Peter Rayney examines the potential tax traps of paying dividends to company shareholders who are close family members.
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Owner-managers frequently place shares in the hands of close family members (such as their spouse, civil partner or children) to obtain tax savings from the payment of suitable dividends. These family members frequently have unused personal allowances and lower tax rate bands, and therefore tax savings can be made.
As with most tax planning strategies, there are various potential traps that must be negotiated to achieve the desired tax benefits. They are the main focus of this article.
Controlling the level of dividend payments
Company law provides that each shareholder of the same class of shares must receive the same rate of dividend per share. However, this may not produce the optimal level of dividend to the relevant family members. It is possible to use judicious dividend waivers to flex dividend payments to the appropriate level, but this tends to be an awkward route. A more elegant solution is the use of separate classes of shares, and this is the one often adopted by owner-managers.
Typically, the family shareholders would each have a separate class of shares – such as ‘A’ ordinary shares, ‘B’ ordinary shares and so on. The separate classes of shares usually rank equally in relation to income distributions or dividends, voting and capital rights, but it is possible for them to have different rights. For example, one class of shares may have restricted or no voting rights. Since each separate class of shares would be entitled to income dividends, the articles or shareholder’s agreement would normally give the directors the ability to set different rates of dividend for each separate class of shares. Consequently, the directors would have sufficient flexibility to calibrate the amount of dividend paid to each shareholder.
HMRC has always taken the view that the dividends paid out to each family member must be received by them unconditionally with no strings attached. There must be no arrangements in place requiring them to transfer their dividend monies to the owner-manager. If there were, HMRC would rightly argue that they received the dividend as a nominee or bare trustee on behalf of the owner-manager. The dividend would then be taxed in the owner-manager’s hands and the desired tax savings would be entirely negated.
Dividends paid to spouses or civil partners
Shares can be issued to or transferred to a spouse on a ‘no gain, no loss’ basis for capital gains tax (CGT) purposes (under TCGA 1992, s 58). Assuming the transferee spouse is UK domiciled or deemed domiciled, there is also complete exemption for inheritance tax (IHT) purposes.
Some years after the introduction of independent taxation of husband and wife (in 1990!), owner-managers began to exploit the tax benefits of spousal dividends since they were taxed separately in (typically) their wives’ hands. A battle ensued with the (then) Inland Revenue, which sought to tax these dividends as the husband’s income using our archaic ‘settlement’ legislation. This culminated in the landmark case Jones v Garnett [2007] UKHL 35 (often referred to as the ‘Arctic Systems’ case).
To be effective, spousal or civil partner dividend planning must be implemented properly. Many of the potential pitfalls can be gleaned from the key issues in Arctic Systems.
Arctic Systems
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 (as it was then) 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 under-value) and these shares “enabled her to receive dividends on the shares which were expected to be paid”. 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 (administrative) services which Mrs Jones provided”.
Consequently, the necessary ‘element of bounty’ for the arrangement to be a ‘settlement’ existed (see ITTOIA 2005, s 624). Since the dividends were funded by Mr Jones’ work, he was the settlor of the settlement. Mr Jones was, therefore, treated as having a requisite interest in the dividend income, since it was payable to his spouse. If this analysis was right, the dividends would be taxable in his hands. However, for spousal dividends, there is an important ‘get-out’ – the ‘outright gifts’ exemption.
The ‘outright gift’ exemption
In Arctic Systems, the Law Lords found in the Joneses' favour because they were entitled to the important ‘outright gifts’ exemption for inter-spousal settlements (in what is now ITTOIA 2005, s 626). This valuable exemption applies where there is an outright gift of assets that do not represent an entire or substantial right to income. It was decided 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 on a sale, and to obtain a return of capital on a winding-up.
Thus, where a spouse (or civil partner) is provided with ordinary shares (carrying the normal full range of rights), any dividends paid on the shares should be treated as their own income. The settlements legislation cannot ‘bite’ because the ‘outright gifts’ exemption would be available. On the other hand, the use of non-voting preference shares will often be ineffective (Pearce v Young [1996] 70 TC 331).
