In order to utilize personal tax allowances, contractors running their own limited company and whose contracts are outside IR35 have often maximised their net income by splitting the shareholdings in their company with a spouse or civil partner.
However in order to combat what is perceived by the taxman as systemic tax avoidance by contracting couples the HMRC re-introduced an existing section (624 ITTOIA 2005) settlements legislation. This is also known as the ‘Husband and Wife, or ‘Family Business Tax’.
The HMRC now expects to see evidence that the dividend paid to a non-spouse can be justified through the non-fee-earner’s active involvement in the company’s affairs.
The method of splitting dividends is quite straightforward and simply requires that the contractor’s spouse or civil partner owns a percentage of the shares in the contractor limited company.
Dividends in most small companies are paid out of company profits according to the amount of shares each shareholder owns.
Simply put If a husband and wife team of two contractors with one company each own 50 shares, and the total number of shares is 100, they each own 50% of the contractor limited company.
If the dividend total were £12,000 each party would receive £6,000
Tax advantages can be gained when a contractor is earning over the higher rate tax (HRT) threshold, and their spouse or civil partner is earning below it and has an unutilised personal allowance.
For example below demonstrates what happens when an entire dividend is paid to one shareholder earning well above the HRT threshold. In this example, the HRT liability is £7,002. That’s equivalent to about month and a half’s gross fees, and a substantial sum.
| £ | |
| Income from contracting | £85,000 |
| Less: Salary paid | -£8,000 |
| Less: Estimated expenses | -£3,200 |
| Profit | £73,800 |
| Less: Corporation Tax | -£14,760 |
| Distributable profits, or dividends | £59,040 |
| Additional tax on dividends: | £7,002 |
| Monthly income after taxes: | £4,986 |
Example 2 below shows the difference made when the dividends are split between the fee-earning contractor and a spouse or civil partner who takes 50% of the dividend, but no salary. In theory the £7,002 HRT liability is wiped out by utilising the spouse’s tax allowances and because basic rate taxpayers receive a 10% tax credit that is designed to avoid double taxation with corporation tax, they have no further tax to pay.
The contractors net monthly income increases to £5,570, from £4,986, because the dividends have been split between a working and non-working spouse.
| £ | |
| Income from contracting | £85,000 |
| Less: Salary paid | -£8,000 |
| Less: Estimated expenses | -£3,200 |
| Profit | £73,800 |
| Less: Corporation Tax | -£14,760 |
| Distributable profits, or dividends | £59,040 |
| Additional tax on dividends: | £None |
| Monthly income after taxes: | £5,570 |
Spouses and civil partners are, under certain circumstances, exempt from the settlements legislation. This exemption can mean that a fee-earning contractor can gift shares, and resulting dividend income, to a non-fee-earning spouse and HMRC cannot apply the settlements legislation.
This ruling carries the following conditions:
If the income splitting regime used by the contractor fails those conditions, the spouse could be found to be inside the settlements legislation. Then they might have to consider one of the strategies for non-fee-earning shareholders outlined below.
In order to avoid being caught in the settlements legislation trap, a recommendation is that the shareholding non-spouse becomes a director of the company and plays a significant role in the management of the company. It’s important that the share allocation reflects the work undertaken by the two parties. This would show more realistic splits like 60:40 or 70:30, rather than the traditional 50:50.
The spouse or civil partner needs to have a clear role in the business to justify earning the dividends. The role could be an administration role enabling the contractor to be free to focus on fee earning. A partnership with one director earning fees and the other ensuring they are able to do so and being paid 30% of the dividend is a legitimate practice.
Contractors cannot afford to be complacent and, whilst there are still tax advantages to be gained from splitting dividends, measure must be taken to ensure HMRC is not given the opportunity to enact the settlements legislation. As stated above the non-fee-earning shareholders must have, and be able to prove, they have an active role in the company.