Reducing income tax with income splitting opportunities
Spreading ownership of assets between a husband and wife is one of the best ways of avoiding both income tax and capital gains tax. In this article we'll focus on the opportunities to save income tax.
The reason it's possible to split income is that spouses are treated as separate individuals for tax purposes BUT they are allowed to transfer assets between each other with no capital gains tax arising.
To benefit it's important that one of the spouses earns less income than the other. The best case scenario is where one spouse is a higher-rate or additional-rate taxpayer (paying 25%/30.55% tax on dividend income and 40%/50% on rental profits and interest) and the other spouse earns no income at all.
Remember that, before tax has to be paid at the 50% rate (reducing to 45% from April 2013), each UK resident individual is entitled to:
• A personal allowance, currently £10,600.
• A savings rate, currently 10% for interest.
• A basic rate, currently 20% and 0% for dividend income.
• A higher rate, currently 40% and 25% for dividend income.
The key is to make sure that your spouse's income tax personal allowance and lower rate tax bands are fully utilized. In terms of dividends, this can mean the difference between a 25% or 30.55% effective tax rate and a 0% rate, just by ensuring that shares are owned by the right person at the right time.
In these circumstances, gifting assets to the low-income spouse will reap enormous tax savings. In certain circumstances there will be absolutely no tax payable at all!
Take the example of a married man who has income above £150,000 and who owns shares which generate dividends of £30,000. He would normally pay around £10,000 in income tax. If, however, his wife has no earnings, transferring all of the shares to her would completely eliminate this tax bill.
And remember transferring assets to your spouse has absolutely no capital gains tax consequences.
However, the capital gains tax position would need to be considered when you come to sell the shares. If 100% ownership is transferred to your spouse (rather than, say, 50%) only one capital gains tax exemption will be available when the shares are sold. In other words, the best split for income tax savings may not be the best split for capital gains tax savings.
However, the good news is that you can have your cake and eat it! There's nothing to stop the lower earning spouse from owning all the shares while they are used to produce dividend income and then transferring some of the shares back to the other spouse prior to sale, so that a second annual CGT exemption can be utilised.
Let's have a look at an example to illustrate the potential benefits.
Example
David has a well paid job in the city and holds share investments that produce net dividend income of £30,000. David will pay income tax of £7,500 on the dividend income as he is a higher-rate taxpayer.
He decides to transfer the shares to his wife, Sue, who earns no other income.
She would be entitled to the personal allowance of £10,600 and given that the remaining income falls solely within the basic-rate band, the tax credit would cover any income tax liability. She would therefore have no income tax to pay on the £30,000 dividend income. This would be a tax saving for the couple of £7,500, enough to buy a small car!
To do this, 'beneficial title' to the shares must be transferred to the other spouse which some investors may not feel comfortable about.
One option is to make use of the '50:50' rule. Where investment assets are held jointly between husband and wife HMRC automatically assumes that the ownership and hence income is split 50:50, irrespective of the actual split between the spouses. In other words, one spouse can own 99% of the shares and the other spouse can earn 1%, with income split equally for tax purposes.
(This makes Revenue's job easier as it would be difficult to identify the true beneficial interests in many cases!)
Therefore, even if one owns 1%, and the remaining spouse owns 99% of a shareholding, the income would still be split 50:50. Where investment assets are held jointly by spouses the 50:50 rule will apply unless the couple make a joint declaration that they want the actual beneficial interests to apply (this can be made on a form 17 -- available from the HMRC website).
Clearly, for our share investor who wishes to split income to save tax, without giving away significant title, the answer would be to not make such a declaration.
If 50:50 is not an aggressive enough split, and you want your spouse to be taxed on all the income, it is necessary to transfer beneficial ownership in all the shares.
Although, splitting ownership can result in greater income tax savings, it's important to point out that, if the shares are sold, capital gains tax will follow the actual beneficial interest, and not the 50:50 rule. In other words, all or most of the gains will be taxed in the one spouse's hands. This could increase the CGT payable because the couple will lose one capital gains tax exemption.
It's also worthwhile noting that the 2004 Budget withdrew the 50:50 rule for shares in close companies. Basically this will apply to unquoted and family companies where the company is controlled by the directors or fewer than five shareholders. In this case, the actual beneficial interests will be used to determine the income for each spouse.
Example
Jack is a higher-rate taxpayer and buys shares worth £100,000. He gifts his wife Emily, who earns no income, a 1% interest in the shares. Dividend income of £15,000 is received during the year.
Assuming no declaration is made by Jack and Emily, the 50:50 rule will apply.
They would each be assessed on income of £7,500, with Jack paying income tax of £1,875 and Emily paying no income tax. Jack has therefore saved himself £1,875 and only transferred 1% of the title.
It would however, be more effective for Jack to transfer all of the shares to his wife. She would then receive the dividends and there would be no income tax payable on the dividends.
However, because only one person owns the shares only one CGT annual exemption will be available when they come to sell.
What Jack and Emily want to do is to minimize both income tax and capital gains tax. To minimize capital gains tax, prior to selling, Emily should transfer sufficient shares so that Jack can make full use of his annual exemption.
For example, let's say Emily holds on to the shares for several years, at which point she decides to take her profits. Let's say the shares have increased in value to £200,000. She is therefore looking at a potential gain of £100,000.
Assuming the annual exemption has risen to £15,000, Emily could transfer shares with a gain equivalent to £15,000 to Jack. This would be equivalent to a transfer of shares with a value of £30,000 (15% of her shareholding).
This option would ensure that:
• The ongoing dividend income is taxed at the lowest rate.
• Both annual exemptions are available when the shares are sold.
• Emily makes full use of her basic-rate tax band for capital gains tax purposes (18% CGT).
