Family taxation
By Michael Steed
Introduction
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The article
Husband and wife taxation has been a topical tax issue since Norman Lamont, then Chancellor, announced that husbands and wives would be the subject of separate taxation in the late 1980s. The recent Arctic Systems case shows that it still has the power to make headlines!
If you stand back and ask what taxation planning measures are available to husbands and wives, it would go something like this:
Capital Gains Tax
In CGT, there is a spousal exemption, which enables assets to be transferred between spouses without there being an unwanted tax hit on the transfer (S58, TCGA 1992).
Example
Fred owns a picture worth £100,000 which he purchased 5 years ago. He now wishes to transfer ownership into his wife's name. The picture is worth £150,000 at the date of the transfer. His wife, Sarah, keeps it for 2 years then sells it for £200,000.
The point for taxation, is that the value at transfer (£150,000) is ignored. When Sarah sells the picture she takes over John's acquisition costs (£100,000) and the taper relief is given on the combined period of ownership (7 years as a non-business asset giving 25% taper and thus leaving 75% chargeable)
On sale Sarah will also be eligible for her annual exemption (£9,200 in 2007/08.
The planning gets even better when it comes to the use of business asset taper relief on employee held shares (subject to some conditions).
Example
Swaphan is a higher rate taxpayer and works for a large publicly quoted trading company.
He exercises some share options in his employer's company and transfers them to his wife Naina who doesn't work as she is at home raising their children. His wife has no other source of income.
By transferring the shares to his wife, they will be able to take advantage of her lower tax rates on dividends (10% up to the basic/ higher rate boundary, which is satisfied by the tax credit that goes with dividends - so no extra tax for her). As a higher rate taxpayer, Swaphan would be subject to a tax rate of 32.5% on the gross dividend with a 10% tax credit.
If they decide to sell the shares say two years later, then it would be sensible to transfer the shares back to Swap (perhaps leaving enough gain to be covered by Naina's annual exemption) so that Swap can use his employee status to claim business asset taper relief.
The reason that this works for tax planning purposes, is that Schedule A1, TCGA 1992 only looks at the identity of the seller when it comes to shares and applies this business asset taper relief to the whole of the period of the combined ownership.
The fact that Naina is not an employee is irrelevant. Business Asset taper relief will apply to the whole of any gain incurred by Swap.
Houses
The spousal exemption can be used on transfers of properties, commonly houses. This will often happen on marriage where both parties have their own houses on marriage and they decide to sell one and put the house that is to be sold into joint names prior to the sale to gain advantage of the two annual exemptions.
Caution is needed here and this could be challenged by HMRC as an artificial; tax planning measure.
Standard tax planning suggests that there is a period of decency between the transfer and the subsequent sale. The Law Society appears to recommend to its members that the transfer should be in one tax year and any subsequent sale should be at least in the next tax year.
Buy to let properties
It is reasonably common for husbands and wives to own buy-to-let properties and the taxation of the properties then becomes important.
The basic assumption is that properties are owned 50/50 and that income from these properties will be taxed in that proportion unless an election is made (using the Form 17) and notified to HMRC.
If one of the spouses is a basic rate taxpayer and one a higher rate taxpayer, then it makes sense to make an election to split the income such that the majority of the income will go to the basic rate spouse.
It is important to appreciate that this election for income tax purposes must reflect the underlying capital split and not be made just for IT purposes.
Principle Private Residence (PPR)
The PPR rules in S222 et seq, TCGA 1992, allow the only or main residence of an individual to be free from CGT on disposal.
For spouses that live together, there can only be one PPR between them.
There is nothing to stop a PPR being overseas.
Reducing gains on buy-to-lets
If owners are flexible enough, then a buy-to-let can be transformed into a residence by living in it for a while - ideally for a year, but it could be less - (it's the quality of occupation that counts, not the quantity), then under the PPR rules in S223 (2), TCGA 1992, the last three years of ownership are deemed occupation.
To make this effective for tax purposes, it would be essential to elect the intending buy-to-let property as a main residence within two years of actual occupation of the property and then re-elect the main home say one month later.
The effect of all this is that there will be a loss of PPR on the main residence for one month, but this will normally be more than compensated for by the last three years of ownership of the buy-to-let being deemed occupation for CGT purposes.
Lettings relief
Lettings relief can extend the relief given on the sale of a house that has been a PPR at some stage and then let, to have further relief.
This relief is given under the rules in S223(4), TCGA 1992, but could be £40,000 per person. For husband and wife ownership, this then doubles to £80,000.
Inheritance Tax
There is a spousal exemption for IHT, such that gifts between husbands and wives are exempted from the IHT charge in life and death (S18(1), IHTA 1984) This is subject to one important exemption - if the receiving spouse is non-domiciled in the UK, then the exemption is capped at £55,000 (S18(2), IHTA 1984).
It is possible to use the split domicile rules to advantage. If one spouse is UK domiciled and one is not, then transferring assets to the non-domiciled spouse who then moves the asset overseas, will allow the operation of the remittance basis, such that future income and future gains will only be taxed in the UK on sums remitted to the UK.
Wills
The IHT spousal exemption can bring its own problems, especially for the family home. The application of the survivor rules under a joint tenancy will mean that the survivor takes all and the IHT exemption will automatically apply.
