Peter Rayney reviews the tax planning opportunities offered by spousal dividends.
Married couples (and civil partners) can create worthwhile tax savings by ensuring that they each use up their personal allowances and basic rate tax bands.
In the vast majority of cases, the ‘non-earning’ spouse does not play an active role in the business. This means that any salary paid to (typically) the wife would not be eligible for a corporation tax deduction, and hence, the overall tax and National Insurance contributions (NICs) cost would be unfavourable.
However, in many cases, tax savings could still be made through the payment of dividends to the spouse. Consequently, owner-managers typically arrange a tax-exempt gift or issue an appropriate amount of shares to their spouse.
Once the spouse holds shares, the company could pay sufficient dividends to the spouse with minimal tax liability.
Arctic Systems – the ‘settlement issue’
The landmark Arctic Systems case (Jones v Garnett [2007] UKHL 35) demonstrated that this type of ‘income shifting’ strategy is far from being straightforward. Although Mr Jones eventually won his long-running battle with the ‘taxman’, the case had to go all the way to the House of Lords for a definitive ruling.
The Arctic Systems case involved an important principle of tax law. It asked whether dividends paid to a spouse could be treated as their husband’s income for tax purposes (thus negating the tax savings).
In this case, Mr Jones was responsible for earning all the company’s profits on computer consultancy contracts but drew only a minimal salary. He was the sole director and chairman of the company. However, the 50:50 share-owning structure gave the ability to pay large dividends to his wife (Mrs Jones).
The House of Lords had little difficulty in finding that Mr Jones had created a settlement in which his wife had an interest within (what is now) ITTOIA 2005, s 620(1). Mrs Jones had acquired her shares at par (at a considerable undervalue) and these shares “enabled her to receive dividends on the shares which were expected to be paid”.
It was held that this was not an arms' length transaction because “Mr Jones would never have agreed to the transfer of half the issued share capital, carrying with it an expectation of substantial dividends, to a stranger who merely undertook to provide the paid services which Mrs Jones provided”. Consequently, the necessary ‘element of bounty’ for the arrangement to be a ‘settlement’ existed; see (what is now) ITTOIA 2005, s 624. Since the dividends were funded by Mr Jones’ work, he was the settlor of the settlement. Mr Jones was treated as having a requisite interest in the dividend income since it was payable to his spouse (ITTOIA 2005, s 625).
Mr Jones did not win on the ‘settlement’ point. Arctic Systems confirms that any gratuitous transfer or issue of shares to a spouse is likely to be treated as a settlement. There will, of course, be cases where shares are provided on a sufficiently commercially defensible basis so as not to constitute a settlement, as illustrated in the case of Patmore v HMRC [2010] UKFTT 334 (TC).
The vital ‘outright gift’ exemption
The Law Lords found in the Jones' favour because they held that the important ‘outright gifts’ exemption (in what is now ITTOIA 2005, s 626) for inter-spousal settlements applied. This valuable exception applies where there is an outright gift of assets that do not represent an entire or substantial right to income. In Arctic Systems, the Law Lords held that the ordinary shares provided to Mrs Jones were more than a pure right to income; they had a bundle of rights, including the right to attend and vote at general meetings, rights to capital growth on a sale, and to obtain a return of capital on a winding-up.
Thus, if a spouse (or civil partner) is provided with ordinary shares (carrying the normal full range of shareholder rights), any dividends paid on the shares should be treated as their income. The settlements legislation would not apply because the ‘outright gifts’ exemption would be available.
The conclusion reached in Arctic Systems may well have been different if Mrs Jones had been given (say) non-voting preference shares instead. The taxpayers in Young v Pearce [1996] STC 743 had ‘failed’ to avoid the settlement rules on this very point.
Thus, in practice the safest way to avoid this trap is to avoid restricting the rights of the shares issued to a spouse (e.g., in terms of voting power or capital returns etc.).
Dividend waivers can be problematic
Dividend waivers are a legitimate way for one or more shareholders to ‘waive’ their dividend entitlement in order to retain additional profits within the company. However, tax problems can occur when waivers are used to distribute more dividends to spousal shareholders than they would be legally entitled to on a pro-rata distribution of the company’s distributable profits.
I have broadly concluded that the issue or transfer of ordinary shares to a spouse and the payment of dividends to them should be safe from HMRC challenge. However, this will not be the case where dividend waivers have been used to provide a spouse with ‘excessive’ dividends. By this, I mean a dividend payment to a spouse that exceeds their pro-rata entitlement to the company’s profits or retained reserves. Dividend waivers are capable of falling within the settlement rules (see HMRC’s Trusts Settlements & Estates manual (at TSEM4225).
These principles were upheld in Donovan and McLaren v HMRC [2014] UKFTT 048 (TC). The First-tier Tribunal found that the dividend waivers would never have been made if the directors had been dealing with a third party at arm's length and, hence, involved a bounteous settlement (ITTOIA 2005, s 620). The settlor husbands were, therefore, taxed on the relevant excess amounts, as in the past the wives clearly received more than their pro-rata dividend entitlement. The dividend income was property in which Mr Donovan and Mr McLaren had an interest within the terms of ITTOIA 2005, s 625, since the income was payable to their wives (see also the earlier case of Buck v HMRC [2008] SpC 716).
Importantly, dividend waivers will not fall within the spousal ‘outright gifts’ exemption since the ‘transfer’ of dividend income is only a right to income. This was distinguished from the Jones v Garnett ruling because the essential arrangement here was not the allotment of the shares to Mr Donovan’s or Mr McLaren’s wives, but the waiver of dividends.
Provided the above mentioned ‘settlement’ issues are avoided, there is no reason why dividend waivers should not be made in commercially justifiable cases. HMRC could only argue that ‘bounty’ had occurred where the dividend declared could not be satisfied out of the current distributable profits unless the relevant waiver was made (i.e., the waiver would enable the other shareholders to receive a greater dividend than would otherwise have been possible). Under the settlement legislation, this element would be deemed to be the income of the shareholder executing the waiver (i.e., the settlor) and, therefore, taxed in their hands. To be effective for income tax purposes, the deed of dividend waiver must be executed before the right to the dividend arises.
Using separate classes of shares
To avoid the perennial problem of entering into dividend waivers, a more elegant solution would be to subdivide the company’s ordinary share capital into two (or more) classes of shares. Each spouse would have a different class of shares (such as £1 ‘A’ ordinary shares and £1 ‘B’ Ordinary shares) with both classes ranking pari-passu in all respects. This would enable the owner-manager or directors to declare a different rate of dividend on each share class.
However, this does not automatically bypass the settlement rules. HMRC considers that it may still be able to challenge certain arrangements involving the use of different classes of shares. For example, HMRC may seek to apply the settlement rules where the level of dividend paid on a particular class of share could not have been paid (by reference to the available reserves) without a bounteous arrangement to pay no or minimal dividends on the other class of shares (see TSEM4225 at Example 2). However, provided separate classes of shares are used sensibly, they would give the required flexibility to declare optimum levels of dividend payments to each spouse.
Practical tip
The relevant legal and practical requirements must be followed for dividend waivers, such as the need to draw up a formal deed of waiver that is signed, dated, witnessed and lodged with the company. A simple letter will not suffice.
