‘Spreading the load’ with spouse dividends

Alan Pink looks at a common income tax mitigation technique, and ‘danger areas’ to avoid.

The UK tax system differs from those of certain other countries, in that it is the individual who is taxed, rather than the household. So, famously (or perhaps infamously), a household in which one of the individuals earns £100,000 and the other nothing will have a significantly higher tax bill than a household in which both spouses earn £50,000. This is because of the effect of higher rate tax on income over that figure (incidentally, where I refer to ‘spouses’ here, you can always assume that the same rules apply to civil partners). 

What I’m focusing in on here, though, is not so much the way couples are taxed on earned income received from a third-party employer, but on the way they are taxed on income taken from their own family company. The way some households get around this is by the company paying each of the spouses a wage or salary, which has the effect of reducing the company’s profits chargeable to corporation tax and, hopefully, using up each spouse’s basic rate band for income tax purposes. 

This is all very well as a profit extraction technique, but there are two drawbacks. One is that employers’ and employee’s National Insurance contributions (NICs) liabilities will apply, in addition to income tax, to the earnings taken out of the company. The other is that, in order to qualify as a deduction against the company’s tax on its profits, each spouse needs to be ‘really’ earning the amount that is paid to them. All too frequently it is the case that a spouse receives a wage, effectively, simply for being married to the protagonist in the business. Where HMRC identify this situation, they will seek to disallow the wage paid and possibly treat it, effectively, as a distribution for tax purposes. 

Dividends, on the other hand, carry with them no liability to NICs deductions (except in very rare cases), and do not carry with them any necessary implication that the person receiving the dividend has done anything to earn it.

But here we come to a case where the tax system definitely discriminates against those who are legally married and in favour of couples who decide to live together without being married. In ITTOIA 2005, Pt 5, there is a rule which deems income of one spouse to be that of the other where it arises from a ‘settlement’. 

Since this word is very widely defined, the anti-avoidance rule effectively applies wherever one spouse has done anything as a result of which the other spouse receives income (subject to an all-important exception, which I will come on to). This rule simply does not apply where one member of a couple who are cohabiting without being married makes arrangements under which the other member of the couple receives income. 

So, on to the exception. For those who like chasing section numbers, this is in ITTOIA 2005, s 626. This states that the basic rule (that the ‘transferor’ spouse is taxable on the dividends or other income received by the ‘transferee’ spouse) does not apply in situations where there is an outright gift of property (in the case we are looking at, the shares in the company) from which income arises, made by one spouse to the other, and meeting two conditions. 

The first condition is that the gift carries a right to the whole of the income (whatever that means), and the second is that the property is not wholly or substantially a right to income. Also, the gift needs to be an ‘outright’ gift (i.e. not subject to conditions or in some way reclaimable by the giver). 

This exception was examined in enormous detail in the case commonly referred to as Arctic Systems (actually the official title is Garnett v Jones [2007] UKHL 35). 

In this case, Mr Jones was running a one-man service company, supplying his own services to a third-party. He and his wife each owned shares in the company, and each received substantial dividends. However, Mrs Jones admittedly took little or no part in the management of the business. HMRC claimed that each dividend was effectively a settlement on Mrs Jones and should, therefore, be taxed on her husband. All the appellate courts which considered this case agreed with HMRC, with the vital exception of the ultimate court of appeal, which at that time was the House of Lords. They decided that, by reference to comments made by the government at the time of the independent taxation of spouses in 1990, it was envisaged by the legislation now in ITTOIA 2005 that such arrangements would be made by spouses, and that the arrangements were valid. 

In the aftermath of this case, HMRC threatened to change the rules to bring the Arctic Systems situation into the scope of the anti-avoidance rules for settlements on spouses. Their proposals, which appeared in late 2007, were that anyone in this situation receiving an excessive dividend in terms of what they contributed should effectively have their income assessed on the other person. There were immediate howls of outrage from the tax profession, who complained that this would involve difficult questions of valuation whenever anyone completed their self-assessment tax return. This gave HMRC pause for thought and, in the interim, the world economy crashed in 2008. The proposed changes to legislation were shelved, and nothing has been heard of them since. 

So, arguably it’s now ‘open season’ for this sort of planning. But here, I sound my first note of caution. This is to beware of what might be referred to as ‘funny shares’. That is shares which give less in the way of the rights over the company than you would expect from ordinary shares. 

For example, shares could be specially designated, under the Memorandum and Articles of Association of the company, to give limited or no voting rights, and/or limited or no rights over the capital of the company on a winding up. These seem to me to be dangerous from the point of view of paying dividends to a spouse (however attractive they may be to the protagonist spouse if they are a ‘control freak’) because they could be argued to be substantially a right to income and, therefore, excluded from the exception in ITTOIA 2005, s 626 as mentioned. Far better to stick to ordinary shares to be safe.

It often happens that one spouse has a significantly higher income than the other and, therefore, you would ideally wish one spouse to receive a higher dividend than the other. 

In the common situation where they are 50:50 shareholders, or something close to that, this can be achieved by the spouse with the higher income waiving their dividend, so that the spouse with the lower income can receive a greater amount without putting the waiving spouse into higher rates of tax on their dividend. 

My second note of caution relates to this: make sure that the waiver is properly executed and is legally effective before the dividend is paid; and, above all, watch out for the situation where the company does not have enough reserves to pay the notional dividend that would have had to be paid but for the waiver. In this situation, it is HMRC policy to treat this as a settlement, which they can counteract.