Income shifting - the big picture

Income shifting revisited

Several years ago the Taxman started an ill-fated attack on Mr and Mrs Jones, the joint shareholders of Arctic Systems Ltd (ASL). Mr Jones had shifted income, in the form of dividends, from himself to his wife to take advantage of her lower tax rate. The Taxman claimed that the law treated the transfer as null and void because gifts of income between spouses were caught by anti-avoidance rules meaning that even though the dividends were legally Mrs Jones’s, they were taxable on her husband. To cut an extremely long story short the Taxman fought his case all the way to the House of Lords but lost. So why did he think he could win in the recent case against Mr and Mrs Patmore?

Husband and wife combo

On the face of it this case might appear similar to ASL. Mr and Mrs P owned all the shares in a company and Mr P diverted income to his wife by creating a separate class of shares on which the company paid dividends to her but not to him. However, what triggered the Taxman’s interest was that Mrs P didn’t keep the money, she brazenly gave it back to her husband to pay off a loan they had taken out to buy the company in the first place. What’s more, they made no secret of this. That was too much for the Taxman to take and he slapped a writ on them claiming the scheme was caught by the anti-avoidance rules.

The big picture

A furious Taxman gave evidence at the tribunal pointing to the audacity of Mr and Mrs P; they had always intended to take advantage of Mrs P’s lower tax rates by paying company profits in the form of dividends to her rather than Mr P and that was against the rules. The judge having listened patiently to the Taxman’s rant said that he had overlooked the bigger picture. She quoted one of the Law Lords in the ASL case; the Taxman had not taken a “broad and realistic view” of the facts.

With all my worldly goods...

The key point he missed was that the mortgage raised to buy the company was in joint names, meaning that Mrs P had put her share of their house up as security for the loan. Therefore, although Mr P bought the business in his name only, he was effectively holding half of it in trust for Mrs P as she had been equally behind raising the purchase money. And if half the company was really hers so were half the dividends. The creation of the separate class of shares was just a way to pay them to her in a tax efficient way. We would like to think that the light bulb in the Taxman’s head flickered on at this point as he realised what the judge’s comments meant, but we suspect a power failure!

Planning

For husband and wife companies this judgment is important.

Tip. Step back and take a “broad and realistic view”. Has one spouse contributed value to the other’s company in a less than obvious way and therefore become entitled to income in return, e.g. dividends. We bet that there are thousands of such companies funded from money generated by a joint mortgage. This judgment means that a spouse not active in the business might be entitled to receive income from it without being subjected to the anti-avoidance income shifting rules.