Adding a second shareholder is straightforward, but may create issues you should be aware of. If the procedure is not carried out correctly, HMRC may deem the appointment of a second shareholder as ‘income shifting’. This means transferring some of the taxable profits you have made to another individual with less tax liability, thereby reducing your own tax liability.
In the Budget Report issued on 22 April 2009 the Government confirmed that they would defer introducing legislation on income shifting and will keep the issue under review. The draft legislation was designed to tackle what the Government sees as the unfair tax advantage gained in some small businesses where the dividends are split between family members. Paying dividends to a second shareholder is allowable as long as they are implemented correctly. HMRC has not introduced legislation on income shifting but the associated risks have not gone away.
The issue of income shifting originated in 2003 when HMRC suffered a major defeat in court against a company called Arctic Systems. Law Lords effectively backed a tax avoidance arrangement used by thousands of small business married couples. The Arctic Systems case and the Background to Income Shifting are worth separate consideration. Here though, we look at what this means for you.
Even with the deferral of the income shifting legislation, several recent tax cases involving second shareholders demonstrate that HMRC may still challenge the tax treatment of the second shareholder, despite losing in the Arctic Systems case. It is important that you understand the potential risks for businesses with two or more shareholders.
Second shareholders who are not married
If you are not married or in a civil partnership the situation is unclear and will remain so until new guidance/legislation is issued.
In the meantime the House of Lords judgment has clarified some aspects of the position for non-married shareholders. It ruled that the transfer of the share from Mr. to Mrs. Jones in the Arctic Systems was a settlement as outlined in the legislation. Now that the settlement legislation applies, the detail of this becomes important. As non-spouses cannot benefit from the exemption available for spouses, it is likely that only dividend sharing with a commercial basis will be acceptable to HMRC.
The Treasury has said they have no wish to upset commercial arrangements. Where the arrangement with your second shareholder has a commercial basis this will support dividends being taxed separately. Your second shareholder does not need to be able to carry on your profession to be of commercial benefit to the business. They can provide assistance with administration, financial management or funding.
The efforts of the non fee-earning shareholder should be documented clearly to emphasise the commercial basis of the arrangement. Unfortunately, the House of Lords did not clarify how to value the second shareholder contribution.
Shareholders who are married or in civil partnerships
Although the Jones’ won in the Arctic case, the detail of the judgment means that the position on second shareholders has only been formally clarified for shareholders who are married or in civil partnerships.
Specifically, the House of Lords agreed with HMRC that the shareholdings in the company had been set up to minimise the tax paid by Mr. and Mrs. Jones. Because the gift by Mr. Jones had been made to his wife and the gift was of an ordinary share, an exemption applied. This exemption only applies to married couples and civil partnerships, and says that if you make a gift to your spouse/civil partner (which comprises more than just income) and it is an outright gift, you should not be taxed on the income arising from that gift.
For the gift to be seen as an outright gift the dividend should be paid into the bank account of each shareholder not into a joint bank account.
Your second shareholder dividend split
As a result of the Arctic decision, if you are married or in a civil partnership with your second shareholder and do not change the initial dividend sharing ratio (the dividend is fixed), the dividend income should continue to be taxed on the individuals who hold the share.
The risk of the second shareholder’s income being taxed on the main shareholder increases if you change the dividend split between you. In addition, how and when you change the split can increase this risk still further.
Amendments to the dividend split, particularly towards the end of the tax year, for the sole purpose of avoiding higher-rate tax, could be viewed by HMRC as aggressive tax planning. HMRC could argue that while the initial gift of shares to your spouse comprised more than just a gift of income the subsequent changes and increase in the dividend share in the favour of your second shareholder represent merely a right to income and the spouse exemption does not apply. This will mean that the dividend paid to your spouse will be taxable on you. This point has been further highlighted in the tax case - Patmore v HMRC (July 2010)
An example of this applying would be if you had an initial dividend split of 70% to you and 30% to your spouse (as a second shareholder) and this was subsequently changed to 50% to you and 50% to your spouse. HMRC could view the additional 20% share of the dividends received by your spouse as merely a right to receive income. They could then argue that this 20% remains taxable on you.
There are ways of Reducing the Risk of potential income shifting that we look at in more detail.