In the third and final article in the series, Lee Sharpe looks at one of HMRC’s key tools to combat income transfers between family and friends.
In previous articles, I have set out the main principles of settlements and the corresponding anti-avoidance provisions, how that works for couples who are married or in a civil partnership, and how they are ‘permitted’ in some scenarios. I also touched on property held by couples in joint names.
This final article looks at:
- arrangements for young children and grandchildren;
- other relatives, such as siblings; and
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settlements.
Doing it for the kids
Eventually, longer-term planning involving property will typically involve children – transferring interests in the property, and income that (ideally) the parent no longer needs. In some cases, the owner may want to transfer interests while the child is still under the age of 18; a minor. Two key issues arise:
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In law, a minor child cannot legally hold property, so legal ownership (as distinct from beneficial ownership) must be held ‘in trust’ for them by an adult (see, for example, HMRC’s Trust Registration Service manual at TRSM23050, but also check the position for married minor children, and under Scottish law).
So far, this alone does not prevent the child from being taxable on rental income from such property, because tax is usually concerned only with a person’s beneficial interest in the property (as distinct from the formal legal title).
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However, where the property that generates such income has been provided by the parent of an (unmarried) minor child, any income arising from that property is taxable on that parent, even if the property is an outright gift with no retained interest (ITTOIA 2005, s 629).
There is an exception if the total income for the tax year is £100 or less, so (for example) interest on modest bank savings may be ignored (although, given current interest rates, balances could be quite ‘immodest’ and still yield under £100).
This relates back to the concept that income provided to a minor child will still fall to the parent’s household – unless the child is married (or in a civil partnership) and, by broad implication, has a household of their own.
Grandchildren
Grandparents are not automatically caught by this special rule for young children; the legislation specifically targets parents rather than lineal ancestors more broadly.
However, HMRC will apply the anti-avoidance rules where the parent has entered into arrangements with other parties to provide property indirectly – including grandparents, or (for example) where adult siblings were to agree to make substantial gifts to their respective nieces or nephews, rather than their own children directly (see HMRC’s Trusts Settlements and Estates manual at TSEM4125, Example 2).
Even so, if a grandparent were to make an outright gift of money or other assets to their young (unmarried, etc.) grandchildren, the settlements anti-avoidance legislation would not be invoked automatically. Understandably, HMRC might well seek assurance that the parents had not been involved at some level – that there was no reciprocity in the arrangements. But if (say) the grandparent has their own wealth and can show that they had come to own the assets in question through their own means, then any income from those assets should be taxed on the receiving children directly.
Having dispensed with the settlements anti-avoidance regime, note that gifts of most asset classes to someone other than a spouse or civil partner may well trigger:
- capital gains tax, based on the asset’s market value at the date of the gift; and
- possibly, inheritance tax – a gift to another individual such as a grandchild will usually count as a potentially exempt transfer, with no IHT implications so long as the donor survives the gift by at least seven years; and
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for real property subject to a mortgage, potentially stamp duty land tax (or devolved equivalent) if the recipient has agreed to take responsibility for the debt.
Some final points about gifts to young children:
(a) It’s a temporary problem – the above provisions that can ‘bounce’ income back to be taxed on the parent have a shelf-life; when the child reaches 18 years (or marries, etc.), income received by the child after that date will no longer be caught by these specific provisions. Such gifts, if caught, are not permanently ‘tainted’ from the date of gift.
(b) Remember, the main settlements anti-avoidance regime may apply instead – while the special rules adjusting the income for gifts to minor children are temporary by implication, arrangements where the parent has, in fact, retained some interest in the property could be caught by the main rules (which can apply indefinitely).
(c) The child does not have to live with the parent – I have introduced the concept of ‘the settlor and their household’ to try to explain the underlying rationale for the regime, and why spouses, civil partners and minor children are also potentially caught. But the legislation for minor children does not include a cohabiting requirement or similar (even so, the idea of households may yet be helpful – see further below).
Other relatives, adult children (and friends)
The settlements regime focuses on arrangements between spouses, civil partners, and parents and their young children. But the main legislation is not limited only to such relationships; it can apply wherever someone transfers property (assets) to another party but retains an interest therein, so that they, or their spouse or civil partner, may continue to benefit from that property (as per ITTOIA 2005, s 625(1)).
For example, Vic and Bob are friends who each own half the shares of a limited company. Vic has a lot of other taxable income, so pays tax at the additional rate, while Bob pays only 8.75% tax on dividends. Vic agrees with Bob that Vic will waive his dividend entitlement so that Bob can take a larger dividend and pay only a small amount of tax; however, Bob will then transfer a proportion of that dividend income over to Vic’s husband, Gordon.
Clearly, Vic still owns the property that has generated the income (i.e., his underlying shares) and Vic or Gordon will still benefit from that income, so the corresponding amount of dividends should be taxed on Vic, despite the waiver (see also Example 3 at TSEM4200).
Settlements – So what?
Having warned that the settlements anti-avoidance regime is more widely applicable than most people appreciate, it is also worth keeping in mind that a settlement or gift of income is problematic only if the original owner (or spouse, etc.) may yet benefit. Simply put, a genuine gift of income with ‘no strings attached’ is not caught.
Here again, I think it may be helpful to think in terms of households; where a person purports to transfer or give away rights to income, and their household does not benefit from the gift, the income given away should not be taxed on the generous donor.
Example: Daughter at university
Several years ago, Papa Smurf gave 25% of his investment property to his favourite daughter, Ethel. Ethel is at university and lives away from home. Strictly, Ethel is entitled to only 25% of the rental income from that property, but Papa Smurf does not need the income, so they agree to split the rent 75% Ethel: 25% Papa Smurf. Ethel’s share of the rent is paid into an account in her sole name.
It follows that Papa Smurf has settled 50% out of his income entitlement on his daughter. But Ethel uses all that income to meet her own living expenses – Papa Smurf doesn’t see a penny of the 50% he could rightfully claim. Ethel should be taxed on 75% of the rental income, her father on only the balancing 25%.
Conclusion
This series of articles has covered the main principles underpinning the settlements anti-avoidance legislation, with an eye to the practical implications – but also its limitations. Readers will appreciate that real-world scenarios are rarely straightforward and specific advice should be taken on any meaningful transactions they feel may be caught.
