Jennifer Adams considers the tax implications of transferring income producing assets between spouses.
The term ‘income shifting’ is used to describe the transfer of income-producing assets between family members (usually spouses or civil partners) either where one pays income tax at a lower marginal rate than the other, or to ensure that personal allowances are fully utilised. Income shifting (or splitting) is a legitimate form of tax planning, provided you are careful not to trigger any anti-avoidance rules.
In a husband and wife company scenario, if one spouse is a basic rate taxpayer and the other a higher rate taxpayer, it may be beneficial for one spouse to receive all (or most) of the distributable profits. The requirement for dividends to be paid in accordance with shareholdings may mean that by having an equal split of shares it is not possible to distribute profits in the most tax-efficient manner.
For one shareholder to be paid in preference to another or paid at a different rate, the company needs either to have different types of shares, or the underlying shareholdings need to be changed.
Alphabet shares allow flexibility for dividend payments, can be voting or non-voting, redeemable or non-redeemable and have such other rights or restrictions, as required. Alphabet shares are so called because they are normally denominated by a letter (e.g. ‘A’ ordinary, ’B’ ordinary, ‘C’ ordinary, etc.), and their use is the primary method by which a company can pay dividends at a different rate and/or different voting rights including rights to the assets on a winding up of the company.
HMRC’s view of alphabet shares is that by paying dividends to one class of share in preference to another of a similar rank is a bounteous arrangement, possibly falling foul of the 'settlements' legislation (ITTOIA 2005, Pt 5, Ch 5). The settlements provisions are a set of rules designed to stop individuals from avoiding tax by artificially diverting their income to other family members. A tax charge is imposed on the 'settlor' of a 'settlement' where he/she retains an interest in property that is settled but any resulting income is or may become payable to or applied for the benefit of him or his spouse.
However, the risk of any challenge is reduced where there is a commercial reason for having more than one class of share, where the shares have equal rights and where there is no link between dividends received and salary forgone. Dividends are a return on capital invested, whereas salary is a reward for employment, and HMRC has been known to review such arrangements to see whether a dividend payment is really an employment reward to be taxed under PAYE.
When making a distribution under an alphabet shares process it is essential that those dividends do not exceed the maximum that would have been supported by the company's distributable reserves if the highest rate of dividend had been paid on all share classes. This restriction usually means leaving some retained profit within the company. A calculation needs to be undertaken for all dividends declared; otherwise any ‘excess ‘ dividends could be construed as a 'dividend waiver' and may fall foul of the anti-avoidance rules.
In addition, to minimise the risk of HMRC claiming that the dividends could not have been paid unless one class of share was not allocated any dividend, it would be preferable for at least some dividend to be paid rather than none.
If the intention is to sell the business in the future it should be remembered that to claim business asset disposal relief the individual must generally be their ‘personal company’, which is defined by reference to at least 5% of various measures including the company’s ordinary share capital and voting rights.