Although this is perfectly legitimate tax planning, it would be wise not to transfer the interest immediately prior to selling the shares. Although unlikely, HMRC could challenge the transfer in such a circumstance on anti-avoidance grounds. This type of tax planning will therefore work best where the transfer was a suitable period prior to a disposal, and no actions had yet been taken to dispose of the shares.
Beware of a Settlement
One of the main points to watch out for when looking at income splitting opportunities is making sure that you don't get caught by the so-called 'settlement provision's. These are anti-avoidance provisions which have an incredibly wide scope (and that's why it's important to take professional advice). If they apply they could prevent any benefit being obtained from income splitting as dividends received by the 'recipient spouse' would be taxed on the 'gifting spouse'.
One of cases where the settlement provisions could apply is where an individual gifts an asset but retains an interest in the gifted asset.
The settlement provisions do not apply to an outright gift by one spouse to another unless:
• The gift does not carry a right to the whole of the income or
• The property given is wholly or substantially a right to income.
When you transfer quoted shares to your spouse you would want to use the exemption for interspouse transfers. This is on the basis that you transferred shares unconditionally and that the shares represented more than 'wholly or substantially' a right to income, as they also represent rights to capital over and voting rights.
The other side of the coin is that the spouse actually making the gift must also not retain an interest in the shares. This would therefore make it vitally important that the transfer was not a 'sham' arrangement and the recipient spouse actually had rights to all the income from the shares, and did not for example pay back dividends to the gifting spouse.
This is one of those areas where it's worthwhile checking with a professional, particularly given HMRC practice in this area can change rapidly.
Using Your Children to Reduce Tax
Once your spouse's personal allowance and lower and basic-rate tax bands are used up, what next? Can you transfer income to your children?
Well, the answer is yes, you can, but unfortunately a transfer of shares to children would be classed as a disposal for capital gains tax purposes, and the disposal proceeds would be deemed to be the market value of the shares. This could result in a hefty capital gains tax bill.
Just as settlement provisions can apply to transfers where a spouse retains an interest, there is also further anti-avoidance legislation that treats income from assets gifted to children as the parent's income when the income exceeds £100.
So, for example, if there is a transfer of shares from a father to his son, the income will be taxed in the son's hands only if it is less than £100 per year. If it's more than that, the whole of the dividend payment will be taxed in the father's hands. Given that he will already have paid capital gains tax on the transfer of the shares, this would be a disastrous state of affairs.
So are there any ways to circumvent these rules? Well, firstly, it only applies to income tax and only where the income is more than £100. So a father could transfer shares which are expected to generate significant capital gains rather than dividend income.
When the children sell the shares the profits will be subject to capital gains tax. However, the potential tax bill could be quite low because children of any age qualify for an annual capital gains tax exemption.
Note that it does not make sense to purchase shares and then transfer them to children, especially if they're showing good profits already as your profits will be subject to capital gains tax. The best bet would be to consider one of the following strategies:
• Transfer cash to your children so they can buy the shares directly.
• Immediately transfer shares after you have bought them and before any gain arises.
• Purchase the shares purely as a nominee. There would need to be a written agreement substantiating this. Tax would then be payable by the beneficial owner of the shares. As the parent would be the owner of only the legal title to the shares (ie in 'name only'), the gain would be taxed in the hands of the child.
Secondly, it's important to remember that these rules only apply to children under 18 years of age.
If your children are over 18 you can transfer shares to them and the income will be taxed in their hands. Of course, this isn't much use if your children are themselves higher-rate taxpayers. However, a great many parents will be in the situation where their adult children are either studying or, if in work, paying tax at the basic rate. In these circumstances there is scope to save income tax by transferring shares to them.
If your adult children are higher-rate taxpayers but have spouses who earn little or no income, tax savings could be achieved by transferring shares directly to their spouses. Of course this is not always desirable for reasons that have nothing to do with tax.
However, many young couples who earn significantly different amounts of income have very few income-producing assets which allow them to make use of the 'poorer' spouse's personal allowance and basic-rate tax band. This is one way they can.
Remember that you will have to pay capital gains tax on any profits when you make the transfer and so may want to consider following one of the strategies outlined above.
Thirdly, the anti-avoidance rules only apply to parents transferring income-producing assets to their children. They do not apply to grandparents (or uncles and aunts etc) who gift shares to grandchildren.
Note that any gift would need to be a bona fide gift. If the gift was in fact a sham and, for example, the share proceeds were passed pack to the adult who gifted them in the first place, HMRC would argue that the beneficial interest always remained with them and tax accordingly. Therefore, transfers of shares would be useful for grandparents, in particular, who wish to transfer assets to their grandchildren and reduce their estates for inheritance tax purposes.
Example
Pete and Ethel have three grandchildren. They have a substantial estate, and amongst their various investments have £500,000 invested in an unquoted trading company listed on AIM.
This produces net dividend income of £50,000 per year. As they are both higher-rate taxpayers, the income tax charge would be £12,500.
They decide to transfer the shares to their three grandchildren. They will each receive shares worth £167,667, with annual dividend income of £16,667. As they have no other income they would pay no tax on the dividends.
On a disposal of the shares in the future, the grandchildren would be taxed on the gain at 18% to the extent they have any basic-rate tax band remaining. If Pete and Ethel held the shares, CGT at 28% would have been payable on the entire gain.
Note that in this example, unquoted trading shares were used, which we have assumed would enable the shares to qualify for gift relief on the transfer to the grandchildren. If gift relief was not available, this may make the transfer of the shares a no go, given the potential capital gains tax liability that will arise when the shares are transferred.
However all is not lost. If the shares are in a regular quoted company Pete and Ethel could treat the transfer to the grandchildren as more of a long-term exercise and realize just enough profit to make use of their annual capital gains tax exemptions (£21,200 per year).
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