Contractors seeking to share ownership of their company with a spouse can do so without fear of the settlements legislation, because of an exemption that was clarified in the Arctic Systems ruling.
The final Arctic Systems ruling provided contractors with certainty about the settlement legislation’s exemption for spouses and civil partners.
The case set the precedent that ordinary share ownership confers more than just a right to income. It also confirmed the existing exemption in the settlements legislation that allows contractors to jointly own their contractor limited company with a spouse or civil partner.
The settlements legislation and Arctic Systems
The original settlements legislation dates back to the 1930s and was subsequently updated first in 1988, when it became the more familiar Section 660. It was changed again in 2005 when it was updated and rewritten into its current form as the less well known but correct name, Section 624 of the Income Tax (Trading and Other Income) Act (ITTOIA) 2005.
HMRC was concerned by what it perceived as excessive tax avoidance by fee-earning contractors making ‘bounteous settlements’ of shares on their non fee earning spouses. The settlements legislation was resurrected and applied to contractors in an attempt to tackle the problem.
The test case was Arctic Systems, in which HMRC tried to prove that IT contractor Geoff Jones, the fee-earning spouse, had made a ‘bounteous settlement’ of shares in his company on his wife Diana, a non-fee earner, and the resulting dividend payments should be treated as Geoff Jones’ income, and taxed accordingly.
Arctic Systems clarified the settlements legislation exemption for spouses
Arctic Systems was interesting because the case was initially all about whether the shares gifted by Mr Jones were a bounteous settlement on Mrs Jones, and HMRC won.
The final ruling by the House of Lords, however, confirmed that ordinary shares come with more than just rights to income; they include rights to vote on company matters and the right to a return of capital when the company is closed.
As a result, the House of Lords ruled that the payments to Diana Jones were indeed dividends which were taxable on her and, crucially, clarified an existing exemption in the original settlements legislation, which is that contractors who gift ordinary shares in their limited company to their spouse or civil partner are exempt from the settlements legislation.
The exemption from the settlements legislation is only for spouses and civil partners
Contractors should be warned that the exemption is only for spouses and not other family members or friends: If a contractor gives ordinary shares to a spouse or civil partner, the transaction is exempt from the settlements legislation and there are no capital gains tax or inheritance tax liabilities.
But if the shares are given to a sibling, child or other family member, then the contractor gifting the shares may still be considered to have an interest in the income arising, and will be taxed accordingly.
Caution should be exercised when gifting shares to anyone other than a spouse . He therefore urges contractors who wish to, for example, gift shares to a friend or family member to consult their accountant beforehand.
Belt and braces: ideally share transfers should be commercial transactions
Despite the exemption for spouses, contractors take a belt and braces approach and demonstrate that any share transfer from a contractor to a spouse is a commercial transaction: The shares can be part of a spouse’s remuneration for working on the business alongside the main fee-earning contractor. A record of time spent and tasks completed would be good evidence.
The other option is for the spouse to buy the shares at market value. However, although it’s a big plus point in favour of the share transfer being a commercial transaction, the valuation process of a contracting business is inherently flawed. If an HMRC inspector really wants to pick holes in a contractor’s share valuation, they will.
So a contractor’s spouse may buy the shares at a fair market value, but there is no market in shares in contractor limited companies, because contractors don’t typically sell their companies when they retire; they close them. That means any valuation is likely to be subjective and could be challenged by HMRC.
What happened to the plans to introduce new income shifting legislation?
Following the Arctic Systems ruling, the then Government vowed to legislate further and outlaw income shifting between spouses, but the 2008 proposals to change the law were deferred to 2009, and then the government changed.
Contractors may not have seen the last of the proposed anti-income shifting legislation and the project is still on the shelf waiting. Any future proposals for new income shifting legislation may come from the Office of Tax Simplification (OTS), which continues to make recommendations to the Government on changes to small business taxation.
Settlements legislation S624 ITTOIA 2005 contractor strategy checklist
An exemption checklist for contractors is as follows:
- Make sure shares given to a spouse are ordinary shares: preference shares or other classes of shares will not qualify for the spouse’s exemption
- Make sure the gift is an “outright gift”: any dividends paid to the spouse should be their income to spend as they wish and not just a mechanism for routing money back to the main shareholder
- Avoid dividend waivers: these are viewed by HMRC as only diverting income to the spouse and the exemption clarified in the Arctic Systems case does not apply.
- Ensure all share transfers and dividends are backed up by paperwork: use signed stock transfer forms and produce board minutes and vouchers for dividends
- Record the spouse’s contribution to the business: Document evidence that the spouse works in the business, so that this can be supplied to HMRC if required.