Understanding the Tax Implications of Family Companies and Settlements

Using a limited company to run a business or hold assets can be an efficient strategy. However, when family members hold shares, potential tax complications—especially those linked to the settlements legislation—can arise. Below, we break down these challenges and provide strategies to navigate them effectively.

1. The Settlements Legislation

The settlements legislation, as outlined in the Income Tax (Trading and Other Income) Act 2005 (ITTOIA 2005), is designed to prevent individuals from diverting income to others in lower tax brackets to reduce overall tax liabilities. This law can apply when:

• Shares are transferred to family members in arrangements that are “bounteous” or not at arm’s length.
• Income from those shares is effectively redirected for tax advantage purposes.

Key Elements of the Settlements Legislation

• Bounteous Nature: The arrangement must show generosity rather than being a commercial transaction.
• Non-Commercial Basis: Transactions that are not conducted at arm’s length are likely to attract scrutiny.
• Right to Income: The legislation may apply if the transfer effectively gives the recipient the right to income rather than control of the underlying asset.

2. Lessons from the Arctic Systems Case

The Jones v Garnett (Arctic Systems) case provides important insights:

• Mr. Jones, a consultant, transferred shares in his company to his wife, and dividends were paid on those shares.
• HMRC argued the settlements legislation applied, treating the dividends as part of Mr. Jones’s income.
• The House of Lords ruled against HMRC, stating that:
  • The transfer was an “outright gift” between spouses.
  • The share gave full rights (not just income rights) to Mrs. Jones.
  • There must be an element of bounty for the legislation to apply.

Implications for Spouses and Civil Partners

Transfers between spouses or civil partners are generally exempt from the settlements legislation, provided the recipient is given full ownership of the shares, including voting rights and other entitlements.

3. Common Traps with Dividend Payments

1. Waived Dividends:
   • If a majority shareholder waives their dividend to allow more income to be distributed to a relative holding shares, HMRC may view this as a settlement.
   • Example: If dividends paid to the minority shareholder (e.g., an adult child) exceed what the company could pay without the waiver, the arrangement may attract scrutiny.
2. Alphabet Shares:
   • These shares, which allow different dividends for different classes, can provide flexibility in distributing income among shareholders.
   • Risk: HMRC may challenge the setup if the company lacks sufficient reserves to pay equivalent dividends to all shareholders or if the arrangement appears artificial.
3. Temporary Transfers:
   • Transferring shares temporarily, especially if they lack voting rights or are expected to be returned to the donor, can be seen as a settlement.

4. Avoiding Settlements Legislation Risks

• Document Share Transfers:
  • Ensure all share transfers are formalized with clear evidence of outright ownership.
  • Avoid arrangements where shares are expected to revert to the original owner.
• Maintain Arm’s Length Transactions:
  • Structure shareholdings and dividend policies transparently, avoiding arrangements that could appear contrived for tax benefits.
• Ensure Sufficient Company Reserves:
  • Declare dividends only from taxed profits to avoid challenges on the legitimacy of the payments.
• Use Alphabet Shares Wisely:
  • Clearly define and document the purpose of issuing different share classes, ensuring they align with the company’s financial capacity and shareholder agreements.
• Seek Professional Advice:
  • Consult tax and legal professionals to structure shareholdings and dividend policies effectively while staying compliant with the settlements legislation.

5. Conclusion

Family companies can be a powerful tool for business and asset management, but they require careful planning to avoid unintended tax consequences. By understanding the nuances of the settlements legislation and structuring arrangements transparently, you can reduce the risk of unexpected liabilities and ensure that your company remains tax-efficient.

At Merranti Accounting, we specialize in helping businesses navigate complex tax laws and optimize financial strategies. Contact us to learn how we can support your business and family wealth planning goals.