NEWS - TAX - 15.02.2006

Victory for family companies

Facts of the case. Despite the company (Arctic Systems Ltd) having a turnover of nearly £100,000, the director paid himself a salary of just £7,000 for running the business, while his wife drew just £4,000 for administrative work. The couple then shared the remaining amount, less tax and expenses, in dividends. This is a very common strategy in family companies as it allows income to be shifted from a higher-rate taxpayer to a basic-rate taxpayer, saving tax of up to 25% of the dividend. Of course, the Taxman doesn’t like this and argued that because the husband did most of the work and did not take a market rate salary, the wife’s dividend income should be treated as the husband’s and taxed accordingly. This would substantially increase the couple’s tax bill.

The decision. The Court of Appeal ruled that paying dividends to the lower-earning wife was not tax avoidance and her husband should not, therefore, be taxed on them. Broadly, the decision was based on the fact that the wife had paid full market value for her share (albeit £1) and that her husband did not have a contract obliging him to work for the company at less than market rate. Any subsequent decision by him to draw a less than full salary, or to pay a dividend, was not part of any arrangement to save tax.

Does this decision apply to you? As long as your company shares these key features, it’s unlikely the Taxman will be able to distinguish it from Arctic Systems and you can now quite happily split the dividends between you and your spouse without fear of challenge. You should even be OK if you actually gave a share in your company to your spouse (instead of them paying for it) - the Court’s opinion was that an ordinary share is not “wholly or substantially a right to income”.

Tip. If your company set-up is similar to Arctic, but for fear of a later challenge, you included your spouse’s dividends on your 2004/5 tax return, then you could now be due a tax rebate. Speak to your accountant about removing these dividends from your return before the January 31, 2007 amendment deadline.