It’s over ten years since the House of Lords ruled in Jones and Garnet 2007 (more commonly known as the “Arctic Systems case”) and thereby killed off HMRC’s attempt to close a tax-saving arrangement commonly used by husband and wife companies. The issue decided by the Lords was whether one spouse was taxable on dividends received by the other where only one of them generated the company’s income.
The example below demonstrates why HMRC was so keen to argue that the income generating spouse should be taxed on all dividends paid by the company.
Example. Bill and Ben are civil partners. Bill is a consultant who’s about to go freelance working through a company. He expects to generate profits of around £170,000 per year (£137,700 after corporation tax). Ben doesn’t work. If Bill owned all the shares in the company and took all its profits as dividends, he would pay income tax of £35,227 but if half the shares were owned by Ben their joint tax liability on the same income would be roughly halved to £17,577.
As time passes the finer points of the Lords’ ruling have faded from peoples’ memories. This has led to some couples and their tax advisors being over cautious or careless about splitting dividend income so that either they miss out on big tax savings or get caught by the anti-avoidance rules which nullify any tax saving. Something that especially seems to cause confusion is whether or not both spouses must own shares when the company is formed or whether income splitting is equally effective if one spouse acquires all the shares and then gives some to the other.
Tip. The answer to the question is that either arrangement is OK and will be effective in splitting the income for tax purposes.
Whys and wherefores
The explanation of why the Tip works is set out nicely in the Lords’ concise and plainly written judgment. In essence, it says that where one shareholder is wholly or mainly responsible for generating a company’s income and allows their spouse to receive a share of it either by transferring shares to them or allowing them to subscribe for them when the company is formed, it counts as a “settlement” (broadly, this means a gift).
Tip. Planning how many shares each spouse should own for maximum tax efficiency can be tricky as the company’s and each spouse’s income is likely to change from year to year. For this reason consider issuing alphabet shares to each spouse so that dividends for each can be varied.