There will, of course, be cases where shares are provided on a commercial basis so as not to constitute a settlement, as illustrated in the case of Patmore v HMRC [2010] TC 619. In such cases, HMRC would be unable to invoke the settlement rules.
Tax savings on spousal dividend
The tax benefits of paying dividends to a spouse or civil partner are clearly demonstrated by a simple example.
Example: Tax saving on spousal dividend
Mrs Cher owns 20 ‘B’ £1 Ordinary shares in her husband’s company (I Got You Babe (1965) Ltd). Her ‘B’ shares carried commensurate voting, income distribution, and capital rights. Mrs Cher’s husband holds the remaining £80 ‘A’ £1 ordinary shares and pays tax at the top rate.
During 2022/23, Mrs Cher received a dividend of %50,000 and had no other income. She would only pay £3,100 dividend income tax – an overall effective rate of some 6%, as shown below:
£ £
Dividend 50,000
Less: Personal allowance (12,570)
Taxable Income 37,430
Dividend allowance 2,000 x 0% -
Basic rate liability 35,000 x 8.75%* 3,100
Tax liability 3,100
On the other hand, if Mr Cher had received an additional £50,000 dividend instead, he would have suffered a further dividend income tax charge of some £19,675 (£50,000 x 39.35%). Thus, by paying the £50,000 dividend to Mrs Cher, the couple has saved tax of £16,575 (£19,675 less £3,100).
* In 2022/23, the basic rate of dividend tax is 8.75% (to reflect the introduction of the 1.25% Health and Social Care Levy). All dividend tax rates are increased by 1.25%. Thus, in 2022/23, the dividend tax rates are 8.75% (basic rate), 33.75% (higher rate) and 39.35% (additional rate).
Owner-manager’s adult children
In suitable circumstances, it may also be tax-efficient to provide dividend income to the owner-manager’s adult children by gifting shares to them. For CGT purposes, the gifted shares would be treated as a market value disposal (TCGA 1992, s 17).
However, provided the company is a qualifying trading entity (TCGA 1992, s 165A), a joint election can be made to hold over the capital gain (based on the market value). In most cases, it is also possible to avoid preparing a formal share valuation (see HMRC’s Statement of Practice 8/92).
For IHT purposes, the gift would be a potentially exempt transfer (PET) and, hence, subject to the seven-year survivorship rule. If the PET fails, 100% business property relief would often prevent an IHT charge.
In 2022/23, each child would have their own £2,000 nil and 8.25% dividend ‘tax-rate bands’. Consequently, they would be able to receive dividend payments at beneficial tax rates. Parents may find this strategy a less painful way of financing the increasing costs of their children’s further education. The dividend income can, of course, be applied by the child for any purpose or simply saved.
Readers will be aware that this strategy does not work for minor children (i.e., those under the age of 18 and unmarried). This is due to the ‘parental settlement’ legislation in ITTOIA 2005, s 629, which ensures that parents cannot provide a tax-effective transfer of income to their minor children.
Retirement plans?
Owner-managers who are contemplating retirement in the short term may wish to adopt a different game plan.
In appropriate cases, they should consider the benefits of retaining reserves in their company, which could potentially enhance the amount payable on a subsequent purchase of their shares by the company. Provided the amount paid for their shareholding represents market value, it may be possible for the owner-manager to obtain the valuable 10% business asset disposal relief CGT rate (up to their available lifetime gains limit) on their exit from the company via a purchase of own shares deal.
Practical tip
When the main corporation tax rate increases to 25% in April 2023, there may be cases where it is better to pay a salary or bonus rather than a dividend. However, this strategy relies on the company obtaining a full corporation tax deduction for the salary or bonus payment. Thus, it would only be worthwhile where the family member works in the business and receives a commensurate salary or bonus.