This will result in the loss of the nil rate band (currently £300,000 in 2007/08) at the first death and an unwanted tax liability of £300,000 at 40%, ie £120,000 on the eventual death of the surviving partner.
It is much better to structure wills such that the Joint Tenancy (JT) is replaced by a Tenancy in Common (TIC). This means that at the first death, the testator will be able to leave his or her half to a Nil Rate Band discretionary trust where the beneficiaries are the children.
The trustees of the trust will not be able to realise their asset as the surviving spouse is in the property (and in any event the trustees allow the surviving spouse to live there), but this is commonly solved by the surviving spouse giving an IOU to the trustees, such that the asset will be returned to them on the second death and then the asset, the house, is subsequently sold and the sums given to the benficiaries.
The point for IHT is that if it is properly structured, the IOU is a debt at the second death and is allowable for IHT purposes (although recent case law suggests that this planning will not be available in all circumstances).
Thus the two nil rate bands are utilised and this will cover the value of many properties in the UK.
Good legal advice is essential here.
The annual exemption
It is well known that the IHT annual exemption allows a person to give £3,000 away per tax year without there being an IHT implication. It is also fairly well known that this can be carried forward one year if it is not used.
Thus a person can give away £6,000 if this is the first gift or there has been a gap in lifetime giving.
What is perhaps less known is that if one of the spouses has money and the other hasn't, then the spouse with the money can gift money to the other spouse and then the receiving spouse can also make annual gifts of £3,000.
Thus a husband and wife could give away £12,000 in the first year of giving and £6,000 per year thereafter even if only one spouse has the cash.
Husband and Wife Company issues
Husband and wife companies are probably the most common type of company in the UK. They offer a range of non-tax and tax benefits but as recent case law shows the precise structure of shareholdings needs to be carefully considered.
Share holdings following the Arctic Systems case
In July 2007, the House of Lords handed down its decision in respect of Geoff and Diana Jones and their service company Arctic Systems Ltd.
This has surely got to be one of the most controversial tax cases of recent times. The Jones purchased an off-the-shelf company from a company formation agent and both Mr and Mrs Jones paid £1 each for their two ordinary shares. It was intended from the start that Mr Jones (the fee earning IT consultant) would take a low salary and that would leave ample post tax profits from which generous 50: 50 dividends could be paid from the company to the Jones. This was a planning measure suggested to them by their accountants. Mrs Jones would provide back-office support taking about 5 hours per week. Mr Jones was the sole director and Mrs Jones was the company secretary.
Clearly this arrangement was good news for tax and NICs for the Jones.
HMRC attacked the arrangement after having looked at the company under the IR35 provisions. HMRC were unsuccessful in respect of IR35 and so tried their luck under the S660A ICTA 1988 settlement provisions (these are now in ITTOIA 2005).
The settlements legislation contains anti-planning provisions that are designed to stop adults giving income bearing assets either to their spouses (and now civil partners) or minor children to take advantage of personal allowances and lower tax rates.
The settlement provisions do not apply where there is an outright gift to a spouse, unless the gift has strings attached, or... "the property given is wholly or substantially a right to income".
So there is a spousal get-out, but it is subject to conditions.
The House of Lords concluded that there was a settlement, but the spousal exemption did apply because an ordinary share was not wholly or partly a right to income. An ordinary share is a right to a number of things, such as the right to vote, to participate in the distribution of assets in a winding-up etc. These are rights over and above a right to income. A preference share, by contrast would be wholly or substantially a right to income.
Mrs Jones had been gifted property and the spousal exemption did apply. So what does this mean? Simply stated, it means that a couple can set up a company and where only one of them is an income earner, both can share the dividends as they wish (the Jones split the dividends 50:50, but presumably it would be possible to split them in any proportion).
The day after the judgement and entirely on prediction, the Treasury came out swiftly to say that the Government would change the law and we can expect announcements in the October Pre Budget Report.
Employee benefit issues
In a husband and wife company, care will be needed in structuring benefits, so that the right balance is struck between utility and tax liabilities.
The provision of cars will give rise to taxable benefits and these may be justified. Fuel benefit will need close scrutiny, so that the tax charge does not outweigh the benefit which may happen if the private mileage is low.
However some benefits may be worth considering - mobile phones - one per employee, will escape a tax charge. Laptops will also escape a tax charge if the private use is incidental.
The annual party (or parties) should be taken! There is no tax charge on such events, if the total cost of provision per head does not exceed £150 per tax year (S264, ITEPA 2003).
Pensions
Pension payments can be made by the company for the benefit of the husband and wife owners, provided they meet the "wholly and exclusively" test. This means that very large pension payments may be challenged by HMRC.
Salary
There are planning possibilities that include paying low salaries that are covered by the personal allowance and result in no personal tax or NIC liabilities for the husband and wife owners. The profits would be taken out of the company by dividend extraction.
Following Arctic Systems, this may be subject to changes in the Pre Budget Report.
Michael Steed is a training consultant at Kaplan Financial - Regional Corporate Division. He develops and presents CPD Taxation courses for Kaplan Financial.
Kaplan Financial offers an extensive programme of public and tailored in-house CPD courses nationwide on taxation, financial reporting, business finance and personal development. Their 'Refresher and Update on Personal Tax' includes a discussion of husband and wife tax. Please visit the Kaplan Financial website for more details.
