The Inland Revenue have a number of questions that they ask to see if contractors and small businesses are caught by the settlements legislation.
The relevant questions are:-
‘¢ What has been invested?
‘¢ What assets, trade, profession have been placed in the company and by whom?
‘¢ Who does what to earn the income of the company?
‘¢ Is the remuneration paid at a commercial rate for the job?
‘¢ Is someone getting a disproportionate return on the capital they have invested because of their relationship with the settler?
All these issues must be considered and if the shares are being used as a vehicle for diverting income then the legislation may apply.
During debates on the settlements legislation (originally) the then Chancellor made it clear the legislation would not apply to outright gifts between spouses. That remains the case.
Where the rights are only to income form preference shares then the settlements legislation probably would apply. There is no outright gift here.
Also, if the company has few assets and a low capital value then the shares would just be considered a ‘˜right to income‘ and would fall under settlements legislation.
However, when the gifts of shares are made to children then the dividends paid to children are deemed to be the income of the parents. Even if they received the shares from someone who once contributed to the company, e.g. their granny, their dividends would still be considered as their parents income.
It appears that for the typical limited company owned by IT contractors, there is no such thing as an ‘˜outright gift‘ and the Inland Revenue tend to view only capital assets like property as something that can be given as an ‘outright gift’.
So what is a ‘˜disproportionate return on capital‘?
As an example, if someone invested £1 in the company and got paid dividends of £35,000 then that would be a disproportionate return.
That same £1 invested in the Stock Market or a bank the return would have been much less.
Goodwill can also be thought of an asset. However, in the typical service company the goodwill is personal to the person who earns the income and does not attach to the company.
It would not be an asset for distribution in the winding up of the company and it will not enhance the value of the shares.
So what is an uncommercial arrangement?
Take for example an IT consultant who was earning £80,000 a year when working for a PLC. If she then earned £120,000 a year, with £20,000 of expenses you would expect that she would pay herself £80,000.
If instead she paid herself £40,000 and then paid £40,000 to a spouse then that would be considered an uncommercial arrangement.
Also, if the spouse undertakes 8 hours secretarial work a week and the going rate for a secretary is £6 pounds an hour then it looks uncommercial if in fact the spouse is receiving £5,000 a year from the company.
When deciding if you are caught by the settlements legislation you should ask the following question:-
‘If I was making these arrangements with an independent third party would I be paying them these wages or dividends or sharing my partnership profits in this way? If the answer is no then the legislation probably applies.
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