HMRC have always been called sore losers by some and when they lost the case of “Arctic Systems Ltd” in the House of Lords in 2007, the following day they simply changed the rules.
HMRC have long been fighting against what they see as disguised remuneration and the Arctic Systems case, and HMRC’s subsequent sulk, did set out the benchmark and some clearly defined pitfalls of husband and wife remuneration planning. Whilst HMRC’s current attention may be publicly focused on so-called payroll “loan schemes” (whereby part of a director/employee’s salary is paid in the form of a loan from the company which is later written off), the “Settlement rules” remain a far simpler and much more potent weapon in the Inspector’s armory.
Settlement legislation for remuneration planning can best be illustrated with this example (set out in purely financial terms). Let us say the main earner in a family is the husband who has his own business. His spouse does nothing directly to assist in the business but was gifted 80% of the shares in the company on which dividends are paid. Ignoring payroll and corporation tax liabilities, the company earns £80,000 per year and the husband draws a £40,000 salary. The remaining £40,000 is paid in dividends (of which £32,000 goes to his wife who has no other taxable income). The practical upshot of the way in which this couple arranged their affairs was to divert income from the husband to the wife, who paid tax at a lower rate than the husband. HMRC will argue – in a court of law if necessary – that this constitutes an arrangement to avoid tax as it was a structure that you would not have entered into with an arm’s-length third party.
This legislation is not new, however. In fact, John Mills, the actor (father of Hayley Mills), fell foul of it in 1974 when he paid his daughter’s earnings into a Trust where the money was accumulated rather than being paid out. The crux of the matter is whether or not a benefit is conveyed to another person (or body) by way of a settlement. In plain English, if the person who receives the income is not the person who originally earned it, a benefit has occurred. If there is then a tax differential (because for example the spouse has a lower tax rate than the earner) this attracts the attention of HMRC.
In the above example, the wife’s shares conveyed a benefit of income. The “benefit” will then be re-assessed on the husband at a higher rate of tax. However, you should contrast this with the situation where a husband runs a business via a Company where the wife had invested money to help get the business off the ground. In this case, the dividends she receives can be deemed to be a return on an investment and simply taxable on her.
HMRC will seek to apply the Settlement legislation for both Ordinary Shares and Preference shares (the latter being arguably a “right to income” anyway)
The settlement legislation can even be applied where partnerships are concerned, again where profits are diverted to a spouse who has lower rates of tax and who does not actively participate in the business.
However, the above legislation is rendered impotent with genuine gifts which are not wholly or substantially a right to income. For example, a gift between spouses of shares quoted on the stock exchange to make best use of the lower rates of tax is not caught. Where there is no control over the level of dividends to be paid, in ordinary tax planning cases such as these, the settlement rules will not apply.
Although the situation is caught by different legislation, it should be remembered that remuneration paid by a sole trader to a spouse employed under PAYE is usually given close scrutiny by the Revenue, to ensure that wages paid are at a level consistent with the duties performed for the business.
It is clear that subtle differences in arrangements or personal circumstances can have huge effects when considering this legislation. As such it is important to take professional advice when considering husband and wife remuneration and dividend arrangements. In this way, you can ensure that that the fallout from the Arctic Systems case doesn’t give you a chill whether you are in partnership, sole trader or company.