend income was property in which Mr D and Mr M had an interest within the terms of ITTOIA 2005, s 625 since the income was payable to their wives (see also the earlier case of Buck v HMRC [2008] SpC 716). 

Importantly, dividend waivers cannot fall within the spousal ‘outright gifts’ exemption since they are simply a right to income. This was distinguished from the Jones v Garnett ruling because the essential arrangement here was not the allotment of the shares to Mr D’s or Mr M’s wives but the waiver of dividends. 

Provided above mentioned ‘settlement’ issues are avoided, there is no reason why dividend waivers should not be made in commercially justifiable cases. However, it is still important to follow the relevant legal and practical requirements, such as the need to draw up a formal deed of waiver that is signed, dated, witnessed and lodged with the company. A simple letter will not suffice. 

Practical tip 

To be effective for income tax purposes, the deed of dividend waiver must be executed before the right to the dividend arises.