Alan Pink considers an anti-avoidance barrier to sharing income between spouses for tax purposes.
A lot of other countries tax the income of married couples in a different, and arguably much more sensible, manner. Rather than taking each of the spouses as a separate individual, they charge tax based on the overall household income. And often, of course, when we’re talking about ‘spouses’ we refer to unmarried partners, same-sex couples, and so on.
In the UK, it is not at all uncommon for spouses and civil partners to have income taxed at widely divergent rates of income tax. If one of the individuals is a high earner and the other stays at home, for example, the difference between the tax rates payable by the couple can currently be as high as 45%.
Of course, this applies to income generally and isn’t peculiar to the problem of rents received from investment properties. But, the rental issue is particularly topical at the moment, with the so-called ‘Osborne tax’ which is being phased in over four years starting with this year (the ‘Osborne tax’, for anyone who doesn’t understand our slang, refers to the disallowance, for higher rate income tax purposes, of interest paid on buy-to-let property loans).
With the Osborne tax, indeed, there’s the possibility of the difference between the tax rates applicable to the respective partners going above 45%: it can even be over 100% for highly geared property portfolios, where a high proportion of rents are paid out as interest to banks, etc., and where the higher earning partner is chargeable at top rates of income tax on the gross rents.
Evening up the income
It’s quite a simple concept, in principle, to even things up, or even move all of one’s rental income to one spouse, simply by transferring the ownership of the property to that spouse. But, some people feel understandably hesitant to do this because of the fear that it might be an irrevocable action! A lot of partners would prefer to give the property over, but with ‘strings attached’.
One way to do this might be by putting the property on trust, with a ‘life interest’ for the spouse. But the following example illustrates a pitfall of this idea.
Example 1: ‘Settlements’ pitfall (1)
Janet is a high-powered executive, occupying a senior role in a listed plc. Her ‘fat cat’ salary easily takes her up into the 45% rate of income tax. Her husband John, on the other hand, stays at home and looks after the house, garden, and children. To be brutally frank, John isn’t at all good with money, and indeed there are a number of claims against him from creditors, some of which, Janet fears, may not yet have come ‘out of the woodwork’.
Janet owns an investment property worth £300,000, on which the annual rents are £12,000. If she could simply transfer this £12,000 income to John, it would move from paying tax of nearly half this amount each year to there being virtually no tax at all, because of the availability of John’s personal allowance. But the last thing Janet wants is for some creditor to pounce on the property.
So, she sets up a life interest trust, in which John is the beneficiary. She remains the trustee, and therefore his creditors don’t see any change in the legal ownership on the land registry. Janet hopes that the income will cease to be hers and will become taxable on John, thus saving over £5,000 a year.
Unfortunately, this doesn’t work because of the ‘settlements’ rules.
Anti-avoidance rules against ‘settlements’
The trouble is, HMRC and the government have thought of that. To use the words of the anti-avoidance settlements legislation, where what one spouse gives the other is ‘substantially a right to income’ the settlement is ineffective for income tax purposes. So, the settlor, that is the person who made the transfer, still ends up paying tax on the income concerned.
Interestingly, this rule only applies to transfers of properties (where the asset is property) between spouses and civil partners. So, if Janet and John had not been married, this anti-avoidance rule wouldn’t have applied (however, nor would the rule that says that the transfer between the two is never chargeable to capital gains tax).
The rule also has effect in the context of properties held through limited companies, as in the following example:
Example 2: Settlements pitfall (2)
Adam owns a substantial property portfolio, through the medium of Eden Investments Limited. This regularly pays out to him dividends in excess of £150,000 per year, thus putting him in the top income tax bracket. Adam’s wife Eve has no shares in the company as yet, and has no other source of income either.
Unfortunately, although they are married, Adam doesn’t quite entirely trust Eve. He tends to blame her when anything goes wrong and the ‘obvious’ income tax planning idea of equalising the shares between the two, so that the average tax rate is minimised, doesn’t therefore appeal.
Adam’s accountant points out to him that you can have shares in a company which don’t give the same rights as the main ‘ordinary’ shares. So, Adam arranges for an equal number of new shares to be issued to Eve, which have no voting rights and no rights to the assets of the company on a winding up.
When HMRC enquires into this situation (after a few years) it attacks the planning on the basis of the ‘settlements’ rules we’ve been talking about. These shares are wholly or substantially a right to income, and therefore the dividends remain taxable on Adam.
This is one of those areas where the rules are just a bit ragged round the edges. If Adam had made the shares voting but non-participating, or vice versa, would the situation have been different? I don’t know.
What does work?
The corollary to the above rule is that a transfer between spouses of an actual capital interest in the property, rather than just a right to the income from the property, should be effective in moving the income over to the transferee spouse for income tax purposes.
Bear in mind that it’s by no means necessary for a husband and wife to have exactly equal, 50:50 interests. This is the case for joint ownership of property, but if, instead, the spouses declare themselves as ‘tenants in common’, the interests can be very far from equal.
But do bear in mind that unequal interests bring with them, as a concomitant, an unequal split of the proceeds if the property were ever sold, and therefore the potential that one spouse’s capital gains tax might be higher than the others. Also, if one of the spouses has only a very small fractional interest in the property, a sale of the property at a taxable capital gain might not fully utilise that partner’s capital gains tax annual exemption. It’s true that the interest could be transferred back into more equal proportions in anticipation of such a sale; however, making this too contrived could lead to HMRC attack on the arrangements as a ‘preordained series of transactions’.
In the property company sphere, it is obviously sensible, if you want to be as certain as possible that the arrangements will work, for your and your spouse’s shares to rank ‘pari passu’. What this means is that the two shareholdings have equal rights, voting, participating, and to receipt of dividends.
In my view, it’s not necessarily solely the case that the two spouses will, therefore, receive equal dividends. They could have an unequal number of shares without breaching the substantially ‘right to income’ prohibition. Alternatively, even if husband and wife owned the same number of shares, they could be of different classes, such that a dividend could be declared at a different rate on the husband’s shares from that declared on the wife’s.