Lee Sharpe looks at the key points to beware when transferring shares to make dividend payments to other family members.
Smaller owner-managed companies may be feeling a little unloved by the Chancellor right now.
On the one hand, ‘IR35 version 3.0’ is a sledgehammer waiting to smite many small companies that are contracting to larger companies (and I hear that many large companies are not bothering properly to check if their sub-contractors are actually ‘caught’, but are just re-categorising en masse to treat them as employed from April 2021). On the other, director-shareholders are typically finding that they fall neatly between the two stools of the Coronavirus job retention scheme (which applies only to salary) and the self-employed income support scheme.
Having managed largely to avoid any special benefit from the various Coronavirus support payments, owner-managed business (OMB) owners should nevertheless be largely unsurprised to find that they are somewhat higher up the list when it comes to helping to foot the bill (call it a hunch!).
With that in mind, let us turn to one of the key measures that a small family business has, to limit exposure to (even) higher tax charges (to anyone who might argue that we should all collectively have to pay more following the pandemic, I broadly concur. But aside from how little benefit that very many small companies/owners will have received from the government’s measures so far, please note that generally the overall marginal tax rate for extracting profits through dividends is already higher than it is for the self-employed, once you factor in the tax suffered by the company, before dividends can be paid out).
Income to other family members
It is common practice to pay income to family members in the household (or beyond). Salaries can help to reduce the company’s taxable profits, while utilising other people’s lower tax bands.
However, it is important to bear in mind that those wages costs will not always be allowable against corporation tax, basically unless they can be justified on a commercial basis. An annual salary of £10,000 might be modest, but even that would not be deductible if the receiving family member did absolutely nothing to earn it.
Dividends are different. While shareholders in small OMB companies are frequently also directors, (hence ‘owner-managed business’), the dividend is a return on the shareholder’s investment in the company, and requires no personal effort to ‘earn’ it. However, there is no corporation tax relief for dividends; they are paid out of post-tax profits.
Example: A tale of two businesses
Jeffrey owns 100% of his online baking tuition business, GoBakeMe Ltd. The company makes a decent profit of £121,415 in 2020/21 (who knew?) and, after a salary of £725 per month (i.e. £8,700 for the year) and corporation tax of £21,415, has profits available for distribution of £91,300.
From total gross personal income of £100,000, Jeffrey will receive around £81,000 (he will pay around £19,000 income tax on his dividend income).
George and Mildred own 50% each of their online baking tuition business, George’s Gorgeous Muffins Ltd (it was originally solely George’s business, but Mildred now owns half of the shares). It just so happens that they too make £121,415, and take a salary of £8,700 each, with the post-tax balance of distributable profits of £84,252, paid out as dividends split equally between them.
George and Mildred’s combined net personal income will be around £96,000 – roughly £15,000 more than Jeffrey on his own.
(Note that for simplicity, it has been assumed that the protagonists have no other income; nor have the companies availed themselves of the Coronavirus job retention scheme in 2020/21).
Settlements anti-avoidance legislation
The then-Chancellor Norman Lamont asserted, when debating the 1989 Finance Act: ‘Independent taxation [of spouses] is bound to mean that some couples will transfer assets between them with the result that their total tax bill will be reduced. This is an inevitable and acceptable consequence of taxing husbands and wives separately.’
Things have moved on somewhat since then: ‘husbands and wives’ now includes civil partners; and HMRC has done its level best to limit the largesse of Mr Lamont’s sentiment ever since (this is perhaps a cynical account; the relevant anti-avoidance legislation was around long before independent taxation, and HMRC will always protest that it merely follows the legislation set by the government of the day. But that overlooks that HMRC is instrumental in advising the government of the day as to what are the latest mischiefs that needed to be addressed. And then advising the government how to do the addressing).
In this context, the settlements anti-avoidance regime looks primarily to determine if the income that has ostensibly been transferred to the ‘other’ spouse or civil partner, actually still ‘belongs’ to the original transferor, (the ‘settlor’), and should be taxed on him or her by treating it as if it had never been transferred (‘settled’).
The main thrust of the legislation is to tackle situations where someone diverts income to a relative or friend, with the intention that they be taxed on it, but really the first person still materially benefits from the income ostensibly given away. Broadly speaking, the law assumes that the first person will automatically stand to benefit, in two typical scenarios.
(a) Spouses and civil partners
It is understandable that the law essentially presumes that one spouse will benefit if income is diverted to the other. However, there is an important feature of the legislation so that it does not bite if the income-generating asset transferred is substantively more than just a right to income (the so-called ‘spouse exemption’).
In the example of George and Mildred above, George has at some point given Mildred 50% of the shares in his company. That is a right to a proportion of the income and the capital wealth of the company (and a right to vote, etc.), but that did not prevent HMRC from trying to argue otherwise in the legendary ‘Arctic Systems’ case (Jones v Garnett  UKHL 35). In that case, HMRC said the husband was the major breadwinner so the income was really attributable to him, so the shares amounted to no more than a right to income in Mrs Jones’ hands. The House of Lords ruled that the spouse exemption applied, because ordinary shares amount to more than a right to income. Lamont’s largesse lives on!
(b) Minor children
Here again, transferring shares from the parent to their minor child(ren) so that they can participate in dividend income is automatically caught; in this scenario, there is no equivalent to the ‘spouse exemption’ so it applies regardless of whether the shares count as being more than just a right to income (although there is a de minimis income threshold of £100 a year, beneath which the settlements legislation is not applied).
Two final points
- If the person receiving the shares that generate dividends is someone other than either the spouse/civil partner or a minor child of the settlor, etc., HMRC basically has to look for evidence that the original ‘owner’ of the income rights will still benefit from the income given away (see, for example, HMRC’s Trusts and Estates manual at TSEM4220).
- However, if the settlor diverts the income to another person (basically anyone) but HMRC can demonstrate that the settlor, their spouse/civil partner, or the settlor’s minor children can still benefit, the regime can still bite (e.g. if Mildred gives some of her shares to her parents under arrangements that they will then use their dividends thereon to pay for Mildred’s young children’s school fees).
The foregoing is a basic introduction to the settlements anti-avoidance legislation, how it can undermine some arrangements to transfer dividend income to other family members, but how it also has limitations. It is sensible to consider the regime not only when contemplating a transfer of shares, but also subsequently to check that a change in circumstances has not affected the treatment; a prime example being where there have been dividend waivers, particularly where waivers have become habitual.
One last point; companies caught by the IR35 ‘off-payroll’ regime will struggle to benefit meaningfully from dividends, whoever holds the shares, as most of the income is taxed as being equivalent to earnings from employment.