Joe Brough reviews the ongoing implications of the Arctic Systems case and other matters to be aware of when gifting shares in the family company to a spouse.
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Jones v Garnett [2007] UKHL 35 was a landmark case, which was found in favour of the taxpayer. The case considered the settlements legislation and the tax implications and application of the spousal exemption found in the settlements provisions. The case is more commonly referred to as the ‘Arctic Systems’ case’.
This is a well-known case among tax advisers, so only a brief synopsis is provided.
Mr Jones provided IT services to his clients via his own personal trading company. Mrs Jones provided administration support, and each owned half of the ordinary shares in the company. Whilst Mr Jones performed the services provided by the company, he only took a minimal salary, with the rest of his remuneration taken as dividends. As a shareholder, Mrs Jones was entitled to dividends despite performing little fee-earning work for the company.
HMRC argued that a settlement had been made by Mr Jones in favour of Mrs Jones which was ‘wholly or mainly’ a right to income. If held as such, the settlements legislation stated the entirety of the dividends paid by the company would be taxable on Mr Jones. After hearing the arguments, it was held that the shares held by Mrs Jones were a bundle of rights and therefore did not constitute ‘wholly or mainly’ a right to income.
As ordinary shares, Mrs Jones was afforded the right, in addition to receiving dividends, to attend and vote at meetings and receive a share of surplus assets on winding up. As such, the case was found in favour of the taxpayer. It was held by the House of Lords that a settlement had been made in favour of Mrs Jones. However, it was exempt as a gift between spouses, by virtue of ITTOIA 2005, s 626.
When does the settlements legislation apply?
In broad terms, the settlements legislation applies where a transaction is entered into on terms which are not commercial, are bounteous or not at an arm’s length basis, with the settlor continuing to derive a benefit from the settled property. The usual result of the transactions is that income is diverted away from the taxpayer, and tax is saved as a result.
Where the settlor retains an interest in the settlement, the income continues to be assessed on them for income tax purposes. A settlor retains an interest in cases where the settled property can be applied for the benefit of either themselves or their spouse or civil partner.
Clearly, where a gift of shares is made in favour of a spouse or civil partner, it is likely that the transferor spouse will retain an interest in the property. The settlements legislation, therefore, provides for some transfers between spouses to be exempted from the settlements legislation under ITTOIA 2005, s 626.
For ITTOIA 2005, s 626 to apply, there must be an outright gift of shares to a spouse or civil partner. In addition, the following conditions must be satisfied:
- The shares carry a right to the whole of the income; and
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The shares given are not wholly or substantially a right to income.
Wholly or mainly a right to income
It is important to note that whilst the Arctic Systems case held that transfers between spouses can be exempt from the settlements legislation, the reasons behind the decision do not subsequently give carte blanche for the exemption to apply to all transfers of all shares between spouses and civil partners.
The key point to remember is that the shares held by Mrs Jones were ordinary shares, which carried more rights than just a right to receive dividends. If the shares had had restricted rights, for example, it is possible that the courts may have taken a different view and the settlements legislation would have applied in that case.
Within owner-managed businesses, alphabet shares structures are often used. This gives the flexibility for dividends to be paid on each class of shares, which are not necessarily equal. The advantage of this is that dividend payments can be structured in such a way as to utilise the dividend allowance and minimise the overall tax payable where one spouse pays tax at a higher marginal rate than the other.
In respect of the settlements legislation, if alphabet shares were issued which carried only a right to receive dividend income, the exemption at ITTOIA 2005, s 626 would be unlikely to apply. In those circumstances, the dividends payable would continue to be assessed on the settlor.
Outright gifts
Where a gift of shares to a spouse is not wholly or mainly a right to income, the settlements legislation can still apply. This would be the case where the gift of the shares is not an outright gift but is subject to conditions imposed by the settlor, such that the transferor spouse can continue to benefit from the asset.
For example, on a gift of shares, if the transfer is subject to the condition that the shares must be returned to the settlor at some point in the future, the gift is not ‘outright’. Therefore, any dividends paid on the shares would be subject to the settlements legislation and continue to be taxable on the settlor spouse.
Other considerations
(a) Income tax
The holding of shares is treated differently for spouses than other investments when it comes to allocating the income (e.g., money held in a joint bank account or a jointly owned investment property, absent a valid ‘Form 17’ election where the income is allocated equally between the two spouses).
This is not the case with shares, as each spouse is taxed on the income relating to their individual shareholding.
(b) Capital gains tax
For capital gains tax purposes, any consideration given or received for the transfer of shares between spouses and civil partners is disregarded, with the transfer taking place on a ‘no gain/no loss’ basis. It should be noted that this is only the case where the couple is living together or separated on a basis that is not deemed permanent.
Separate rules apply where assets are transferred as part of divorce proceedings.
By each spouse holding shares, this can enable the couple to access two capital gains tax annual allowances on the sale of the shares. Also, if the qualifying conditions are met, potentially two lots of business asset disposal relief are available.
Similarly, if one spouse has capital losses available, transferring shares prior to disposal would enable the recipient shares to utilise these losses, which may otherwise be wasted.
(c) Inheritance tax
For inheritance tax purposes, a transfer of value between spouses is generally exempt.
The transfer of value is of an unlimited amount, except in the case where immediately before the transfer, the transferor spouse is domiciled in the UK but the transferee spouse is not. In such cases, the exempt amount is restricted to the inheritance tax nil-rate band applying at the time of transfer.
Records
It can be the case that where shares are transferred between spouses, not all records are properly updated. This can put clients at a disadvantage with HMRC should it later be relied upon that the shares were held in different proportions than officially shown in the company’s statutory records.
For a ‘belt and braces’ approach, especially where there is significant tax at stake, it is important to ensure that all official documents are updated promptly following a transfer. Although as a nil gain or nil loss transfer no entry is required on a tax return, it may be considered prudent in some circumstances to note the transfer in the ‘white space’ on the return.
Practical tip
Transfers of shares between spouses can be a useful tax planning tool to make full use of tax allowances and lower income tax bands. However, careful planning is required and a full review of the arrangements entered into should be performed to ensure the settlements legislation does not apply, which could prove costly for the taxpayer.
