One of the main advantages in operating a business through a small family company is that some shares in the company can easily be transferred into the name of the director’s spouse. This enables some dividends to be paid to him or her thus benefitting lower rates of tax. Everyone will remember the much celebrated Arctic Systems case in which HMRC challenged this type of arrangement but ultimately failed in the House of Lords. Although subsequently HMRC issued detailed proposals in order to prevent any tax advantage being gained by this method, those proposals subsequently proved to be unworkable and were never implemented.
This does not mean however that the whole area is a wide open goal for the taxpayer to exploit at his pleasure. In an earlier case it was not ordinary shares in the company which were given to the wives of the directors but preference shares with limited rights except as to income.
It was held that the dividends paid on these shares to the wives were to be treated as that of the directors themselves for tax purposes because the preference shares were mainly a right to income.
Income splitting is only effective where (1) the shares given away are not wholly or mainly a right to income and (2) the income stream is not used to the benefit of the donor. These shares failed the first of these two conditions.
Wholly or Mainly a Right to Income
A recent case heard by the Tax Tribunal examined a slightly different arrangement where a husband and wife jointly purchased shares in a company but most of them were put into the name of the husband.
Shortly afterwards a new class of B shares was issued to the wife so as to enable dividends to be streamed to her independently of any dividends paid on the ordinary shares. The case took quite a few unexpected turns at the hearing before the Tribunal, but the conclusions reached were that the new B shares were not wholly or mainly a right to income, even though the main point of the exercise was to enable them to receive disproportionate dividends. Nevertheless paying dividends on those shares alone was itself an arrangement for tax purposes made by the husband and this arrangement was to be regarded as a right to income (i.e. the dividends).
In principle each dividend therefore failed the first test above. Furthermore, the wife had been in the habit of paying the dividends back to the husband so that they could reduce some loans which they had taken out and this meant that he benefited from them. Thus both the hurdles which one has to surmount in order for this type of arrangement to succeed were not satisfied.
What Lessons Can We Learn From This?
The main one is that setting up a complex share structure in order to stream dividends to the director’s husband or wife is unlikely to succeed. Much better is to keep the share structure simple with simply one class of shares. There is no reason to suppose that these need to be split in any particular proportions between them. In fact it would be perfectly permissible for the director to have none of the shares and to give all of the shares to his wife.
The second lesson is that in all cases it is necessary to ensure that dividends paid on the spouse’s shareholding should not simply be paid back to the director as soon as they are received. They should be paid into a bank account in the sole name of the spouse and there should be no arrangement for him or her to use those dividends for the particular benefit of the other.
In the June 2010 Budget it was announced that a review of ‘IR35’ and the taxation of small businesses is to be undertaken and we await to see what comes of this in due course. Let us hope that the previous anti-income splitting proposals are not revived.
By Malcolm Gunn