Many people will have heard of the concept of a business person employing members of their family in order to use up personal tax allowances or even move income out of the higher rate band into the basic rate. As with most tax planning opportunities if it sounds too good to be true then there will always be an element of risk and I want to highlight some of the key issues and legislation that effect this area.
This area is covered by something called the “settlements legislation” aka “section 624”, it covers the aggressive reallocation of earnings between family members to reduce tax bills. The good news for family tax planning is that during the test case based on “Arctic Systems Limited” the House of Lords ruled against HMRC, the bad news for tax payers was that HMRC spent £500k on legal costs.
The Arctic Systems case looks at moving dividend income and shares between a husband and wife to minimise their tax bills, it’s quite a complex area so to build some context before we delve into it lets considers some simpler examples and consider what appropriate behaviour looks like.
One of the most common mistakes made by business owners is employing their child at a full £10k a year salary to use up their personal allowance. Providing the child is 16 or over then this might seem like a good idea but as with any tax planning strategy it’s important to understand how commercially realistic the arrangement is and whether it would exist if the owner and the employee weren’t family members.
Okay so if their child had left school to work in their business then £10k a year for an unqualified school leaver working full time might make sense but what if the child was still at school studying for their A-levels or diploma? Could it still be argued that the 10 or so hours they were capable of working a week would qualify for that £10k a year salary if they weren’t related?
This is where the arrangement falls over due to its lack of commerciality and identifies the dangers of being too aggressive with tax planning, there would of course be back taxes and penalties due to HMRC after the enquiry. The key lesson learned from this scenario is that not only does the arrangement have to make commercial sense but the business owner would also be expected to provide evidence of the number of hours worked and the nature of that work.
Giving a family member a salary is one option but how about issuing them with shares in a company and then paying them via dividends. Well if it involves gifting shares to a son or daughter over the age of 18 then this can be okay providing that complete control has been handed over and that there is no financial benefit left to the parent gifting the shares. In fact it is even possible to claim holdover relief in this situation to avoid capital gains tax on the transfer.
If the child is under 18 years then there are anti-avoidance legislations that mean that the income is taxed as if it had been incurred by the parents themselves, this would make any tax planning to utilise personal allowances pointless although there are a few other benefits outside the scope of this article. Trusts can often be a better alternative to transferring shares to children outright as they reduce the responsibility place on the child at a young age.
The Arctic Systems (Jones family) case looked at a husband who was an IT contractor and wife who took care of the administration in the business, they both owned an equal share holding of ordinary shares and drew small salaries with the rest of the income coming from dividends. This meant that although the husband was doing the majority of the fee earning they were paid equally and as a family they avoided the higher tax rate.
HMRC argued that there was a lack of commerciality in this agreement and wanted to recover money relating to higher rate taxes they had missed out on, this case went through several stages of appeal with it finally being thrown out and no tax liability arising.
The saving grace for the Jones’ was based on them both having equal control and dividend rights for the company through ordinary share capital, this could have been a very different story if they had an alphabet share structure with variable dividends and voting rights. It would have been even worse for them if there was some form of agreement where the shares would be repatriated back to Mr Jones in the event of a divorce.
Family tax planning can be a very complex area but to do it safely an effort has to be made to be as transparent as possible in terms of arrangements and to behave in a way that is commercially logical. If you want help structuring your taxes to be as efficient as possible then please get in touch and together we can find the most appropriate method based on your needs.