The House of Lords has issued a landmark ruling which will be greeted with considerable relief by small company owners throughout the land. However, the ruling is not the ‘anything goes’ judgment it is being portrayed as in some quarters. In the case in point, a company (Arctic Systems Ltd) was set up by a Mr and Mrs Jones, with both subscribing for shares.
Although all of the income of the company was generated by Mr Jones' work, the effect of their arrangements was that Mrs Jones received considerable dividends and the tax paid by the Jones family as a whole was reduced by virtue of the fact that her income was taxed at a lower rate of income tax than her husband's. They also avaoided National Insurance contributions by paying dividends rather than salaries.
The question which was in point was whether or not the original division of shares (an income producing asset) was effectively a ‘settlement’ (a gift from Mr Jones to Mrs Jones) and thus was caught by what is now S660 of the Income and Corporation Taxes Act 1988. This provides that where such a transfer takes place, with the effect that the right to income is transferred from a higher rate taxpayer to one with a lower rate, the income is treated as belonging to the transferor.
For a settlement to exist there has to be an element of bounty. HM Revenue and Customs argued that the Mrs Jones’ shares were, in effect, a ‘right to income', which had been gifted by her husband. The Joneses held that this was not the case because Mrs Jones had paid for her share when the company was formed and her shares had not been given it as a gift by her husband. The Lords unanimously rejected that defence.
However, the Joneses were successful in claiming that the exemption to the settlement legislation for transfers between husband and wife applied. The Treasury has now announced that it intends to change the law - most likely by removing the exemption for transfers between spouses (which will also apply to civil partners). Moves to make dividends subject to National Insurance Contributions are also thought to be under consideration.