Should You Reduce Your Tax Bill By Paying Your Spouse A Salary?

Jennifer Adams highlights anti-avoidance rules affecting tax planning between spouses or civil partners. 

One of the most efficient methods of reducing your tax bill is by paying your spouse (or civil partner) a salary. However, you have to be careful that the payments do not fall foul of the settlement ‘income splitting’ rules. (Note: throughout this article it is assumed that the ‘spouse’ is a wife).

On first reading the ‘settlements’ legislation would appear to have nothing to do with the payment in a business situation. A settlement usually involves the creation of a trust. However, in tax law the word ‘settlement’ has a much wider meaning, being “any disposition, trust, covenant, agreement, arrangement or transfer of assets” (ITTOIA 2005, s 620(1)). Therefore a settlement could apply in any non-trust situation. 

The anti-avoidance rules (at ITTOIA 2005, s 624) further state that if a person creates a settlement but retains an interest, then the income of the settlement is treated as still belonging to the settlor. The legislation is intended to prevent an individual from gaining a tax advantage by making arrangements which divert a higher rate taxpayer’s income to someone who is liable at the lower rate of tax or not liable for tax (ie ‘income splitting’).

‘Retaining an interest’ is defined (in s 625) as including a situation where the settlor’s spouse can benefit. On its own, this section would prevent tax saving by the making of gifts of income-producing assets to spouses paying lower rates of tax. However, further legislation (at s 626) goes on to qualify the rules by stating that an outright gift between spouses is not caught provided the gift carries a right to the whole of the income and is not ‘wholly or substantially a right to income’. 

The words ‘wholly’ and ‘outright’ are important, because should the settlor retain an interest in the settled property or income, the s 624 rules apply with all income being treated as that of the settlor and thus the tax benefit would not arise. 

The question here is whether by allowing a spouse income from the business, she is actually earning a PAYE salary or whether the owner husband has created a settlement but has ‘retained an interest’ in the business.

Allocating a spouse a salary is permitted under the settlement rules, but only on condition that she contributes to the running of the business. The amount needs to be reasonable for the amount of work undertaken but care must be taken that the amount is similar to the amount that would be paid to another unrelated person in a similar role. As the amount will be an allowable deduction against profits there will be a tax saving.

The creation of a partnership might be seen to be an arrangement (settlement), especially should the spouse not invest capital in the business or take an active role in its running. If a contribution is made but the spouse receives a share of the profits out of proportion to the contribution, the arrangement could be deemed to include an element of ‘bounty’ rather than payment for the work undertaken. 

At first sight, the situation might seem to be less restrictive with a company. Again, the PAYE salary must be reasonable for the work undertaken, but by appointing the spouse as an officer a small salary could be paid even if the actual work undertaken is little, if any. Salary greater than would be paid to someone else to do the work could be investigated. 

However, the cases brought to court under the settlements rules have included arrangements where one spouse is a director owning shares in the company and receives dividends, but where the other spouse has generated most of the company’s income from which the dividends are paid. It then needs to be considered whether ‘income splitting’ has taken place. The ‘Arctic Systems’ case is a leading case in this area, involving a husband and wife company. 

In the Arctic Systems, case (Garnett v Jones [2007] UKHL 35; see

http://www.bailii.org/cgi-bin/markup.cgi?doc=/uk/cases/UKHL/2007/35.html&query=Jones+and+v+and+Garnett&method=boolean), Mr and Mrs Jones purchased an ‘off-the-shelf’ company which issued just two shares, each spouse taking just one share with no further shares being issued. Mr Jones was the sole director and Mrs Jones was company secretary. Mrs Jones worked for the company as bookkeeper but this only took four or five hours a week. The usual system of taking the primary threshold NIC salary with no tax or NIC being levied was used, with the remaining payment taken as dividends. 

HMRC’s stance was that the profits were generated by Mr Jones’ work only, and that by Mrs Jones taking a share (and thus dividends) this arrangement was a ‘bounteous arrangement’ and the settlements legislation (in s 624) applied. HMRC further contended that the allocation of the one share meant that Mr Jones had made a gift to his wife and had benefited from this gift and as such should be taxed on all dividends declared. Finally, HMRC stated that the spousal exemption (in s 626) did not apply as the company was a new company, there was no existing capital and what had been granted on the issue of the one share was a right to income.

The House of Lords agreed that the company arrangement had been used solely to minimise the tax payable, but disagreed that the reason for Mrs Jones taking a share was solely for the right to income. The judges dismissed the appeal with the words “an ordinary share carries with it much more than a right to income’.

Legislation to counteract this ruling has never been enacted (even though at the time it was threatened), but that has not stopped HMRC from trying with other cases. The low salary/dividend arrangement is fairly standard for many small companies, not least because NIC are not payable, but HMRC have challenged thousands of companies and four cases have reached the court - HMRC winning three and partially winning another. 

Various commentary published at the time of the Arctic Systems case suggested the use of dividend waivers in order to give a greater share of dividends to the spouse. However HMRC have challenged this form of tax planning on a number of occasions.

For example, in the case Buck v Revenue & Customs Commissioners [2008] SpC 716 (www.bailii.org/uk/cases/UKSPC/2008/SPC00716.html), the husband held 9,999 shares and his wife 1 share. The husband waived his dividend entitlement, allowing large dividends to be paid to his wife. It was held that this was caught by the settlements legislation, plus the ‘bounty’ point applied and hence the whole amounts of the dividends were to be taxed on the husband. 

With dividend waivers, HMRC will quote their Trusts Settlements and Estates manual at TSEM4225 (www.hmrc.gov.uk/manuals/tsemmanual/tsem4225.htm), in deciding whether the settlements legislation applies. Inter alia they will consider:

And most importantly, whether ”the non-waiving shareholder would pay less tax on the dividend than the waiving shareholder”. 

The shares should be of the same class, as in some cases HMRC have stated that they consider the use of different classes of shares, with dividends being voted separately on one or more classes so as to benefit particular shareholders, to also constitute a settlement arrangement.