Income splitting between husband and wife

It was as long ago as 1938 that legislation was introduced to prevent a husband or wife gaining a tax advantage by putting assets into the name of the other whilst retaining some future entitlement from them. This legislation is known as the 'settlements legislation' and although that makes one think of trusts, the title is a complete misnomer as the legislation applies to any form of gift or arrangement between them.

There is an important exception from the legislation. It applies where there is an outright gift of an asset (outright meaning not in trust, at least on HMRC's interpretation) and the gift is not wholly or substantially a right to income without capital entitlement. The necessity for an outright gift also precludes any conditions to the gift or any circumstances in which the donor may benefit in the future from the asset or from the income produced by it. So the exception is subject to detailed conditions, but an outright transfer of shares, for example, from husband to wife will in normal circumstances be a typical example of what is excluded from the settlements legislation.

As is widely appreciated, if a gift of quoted shares may be made between married persons with full effect for tax purposes, so also shares in a family company may be transferred between them; any such gift will normally be within the exception to the settlements legislation mentioned above. Thus it will not matter that either the husband or the wife is the only employee of the company and is therefore the one producing all the profits. Dividends on shares split between them are not caught by the settlements legislation and those dividends therefore go on their own respective tax returns.

This of course gives a significant opportunity for tax planning in relation to small family companies. The planning was upheld in the well-known Arctic Systems case and although HMRC attempted to change the law following that case, their proposals were eventually dropped. As a result, it is not even necessary for husband and wife to have equal shareholdings, or even unequal shareholdings – one may have all the shares and the other none of them. This means that trading via a family company can have a significant tax advantage as compared to trading as a partnership between husband and wife. Unless the partnership has significant capital assets, any gift of a partnership share between husband and wife will be classed as a right wholly or mainly to income and the gift will not therefore be recognised for tax purposes.

There are however limits to the principle that a gift of shares is not caught by the settlements legislation. For example in one case it was held that in the circumstances of the case, preference shares were mainly a right to income and thus the arrangement failed for tax purposes. Also, if the gift of shares is to the infant children of the director/shareholder, the exception to the settlements provisions mentioned above does not apply, because that only covers a gift between husband and wife.

A case very recently reported by the first tier Tax Tribunal has highlighted some more limitations on what can be achieved with this type of tax planning. The facts were that the husband and wife jointly purchased the shares in a trading company with the initial purchase price being financed by way of mortgage on the family home. Although it was a joint purchase,, in fact the husband took nearly all the shares transferred by the vendor and only a 2 per cent shareholding was transferred into his wife's name. Subsequently, a new class of shares was set up, these being B shares without voting rights and dividends were paid on both the classes of shares thereafter. This somewhat complex structure led HMRC to contend that the B shares were wholly or mainly a right to income and so the dividends on those shares should be taxed on the husband.

As is often the case, events at the Tribunal hearing took some unexpected turns. The Tribunal chairperson raised her own argument and then decided that it was correct, without much input by the representatives for either of the parties!

One of the reasons why HMRC considered that the arrangements failed for tax purposes was that the dividends paid on the B shares to the wife were immediately paid by her back to the husband so as to reduce the mortgage and loans taken out to buy the shares in the company. This meant that the husband benefited from the gifted shares and so the exception to the legislation as set out above did not apply. The Tribunal agreed this conclusion.

However in the particular circumstances of the case, it still found largely for the taxpayers on the basis there was a constructive trust in favour of the wife for one half of the shares purchased together by them in the company - it was after all a joint purchase. As a result, in the words of the Tribunal, 'the inequity was not in the wife receiving 40 per cent of the dividends but in that she did not receive 40 per cent of the shares'.

Whether or not there was in fact a constructive trust may be a matter of some debate. Constructive trusts arise where it can be shown that there was some prior agreement, however informal, for two parties to share the beneficial interest in an asset which is in the sole name of one of them. If the other party has altered position to his or her detriment on the assumption that he or she has an interest in the asset concerned, the court will impose a constructive trust on the other party so as to compel recognition of the entitlements of both of them. It may seem a little far fetched to apply this doctrine in the circumstances of this particular case as the whole point of the arrangements as devised, and which the husband and wife apparently agreed to, was to secure tax advantages. They could hardly have expected to have those advantages cut away by the imposition of a constructive trust. Anyway, be that as it may, the result was that HMRC's argument largely failed because all the dividends were to be split for tax purposes equally between husband and wife.

A further point discussed by the Tax Tribunal was whether the dividends themselves on the B shares were gifts by husband to wife and were thus caught by the legislation as being pure income entitlements. In principle, the Tribunal agreed that this could be the case. When the husband chose to pay dividends on the B shares without a dividend on the other shares this could be regarded as an arrangement which was caught by the legislation concerned. However this did not impact on the overall result because it remained the case that the wife was entitled to one half of the dividends paid on all the shares by virtue of the constructive trust.

The lessons to be learned from this case are as follows:

1. Although non-voting B shares are not to be regarded as an asset which is wholly or mainly a right to income, the planning is unlikely to be tax effective because the whole point of having B shares is to enable dividends to be declared on them alone at certain times. The dividends themselves can therefore be caught by the legislation, even though the basic gift of the shares will not.
2. In any husband and wife situation, where dividends are paid back on gifted shares to the other party, this will similarly cause the arrangements not to be tax effective.
3. Accordingly, the planning should be kept simple with one holding of shares and these can be split in any proportions between husband and wife so long as gifted shares are not used for the benefit of the other.

There is a final word of caution. In the June 2010 Budget the Government said that it remains committed to a review of IR35 and small business tax. What will come of this review in relation to income splitting arrangements remains to be seen.

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