Lee Sharpe looks at one of HMRC’s key weapons to combat income transfers between couples and other family members.
This is the first of a series of articles that will look at the so-called ‘settlements’ regime – the settlements anti-avoidance legislation (at ITTOIA 2005, Pt 5, Ch 5; starting at section 619) – and how it applies; also, how to avoid it in the various scenarios that a property owner is likely to encounter.
It should be noted that, just like the phrase ‘tax avoidance’, the word ‘settlement’ can mean different things to different people – and this is generally okay, right up to the point where it is not. Without wishing to offend lawyers, ‘settlement’ is often used interchangeably with ‘trust’, to describe when the original owner transfers one or more assets to a custodian to look after for someone else’s benefit. Or, in more traditional language: the settlor settles property in trust for the beneficiaries.
This description would work fine for, say, the taxation of trusts and inheritance tax (IHT); but when it comes to settlements and income tax, it is important to understand that (again, a bit like tax avoidance) the definition in the legislation is pretty much as wide as the government wants it to be, including any disposition, trust, covenant, agreement, arrangement or transfer of assets. That wider description does not require any trustees and can include certain gifts from one party to another.
While these articles may discuss the transfer of assets etc., we are focusing on income tax, and the wider description applies. Even so, a settlement here will include an element of gift, or ‘bounty’. So why do we not just call them gifts?
Strings attached
The thing about settlements that trigger income tax anti-avoidance measures is that they are not usually a complete or outright gift; the original owner ‘reserves some interest’ in the property transferred or imposes conditions so that he or she retains some control. Generally, ‘the settlor has retained an interest in the settled property’.
The classic example would be where someone ‘gives away’ their home, hoping to reduce their IHT liability on death, but reserves the right to live in the property until they die (in fact, IHT has its own ‘gifts with reservation of benefit’ rules, which mean that this is unlikely to work for IHT purposes).
Another example might be where one spouse or civil partner gives an asset to their spouse etc., but on condition that they will take back the asset in the event of, say, divorce or similar.
Why do we want to settle assets?
Let’s say that Amina is a successful businessperson and pays income tax at 45%. Her spouse, Sam, works part-time at a charity shop and only just pays basic rate income tax of 20%. Amina has a residential investment property that generates net rental income of £20,000 pa.
In theory, Amina and Sam as a couple could reduce their overall income tax liability if Sam paid tax on that rental income instead: £20,000 x (45% - 20%) = £5,000 pa saving.
NB In fact, as many readers will be aware, the savings could be higher if the property were mortgaged and Amina had interest costs before that profit of £20,000; she would usually be able to claim only basic rate 20% income tax relief but if Sam paid the mortgage instead, that is all the tax relief that Sam, as a 20% taxpayer, would need.
So far, we have Amina contemplating an outright gift of her residential investment property. This alone might be a settlement insofar as it amounts to a gift, but it would not yet fall foul of the settlements regime (because as yet no retained interest in the settled property). But if, for example:
- Amina gives the property to Sam on condition that Sam must return it if they separate; or
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Amina stipulates that Sam must return it (or some of the rental profits) if Amina’s income falls and she is no longer exposed to more than 20% income tax herself.
HMRC will be keen to invoke the settlements legislation because Amina has reserved some interest in the property in question.
What if the settlements regime bites?
The purpose of the settlements regime is to discourage or prevent income from being taxed on another party (usually the spouse or civil partner) at a lower rate than it would have been on the original owner (the settlor).
If the transfer amounts to a settlement and also triggers the regime, the corresponding income from that asset is taxable on the original owner (the settlor) as their top slice of income. Amina would, in effect, remain taxable on the rental income from the investment property that she had ‘given’ to Sam. Fortunately, Amina is allowed to deduct the same reliefs etc. from that income as if it had always been hers; the broad intent of the rules is to restore the pre-settlement position rather than to punish the settlor.
Under the self-assessment regime, the taxpayer is supposed to recognise when the settlements regime has been triggered, and account for the corresponding income on their own tax return. There may well be situations where a taxpayer does not realise that these wide-ranging and complex rules apply.
‘Retaining an interest’: clarification
Note that the rules focus on the property or assets being transferred.
This does not mean that if Amina decides to make an unconditional gift of (say) 70% of that investment property to Sam, and keeps 30% for herself, that she is ‘retaining an interest’ in the rented dwelling so all the rental income must still be taxed on Amina. What matters is whether Amina has retained any interest in the part transferred to Sam.
But what is actually being settled?
Up to now, we have considered the settlements regime in terms of income-producing assets being transferred to a lower-taxed individual. But it is even possible to settle the income itself.
A common example would be dividend waivers, such as where one shareholder waives their right to a dividend so that other shareholders can receive more dividend income themselves. The underlying assets (i.e., the shares) have not moved, but the first shareholder has given away a right to income, and that can trigger the settlements regime.
Suppose that Amina decides to give Sam a 50% beneficial interest in the buy-to-let property but still holds it solely in her own name. Sam is now entitled to 50% of the rental income. If Amina then decides that Sam can have, say, 75% of the rental income instead of just half, then Amina has effectively foregone her entitlement to 25% of the rental income for Sam’s benefit, so she has settled that 25% income on Sam. See, for example, Buck v Revenue and Customs [2008] SPC00716, and more recently Donovan and McLaren v HMRC [2014] UKFTT 048. HMRC will expect this to be taxed on Amina, as although there is no ‘retention of interest’ condition for settlements between spouses or civil partners, the gift wholly or substantially comprises a right to income (we shall cover this further in a later article).
Other considerations
We have so far considered settlements primarily between spouses and civil partners. This is partly because this is quite common and partly because this is relatively easy to effect.
Remember that gifts have implications for CGT and potentially for IHT (although spouses and civil partners are generally protected); likewise, mortgaged property may have stamp duty land tax implications (or the devolved equivalents) even for gifts.
Conclusion and further aspects
Our foray into the settlements anti-avoidance legislation has set out the basics of what is a settlement, when a settlement can trigger the income tax anti-avoidance regime and the effect. Future articles will cover:
- More detail on settlements between spouses or civil partners and the useful ‘spouse exemption’.
- The settlements regime and implications for gifts to children or grandchildren.
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Settlements – so what?
