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Taxation of Small Company Dividends

Well, the court decision many company owners have been waiting for has finally arrived. But are we any nearer having clarity on the use of dividends by husband and wife companies? The answer is a resounding no.

One of the traditional advantages of incorporating a small business is the opportunity to make your spouse a shareholder and extract cash by making dividend payments to both of you. This was particularly attractive if one spouse had little or no other income (a non-working spouse) because basic-rate taxpayers do not pay any income tax on their dividends.

This is an old article. More up to date information on this subject is contained in our guide Salary versus Dividends

However, the taxman began to take exception to this last year and has published guidance stating that in some husband and wife companies the 'settlements legislation' could apply.

The effect of this is that the entire dividend income paid to the second spouse could be treated for tax as belonging to the other.

There was a great deal of confusion surrounding the issued guidance as not only was it unclear, there was also uncertainty as to whether it was legally sound.

So many tax professionals and small business owners have been waiting with bated breath for the first legal case to come before the Inland Revenue Commissioners.


The Arctic Systems Case

The recent case of Inland Revenue v Arctic Systems looked at the position of Geoff and Diana Jones, who own a West Sussex information technology firm called Arctic Systems.

Geoff was the sole director although both he and his wife were shareholders. As is the case with many family companies, they both extracted profits via dividends and managed to make large income tax savings.

Everything went fine and dandy until the Inland Revenue published guidance relating to the settlements legislation last year. If this applied it would deem the total dividends to be received by just the working spouse (Geoff in this case). This would clearly result in an increased overall tax bill as the other spouse's personal allowance and basic-rate tax band would not be available.

Let's have a look at the facts of the Artic systems case in a little more detail to see if they apply to you and your company.

Geoff and Diana run their business, Artic Systems Limited, through an off-the-shelf company. The majority of the technical work of the business is performed solely by Geoff. Diana handles all the financial and administrative requirements of the company and acts as the company secretary. These duties take four to five hours per week to perform.

Geoff is the only director and the company's share capital is owned equally by Geoff and Diana with them each holding one share. Diana originally subscribed £1 for her share. The company paid small salaries to both of them and declared significantly larger dividends.

The Inland Revenue is using part of the 'settlements legislation' to effectively challenge the income assessable on the non-working spouse. Before looking at the result let me explain exactly what a 'settlement' is.


What is a Settlement?

The settlement provisions provide that where a person makes a settlement (which includes making a gift of an asset such as company shares), any income arising from the asset will be taxed in the hands of the person making the settlement, if the income could become payable to him or to his spouse.

For the legislation to apply, there has to be an element of 'bounty' - something given to the other party in exchange for no consideration.

However, there is a special exemption which excludes from these provisions an outright gift by one spouse to the other unless the property gifted is 'wholly or substantially a right to income'.

Up until last year, the taxman had not interpreted this as applying to husband and wife companies and it has always been assumed that any gift of shares in a small company is not just a 'right to income' but in reality is much more.

However, Inland Revenue published guidance stating when they consider a settlement may be in point. This has always been a contentious issue and many tax professionals still believed that the use of settlements legislation in these cases was incorrect. They (and their clients) have therefore been waiting for this decision with much anticipation.

The upshot was that the two commissioners were split. One felt there was a settlement and the other felt there wasn't. It's worth examining the reasoning behind the differing views.


The First Commissioners View

The presiding commissioner felt that the use of the shares, low salaries and higher dividends constituted an 'arrangment' and that the dividend income received by the spouse constituted income received from a settlement.

She ruled that the spouse exemption could not apply as Geoff was the sole director (his wife, Diana, was just the company secretary) and as the declaration of dividends was up to directors she regarded this as "wholly or substantially a right to income." This therefore excluded the husband - wife exemption from applying.


The Second Commissioners View

The second commissioner took the opposite view. She stated that a purchase of a share may constitute a settlement, however in this case it did not. She felt there was no arrangement in place and the gift of the share to Diana was not wholly or substantially a right to income.

No one could tell at the point of initial subscription whether it would become a source of income for the future, and in any event ordinary shares give the holder a whole bundle or rights which far exceed just a right to income. She specifically made the comparison between ordinary shares and dividend-only preference shares (which could be viewed as a right to income).

As there were only two commissioners and both had opposite views, the presiding commissioner used her casting vote, and the Inland Revenue regarded this as a victory.


Will There be an Appeal?

Geoff and Diana's lawyers certainly want to appeal, so this may not be the last we've seen of the Artic Systems case. They initially approached the Inland Revenue to fund the appeal. This has been something that the Inland Revenue has agreed to in the past for certain test cases which will have a large impact on taxpayers.

However in this case, unbelievably the Inland Revenue has refused on the grounds that they do not believe the case to be "of significant interest to taxpayers as a whole."

Therefore a 'fighting fund' has been established to try and raise funds to take this to the next level (likely to be the High Court).


So Where Do You Stand Now?

There are still many professionals who believe that the decision is wrong, not just technically but also on procedural grounds.

In this case there was a deadlock, and the presiding commissioner cast her vote in the taxman's favour.

However, some lawyers believe that this was incorrect and that the casting vote does not simply give one commissioner two votes. If that is the case, it is debatable whether there would be any point in having two commissioners, as the presiding commissioner could always overrule the other.

Inland Revenue stated that it will provide some detailed guidance in the light of this decision, however on the basis of the technical and procedural objections I'd be surprised if this is the last we've heard of this case. The fact that the two expert commissioners disagreed so fundamentally also doesn't instil confidence in the decision.

It's highly unlikely that the taxman will back down on this issue and so at present current advice is to carefully review proposed remuneration strategies particularly where one spouse is a sole director, and where:

The fact that there was only director was a particular point that the presiding commissioner used to bring the settlements provisions into play.

It was argued that there was not an outright gift from Mr to Mrs Jones , as Mrs Jones was only entitled to dividend income which could be paid only if Mr Jones, as sole director, decided to distribute profits.

However, it's also important not to place too much emphasis on this point - simply electing an additional director would not, on its own, be likely to avoid the settlement provisions.

We're now in a state of limbo, but must rely on the previous guidance from the Inland Revenue being valid, until this is superseded by a contrasting court decision or further guidance.