Have recent tax changes affected spousal dividend planning? Peter Rayney investigates.
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Ever since the arrival of independent taxation in 1990, married couples (and more recently, civil partners) have been able to save useful amounts of tax by ensuring that they each use up their personal allowances and basic or lower-rate tax bands.
In the vast majority of cases, the ‘non-earning’ spouse does not play an active role in the business. This means that any salary paid to (typically) the wife would not be eligible for a corporation tax deduction, and hence the overall tax and National Insurance contributions (NICs) cost would be unfavourable.
However, in most cases, tax savings can be made through the payment of dividends to the spouse. With high dividend rates set to remain for some time yet, spousal dividends are likely to provide an even greater role in minimising profit extraction costs for owner-managers.
Setting a suitable spousal dividend
Owner-managers typically arrange a tax-exempt gift or share issue of a suitable amount of shares to their spouse. It is generally best to make sure that the spouses’ shares are of separate classes to ensure flexibility of future dividends. This class of shares should carry the full range of shareholders’ rights (see below).
The company could then pay sufficient dividends to the spouse with minimal tax liability. For example, in 2022/23, it is possible for a spouse (with no other taxable income) to receive a dividend of (say) £50,000 at a tax cost of only £3,100 (see example below).
Since 6 April 2022, higher dividend rates of 33.75% or 39.35% apply to substantial dividends, and this is likely to continue for a number of years. Spousal dividends are also likely to play a beneficial role in such cases by reducing the overall effective dividend tax rate suffered by the couple.
Example: Dividend of £50,000
Diana owns 20 ‘A’ £1 ordinary shares in her ‘husband’s’ company – Costello Ltd. Her ‘A’ shares carried commensurate voting, income distribution, and capital rights.
During 2022/23, she received a dividend of £50,000 and had no other income. Diana would only pay £3,100 dividend income tax – an overall effective rate of some 6%, as shown below:
Dividend £50,000
Less: Personal allowance (12,570)
Taxable income £37,430
Dividend allowance £2,000 x 0% -
Basic rate liability £35,430 x 8.75% *
Tax liability £3,100
*The Autumn Statement 2022 announced that the 2022/23 dividend basic rate of 8.75% will also apply in 2023/24. The dividend allowance reduces to £1,000 in 2023/24.
Arctic Systems – the ‘settlement issue’
The Arctic Systems case (Jones v Garnett [2007] UKHL 35) showed us that this type of ‘income shifting’ strategy is far from being straightforward. Mr Jones eventually won his long-running battle with the ‘taxman’ but he had to go all the way to the (then) House of Lords for a definitive ruling. The Arctic Systems case considered whether dividends paid to a spouse could be treated as their husband’s income for tax purposes under the archaic settlement legislation.
The basic facts were as follows:
- Mr Jones was responsible for earning all the company’s profits on computer consultancy contracts but drew only a minimal salary.
- Mr Jones was the sole director and chairman of the company.
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The company had a 50:50 share-owning structure, which enabled large dividends to be paid to Mr Jones’s wife.
The Law Lords had little difficulty in concluding that Mr Jones had created a settlement in which his wife had an interest within (what is now) ITTOIA 2005, s 620(1). Mrs Jones had acquired her shares at par (at a considerable under-value). This was clearly not 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 (secretarial and administrative) services which Mrs Jones provided”. The necessary ‘element of bounty’ for the arrangement to be a ‘settlement’ (within ITTOIA 2005, s 624) therefore existed. Since the dividends were effectively funded by Mr Jones’ work, he was the settlor. Mr Jones was treated as having a requisite interest in the dividend income, since it was payable to his spouse (ITTOIA 2005, s 625).
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, as will often be the case.
Rescued by the outright gifts exemption
The key ‘take-away’ from the Arctic Systems ruling is that the Joneses were able to benefit from the important exclusion for ‘outright gifts’ (in what is now ITTOIA 2005, s 626). This valuable exemption for spousal settlements covers outright gifts of assets that represent more than an entire or substantial right to income. In this case, the ordinary shares provided to Mrs Jones gave considerable rights that went further than a right to dividend income. The rights attached to Mrs Jones’ shares also included 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. Consequently, the settlements legislation was prevented from applying, and the dividends paid to Mrs Jones could be treated as her dividend income for income tax purposes.
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 ‘failed’ to avoid the settlement rules on this very point.
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 generally occur when waivers are used to distribute more dividends to spousal shareholders than they would legally be entitled to on a pro-rata distribution of the company’s distributable profits.
I have broadly concluded 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 is not the case where dividend waivers are designed 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.
Dividend waivers are capable of falling within the settlement rules, since they can represent the gratuitous transfer of income and cannot, therefore, be protected by the outright gifts exemption. However, provided the settlement issues can be avoided, there is no reason why dividend waivers should not be effective in legitimate ‘commercial’ cases.
Using separate classes of shares
To avoid the perennial problem of entering into dividend waivers each year, a more elegant solution would be to recategorise the company’s ordinary share capital into two (or more) classes of shares. Each spouse would have a different class of shares – such as £1 ‘A’ ordinary shares and £1 ‘B’ ordinary shares – with both classes ranking ‘pari-passu’ in all respects. This should provide owner-managers or directors with the flexibility to declare different levels of dividend on each separate class of shares.
However, care should be exercised to avoid being aggressive with such arrangements. HMRC considers that it is still able to apply the settlement rules if the level of dividend paid on a particular class of share could not have been paid (by reference to the available reserves) without a bounteous arrangement to pay no or minimal dividends on the other class of shares (see HMRC Trusts, Estates and Settlements manual at TSEM4225 – Example 2).
Practical tip
Owner-managers should normally provide their spouses with a separate class of ordinary shares (carrying full economic rights). This will enable them to pay a suitable tax-efficient dividend to them – but they should always act reasonably!
