Shared returns

Are you a shareholder in a family company? Do you take dividends instead of salary? Is your salary reduced in order to pay more dividends? Do certain family members waive dividends so that other members can have higher ones?

If you answer yes to any of these questions, then you and your company may now be the subject of an Inland Revenue enquiry. These are at best a nuisance and at worst extremely expensive. They can generate high legal or accountancy bills and interest on underpaid tax going back several years and probably give rise to penalties.

So how has this situation arisen? The answer is a landmark High Court decision, the Arctic Systems case, which in June overturned standard tax planning advice previously given by lawyers, accountants and Business Link – the support agency run by the Department of Trade and Industry.

Business Link’s guidance did not suggest deliberately diverting income from higher rate taxpayers to other family members to save on tax. It did however suggest that family members’ pay might be “topped up” through dividends, pointing out that shareholdings between husband and wife are “a perfectly acceptable way for them to do business”.

Arctic Systems was an IT company, run by a husband and wife Geoff and Diana Jones. They acquired one share each when the company was bought “off the shelf”. Geoff Jones was an IT consultant and the only company director. Diana Jones dealt with the administration and was company secretary. They were each paid a small salary. This is a common situation, affecting family firms in many types of business.

The Revenue decided that, as Geoff Jones was the only director and he would have expected to earn a much larger salary, he had made a ‘settlement’ as defined in the Section 660A Income and Corporation Taxes Act 1988. This meant that his wife’s income would be taxable upon him. They issued an assessment for £42 000 for extra tax for the year 1999-2000 and earlier years.

The Jones’ appealed to the commissioners. The Revenue agreed to drop the claim for earlier years’ tax and proceeded on the assessment for 1999-2000. Two special commissioners heard the case and disagreed on the outcome. The senior commissioner used her casting vote and the appeal was dismissed.

The case then went to the High Court. The judge said that the taxpayer and his wife each owned a share in a company that earned profits by providing the taxpayer’s services to clients. He drew a relatively small salary so that the firm earned profits, distributed as dividends. His wife, the company secretary, received half. The Inland Revenue claimed that the company structure was a ‘settlement’. However, this legislation does not apply to outright gifts.

The judge held that there was not an outright gift, as Mrs Jones had bought her share for £1 when the company was set up. There was a settlement though, because the dividend contained ‘an element of bounty’ – a requirement for the legislation to apply. In taking a low salary, her husband had increased the company profits, therefore increasing his wife’s income. This income was therefore taxable on Mr Jones as settlor of the settlement.

As a result of their win, the Inland Revenue has issued guidance on the situations with which they are not comfortable.

Situations that would invite their attention include:

• a main earner drawing a low salary leading to enhanced profits from which dividends can be paid to shareholders who are friends or other family members;
• disproportionately large returns on capital investments eg excessive rates of interest paid on loans;
• differing classes of shares enabling dividends to be paid only to shareholders paying lower rates of tax;
• dividends being waived so that higher dividends can be paid to shareholders paying lower rates of tax. Waivers must be made before a dividend is declared, so that leaves a higher profit available for distribution to the remaining shareholders;
• income being transferred from the person making most of the profits of the business to a friend or family member who pays tax at the lower rates.

There are some important statutory exemptions from the legislation. Section 660A(6) exempts situations where the property passed to a spouse is an outright gift, unless:

• the gift does not carry the right to the whole of the income arising; or
• the property given is wholly or substantially a right to income.

Many of the situations above have long been accepted as legitimate tax planning, but now taxpayers will ignore the Revenue’s warning at their peril. Not all husband and wife firms will be affected. If a couple set up a company and run it together, it does not follow that the husband will be taxed on the wife’s dividends.

This case related to a husband and wife company, but the scope of the legislation is not limited to such situations, nor only to companies.