Contractors trading via a limited company who want to share company ownership and income with a non-fee-earning partner, family member or friend are at risk of HMRC inspection and possible penalties under the Section S624 settlements legislation, formerly known as Section 660.
If payments to a non-fee earner are found to be inside the settlements legislation, HMRC will treat all the income as being earned by the contractor, and tax them accordingly. But there are a number of strategies contractors can adopt to minimise the possibility of the income paid to the non-fee earner attracting HMRC’s attention.
The settlements legislation does not apply to spouses
HMRC cannot apply the settlements legislation to arrangements between spouses. This was confirmed by the House of Lords ruling against HMRC in the Arctic Systems case. HMRC had tried to prove that IT contractor Geoff Jones, the fee-earning spouse in a husband-and-wife-owned limited company, had made a ‘bounteous settlement’ of shares in his company on his wife Diana, a non-fee earner.
HMRC had argued that the resulting dividend payments to Diana should be treated as Geoff Jones’ income, and taxed accordingly. But HMRC lost the case, and the ruling has provided married contractors with certainty about the settlement legislation’s exemption for spouses and civil partners.
As long as the shares are ordinary class shares, this means a fee earning contractor can jointly own a limited company with their non-fee-earning spouse or civil partner, split the income from the ordinary shares, and have no fear that HMRC will attempt to tax all the income as the contractor’s.
Solutions for non-spouses
The Arctic Systems case did not provide an exemption for contractors seeking to split share ownership and income with a non-spouse, such as a partner, family member or friend. So to avoid HMRC claiming that shares and income has been ‘settled’ by the fee-earning contractor on their non-free earning partner, the income must be justified on commercial grounds.
Contractors could consider the following:
- Investment/share purchase: the non-earning spouse can make an investment and buy shares in the contracting business at market rate. This may be a good option if the contracting business has potential to grow beyond a single fee-earning contractor. The pitfall of this approach is that there may be limited or no financial net benefit for the non-fee earner. Also, shares in small privately-owned companies like those typically run by contractors are notoriously hard to value, and HMRC can challenge the share valuation.
- Justify the share split and income: Non-fee earning does not mean non-working, and many contractor limited companies would rapidly cease to function if the non-fee-earner stopped sending out invoices, handing banking and keeping the books. If the non-fee-earner has a defined role in the business, it is possible to justify to HMRC that shares and resulting dividend income are fair compensation for the work the non-fee-earner puts into the business.
Settlements no-go zones
HMRC is applying increasingly sophisticated data-mining tools to profile high-risk tax avoidance targets, and the settlements legislation is still an area in which HMRC investigations are active. So contractors should avoid:
- Creating complex share structures with multiple classes of shares. HMRC can and does access Companies House records, and the spousal exemption is called into question if the shares are not ordinary
- Using dividend waivers to shift the fee-earner’ dividend payments onto their spouse, particularly if the non-fee earner has a low percentage of shares. This really is like waving a flag and shouting out, ‘Please investigate me!’
- Forgetting to complete and file the paperwork. All share transfers and dividends must be backed-up by paperwork. If they’re not, HMRC could, for example, simply reclassify payments as earnings, not dividends, and tax and fine the fee-earner and non-fee-earner accordingly.
If the tax savings of splitting an element of ownership and resulting income from a limited company are likely to be significant, contractors should speak to their accountant before taking any key decisions.