In the first of a series of articles on ‘profit extraction’, Peter Rayney considers how spousal (or civil partner) dividend planning is affected by the new dividend rules.
Under the pre-6 April 2016 dividend regime, owner managers were able to pay ‘tax-free’ dividends to their spouses (or civil partners) of around £33,000/£35,000 (assuming they had no other taxable income). If the spouse did not work in the company, it was not possible to justify any salary.
However, since 2016/17, this has all changed following the abolition of the 10% dividend tax credit and the introduction of a 7.5% (basic rate) charge on dividend income. However, this does not mean that spousal dividend planning is dead! To take a few examples:
- a (non-taxpaying) spouse can take a tax-free dividend of £16,500 in 2017/18 (i.e. equal to the combined personal allowance (£11,500) and £5,000 dividend allowance); and
- it is possible for a spouse to receive a dividend of (say) £45,000 at an income tax cost of a little over £2,000 – an effective rate of 4.5% (as shown in the example below).
Example – Income tax on spousal dividend of £45,000
McVie Ltd’s issued ordinary share capital is held by John (70%) and his wife Christine (30%).
John works full-time for the company but Christine does no work for the company.
Assuming Christine has no other income, the company could pay Christine a dividend of around £45,000 in 2017/18 at an acceptable tax cost, as shown below:
Cash dividend 45,000
Less: Personal allowance (11,500)
Taxable income 33,500
BR band - £33,500 but
First £5,000 dividend nil rate band 0
Next £28,500 @ 7.5% 2,138
Tax liability 2,138
Potential HMRC challenge
Prior to the landmark ruling in Jones v Garnett  UKHL 35 (commonly known as the Arctic Systems case), the (then) Revenue sought to apply the settlement legislation to counter what it considered to be unacceptable tax avoidance, being the ‘passing’ of dividends (through split-share ownership) to lower tax paying spouses.
Consequently, to provide dividend income for spouses, it is necessary to ensure the shares are transferred or issued to them in a robust manner that avoids any challenge from HMRC. The decision in Arctic Systems tells us that such arrangements, which will generally confer bounty on the recipient spouse, will constitute a settlement (under what is now ITTOIA 2005, s 620). Broadly, this is because the spouse would acquire the shares on very beneficial terms with the practical certainty that they would produce future dividends (with the underlying company profits being generated by her husband).
Where such arrangements are caught by the settlement rules, the relevant dividend income would be treated as the settlor’s income (under ITTOIA 2005, s 624), which would nullify the tax benefits.
The outright gifts exemption
However, as demonstrated by the Artic Systems ruling, it should be possible for the ‘settlement’ to escape the settlement legislation under the ‘outright gifts’ exemption in ITTOIA 2005, s 626. Where the spouse receives ‘fully fledged’ ordinary shares, they will contain the full bundle of rights such as the right to dividends, vote, and capital on a sale or winding-up. These rights go beyond a right to a dividend (income) if one is declared. Consequently, the outright gift of shares will satisfy ITTOIA 2005, s 626(3), since they will not be ‘wholly or substantially a right to income’. This is, indeed, the point that secured ‘victory’ for Mr and Mrs Jones in Arctic Systems.
Spousal dividend planning requires careful implementation. The shares issued or transferred to the spouse must contain the full range of rights. Any attempt to create a separate class of shares with restricted rights will probably not satisfy ITTOIA 2005, s 626(3). This was demonstrated by the decision in Pearce v Young  STC 743 – here, the spouses received non-voting preference shares.
The taxpayer lost this case on the grounds that these shares only conferred a right to income!
Spousal dividends should be provided via ordinary shares.
This article was first printed in Tax Insider in June 2017.