Richard Curtis points out that family companies have many advantages but warns that unexpected liabilities can arise for the unwary.
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Learn more about this topic in our tax saving report, Tax Planning for Family Companies.
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An individual may form a limited company to carry on their business – or indeed to hold assets (e.g., a property portfolio). The shares in the company may be held by the individual or individuals who are actively involved in running the business, whether trading or investment.
However, shares (perhaps minority shareholdings) may also be held by other family members, perhaps a spouse, civil partner or children. The shares may yield dividend income, and this is an area where unexpected tax issues can arise.
Settlements
A potential problem when shares are given to relatives and dependents is whether the anti-avoidance settlements regime (in ITTOIA 2005) will apply. HMRC states: ‘The settlements legislation is intended to prevent an individual from gaining a tax advantage by making arrangements which divert their income to another person who is liable at a lower rate of tax or is not liable to income tax. The arrangements in question must be bounteous, not commercial, not at arm’s length, or in the case of a gift between spouses or civil partners, wholly or substantially a right to income.’
The Arctic Systems case
In Jones v Garnett [2007] UKHL 35, a consultant formed a company (Arctic Systems Ltd) through which he carried on his consultancy business, and his wife was issued one of the two shares. Dividends were subsequently declared on the shares and HMRC contended that the settlements legislation applied because income had been diverted to the wife.
However, the House of Lords held that although there was a settlement of the share by Mr Jones to his wife, her income was not treated as his for tax purposes, because the transfer of the share to Mrs Jones had been an “outright gift between spouses”. The share was not simply a right to income but of all the rights in the shares. There had to be “an element of bounty”.
Waived dividends
Generally, the settlements legislation may be invoked when it seems that income is transferred from one party to another. A common trap where this might occur is if, say, dividends are waived by the settlor (perhaps the majority shareholder) in favour of a relative who also holds shares (perhaps an adult child where the spouse exemption would not apply). The result would be that more is available to be paid to the minority shareholder. This is particularly likely to be challenged if the level of dividend paid to the recipients would not have been possible if the waiver had not been made. Remember that the company must have sufficient reserves of taxed profits from which dividends can be paid.
Family companies may also have ‘alphabet shares’, whereby each shareholder will have a different class of shares. This may avoid the problem of some shareholders having to waive their dividend entitlement if it is desired to provide more income to other shareholders because different dividends can be declared on the different classes of shares. However, HMRC may again take the point that there is a settlement if the company does not have sufficient reserves to pay a similar level of dividend to all the shareholders.
If there was an arrangement for shares to be transferred back to the donor after a period of paying a higher rate of dividend or perhaps the shares have no voting rights, this may also be evidence of a settlement.
Conclusion
Family companies can be a tax-efficient and practical way of carrying on a business or holding assets.
However, care is required when taking income from the company to avoid triggering the settlements legislation, resulting in unexpected liabilities on the settlor.
Practical tip
Take care if the company does not own significant assets and relies on the earning power of an individual, with income distributed to others through their shareholdings. If the shares are simply a right to income, this may be evidence of a settlement.
