Sarah Bradford highlights some traps to be wary of when seeking to spread rental income.
To save tax, it may be tempting to try and ‘give away’ rental income to a spouse, civil partner or other family members where the income would be tax-free or taxed at a lower rate in the hands of the recipient.
However, extreme caution should be exercised when seeking to do this to avoid falling foul of anti-avoidance legislation. In this article, we’ll look at when the anti-avoidance provisions bite and also how to transfer income in a way that will not attract unwanted attention from the taxman.
Anti-avoidance rules
There are two sets of anti-avoidance rules that may come into play here; the transfer of income stream rules and the settlements legislation.
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Transfer of income streams rules
The transfer of income streams legislation applies broadly where the intention is to transfer the income stream only with the original owner retaining the underlying income. For example, if the owner of a rental property tried to transfer some or all the rental income to another person while retaining full ownership of the property.
The transfer of income rules are complex and apply to companies and individuals. The rules were designed to target businesses that sought to turn income into capital so that it was taxed at a lower rate. However, the rules may also catch the reallocation of income.
The rules are complex, but essentially invalidate attempts to transfer the income stream, taxing the income as that of the transferor.
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Settlement legislation
The ‘settlements’ provisions are anti-avoidance rules, which are intended to prevent an individual from gaining a tax advantage from arrangements that divert income to another person who is liable to tax at a lower rate or who is not liable to tax at all.
The legislation only applies where the settlor has retained an interest in the settled property. Where an arrangement is caught by the rules, the effect is to treat the income transferred by that of the settlor as the settlor’s for tax purposes. For the legislation to apply, there must be an element of bounty. ‘Bounty’ is the provision of value without any corresponding quid pro quo. An example would be the transfer of rental income to another person without receiving anything in return.
The settlements legislation may circumvent attempts to transfer rental income to spouses and minor children. For example, if a parent transferred rental income to a minor child, the rental income would continue to be taxed as that of the parent (if more than £100).
The settlements legislation contains an exemption for outright gifts between spouses and civil partners. The rule that income is treated as remaining the settlor’s where the settlor retains an interest in the property in a settlement does not apply to an outright gift by one spouse or civil partner to another, unless:
- the gift does not carry a right to the whole of the income; or
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the property given is wholly or substantially a right to income.
A gift is not regarded as an outright gift if it is subject to conditions or there are circumstances in which the property, or any related property:
- is or will become payable to the giver; or
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is applicable, or will become applicable, for the giver.
Example 1: Settlements: outright gifts exemption
Mr A has a property he rents out. The property is in his sole name. He transfers the property to his wife, and following the transfer, she receives the rental income. Mr Brown has no further rights over the property following the transfer.
The gift is an outright gift and the exemption from the settlements legislation for outright gifts between spouses and civil partners applies.
Example 2: Gift with strings attached
Mr B also owns a rental property. He transfers the property to his wife but does so under an agreement under which his wife can return the property to him at a later date. The gift is not an outright gift as it is made under circumstances whereby the property can be returned to the giver.
Consequently, the exemption does not apply. Under the settlements legislation, the rental income received by Mrs B is treated as Mr B’s income, despite the fact the rental income is paid to Mrs B, and he has no right to it while the property remains in her name.
To ensure that the protection given by the exemption is not lost, gifts between spouses must be outright gifts, made without conditions.
Jointly owned property: Spouses and civil partners
Where property is owned jointly by spouses or civil partners, specific rules apply to determine the allocation of income between them.
The default position is that regardless of the actual underlying beneficial ownership, each spouse is treated as receiving 50% of the income. This may or may not work in their favour.
Example 3: Share and share alike
Mr and Mrs C own a property jointly as tenants-in-common. Mr C owns 90% of the property and Mrs C owns 10%. Mr C is an additional rate taxpayer. Mrs C has no other income.
Mr and Mrs C are each taxed on 50% of the rental income. This is advantageous as income that would otherwise be taxed as that of Mr C (if the income was allocated in accordance with their ownership shares and taxed at 45%) is instead taxed on Mrs C and is tax-free to the extent that it is covered by her personal allowance and taxed at the basic rate otherwise.
Where this does not work in the couple’s favour, they can elect instead to have the income taxed by reference to their underlying beneficial shares by making an election on Form 17. If Mr C instead owned 10% of the property and Mrs C owned 90%, a Form 17 election would be beneficial; Mrs C would be taxed on 90% of the rental income utilising her personal allowance and basic rate bands.
To tailor the income allocation to achieve the best tax result, it may be necessary to alter the underlying beneficial ownership. It should be remembered that it is possible to transfer an asset or a share in an asset to a spouse or civil partner without triggering a chargeable gain as the transfer is made on a no gain, no loss basis. Therefore, the income allocation can be changed without unwanted attention from the taxman by changing how the property is owned and making a Form 17 election.
Jointly owned property: Owners, not spouses or civil partners
Where property is jointly owned and the owners are not spouses or civil partners, the position is more flexible. While the income is normally allocated in relation to the ownership shares, the owners can instead agree on a different allocation between them. Each owner is taxed on the share actually received.
For example, where a property is owned by siblings, they may agree to share the rental income between them in a way that minimises the tax payable on that income regardless of how the property is owned.
Family property companies
If the rental property is held in a family company, an ‘alphabet’ share structure provides flexibility to extract the profits in a tax-efficient manner that minimises the tax payable on those profits when they are taken outside the company.
If the company has sufficient retained profits and wishes to extract those profits as dividends, an alphabet share structure provides the flexibility to tailor the dividends paid to each shareholder as each shareholder has their own class of share. This, in turn, provides the flexibility to decide how the profits are allocated. Dividends can be tailored to make use of shareholders’ unused dividend allowances and basic rate bands. Without an alphabet share structure, dividends must be paid in proportion to shareholdings.
Profits can also be extracted in the form of a salary where the shareholders’ personal allowances remain available.
Practical tip
When seeking to reallocate rental income to reduce the tax ‘hit’ on that income, be mindful of the anti-avoidance provisions and avoid strategies that fall foul of those provisions. It is advisable that professional advice is sought in advance.
