Family Property Companies: Negotiating The ‘Settlements’ Minefield

Alan Pink considers the anti-avoidance barriers in the way of spreading property company income around family members. 

 

A property investment company can be a very flexible way of shifting income from family members who pay income tax at a high rate to those who pay tax at a lower rate.  

 

Whilst arguably property investment limited liability partnerships (LLPs) are even more flexible in this regard, what a property company does is effectively to ‘securitise’ the property holding. In order to shift income to lower tax paying family members, it isn’t necessary, where the property portfolio is held in a limited company, to go to the expense of moving property ownership from one person to another. Instead, you can spread the shares in the company and ensure that dividends are paid to the lower tax paying family members, without that income needing to be specifically related to any particular property.  

 

The basic rule for income tax purposes, of course, is that a person in receipt of dividends from a company has to declare a liability to income tax on that dividend if the amount of the dividends is more than their dividend allowance for the year (currently £2,000 per person). But the ‘settlements’ anti-avoidance rules, which are the subject of what follows, provide exceptions to that basic rule. Where the settlements legislation applies, persons other than the actual recipient of the income can be treated as if they were the recipient for income tax purposes and, therefore, made to pay the tax even though they haven’t had the income. 

 

So, the settlement's rules are one obstacle standing in the way of the completely free reallocation of income from a property company to save tax.  

 

Another possible barrier is capital gains tax (CGT), because if shares are transferred from one family member to another, this transfer represents a disposal for CGT purposes. This isn’t our subject here but suffice it to say that there are certain ways in which transfers of family property company shares can sometimes be brought about, without triggering a CGT liability – and this is not just where the shares in the company have not increased in value.  

 

For those who like to follow up the statutory references, the settlement's rules are now mostly to be found in ITTOIA 2005, Pt 5 (that is, sections 619 and following of that Act). Whilst there are a number of situations where the income of one person can be taxed on another, there are two main heads of charge which are overwhelmingly important in comparison with the others:  

It’s important to note that these anti-avoidance provisions don’t just apply where there is a ‘settlement’ in the general legal sense – that is, where a trust has been set up by a settlor on behalf of named beneficiaries. The settlements rules apply to all kinds of arrangements under which income is paid to a different person than it would otherwise have been paid to. 

 

Bearing in mind this extended definition of the term ‘settlor’ (as meaning anyone who has made arrangements under which income is paid to another person), the effect of the settlor-interested rules is to tax that person on other persons’ income where there are any circumstances where the property giving rise to the income could be payable to the settlor or the settlor’s spouse, or is applicable for the benefit of the settlor or settlor’s spouse. This applies both to the situation now and as it will or may be in the future. So, the net is cast very widely indeed; and it’s important to note the inclusion of the settlor’s spouse (or civil partner) in the definitions.  

 

Here are a few case studies to illustrate how this rule might apply.  

 

Mr Bennett has 100% of the shares in a small family property investment company. He transfers 49% of those shares to a family trust in which his children are the principal beneficiaries. The trustees are given the power to add further beneficiaries, who are members of the same family.  

 

Any income paid under this settlement is caught by the settlor-interested rules because, in this instance, Mr Bennett and his wife are not excluded from being added as potential beneficiaries in the future. It doesn’t matter whether they are actually so added; the rules will apply nevertheless, and Mr Bennett will be treated as directly taxable on all of the dividends paid on that 49%.  

 

Mr Brown has set up a similar trust, and this trust has subscribed for shares in the new property investment company he is setting up. Unlike Mr Bennett, Mr Brown has included a strict ‘exclusion clause’, under which he cannot in any circumstances be made a beneficiary or benefit in any way from the trust.  

 

Unfortunately, though, the solicitor drawing up the trust has not thought to exclude Mr Brown’s spouse because at the time he sets up the trust he is single, being a widower. On his subsequent marriage to a second Mrs Brown, the trust becomes settlor interested because there are circumstances in which Mrs Brown could be added as a beneficiary. So, all of the trust’s income, again, gets taxed on the settlor. 

 

Mr Sparks owns all the shares in the Sparks Family Property Company Limited. He decides, avowedly for tax planning reasons, to give half of the shares in this company to his wife. This is an outright gift, rather than a gift into trust.

Therefore, the ‘outright gift’ exception applies for the purposes of the settlements rules, and Mr Sparks has successfully transferred the right to the income, for tax purposes, to Mrs Sparks.  

 

This is a clear-cut case because he has transferred shares to his wife which are ordinary shares, giving all the same rights as the ones he has kept. Beware of situations where shares with diminished rights are given to a spouse. For example, if Mr Sparks had changed the company’s Memorandum and Articles of Association, such that the shares he was giving to his wife had no voting rights or no capital rights, or perhaps neither voting nor capital rights, this would put a big question mark on the issue of whether the outright gift exception could be relied on. The essential feature of outright gifts to a spouse, for them to be effective for tax purposes, is that the shares should not be ‘wholly or substantially a right to income’.  

 

There is some case law authority for the proposition that ‘funny’ shares given to a spouse will not be effective for tax planning purposes. It is therefore much more sensible to give one spouse ‘full fat’ shares; and if one wants to keep control of the company, simply resign oneself to giving a non-controlling shareholding. 

 

Mr Squires gives 50% of the shares in his property investment company to his children, who are aged two, five, and eight.  

 

Any dividends paid on these shares will be taxed on him as ‘settlor’ under the settlements on children rules. 

 

Mr Susans is a director of the family property company originally set up by his parents. His parents have given some of the shares to his own children (i.e. their grandchildren). On the face of it, this should work to avoid the settlements provisions because these don’t apply to gifts by grandparents to grandchildren.  

 

Unfortunately, however, Mr Susans has ‘muddied the waters’ by putting some money into the company himself. This gives HMRC a foot in the door to claim that he is partially responsible for the income received by his children, hence the application of the settlements on children to treat the dividend income as if it were his. 

 

Similarly, Mr and Mrs Dawson run a family property company in which three generations (of which they are generation two) all hold shares. The company, similar to the example of Mr Susans, was set up and entirely capitalised by generation one, that is, Mr Dawson’s parents.  

 

However, HMRC again is given the chance to attack the situation because Mr and Mrs Dawson, generation two, work full-time administering the property company but only take a nominal salary. So, they have made arrangements under which the company is benefited, by having their services provided at an undervalue. Again, HMRC seizes on this and claims that the income should be treated as taxable on Mr and Mrs Dawson as generation two. 

 

Finally, a case study with a happy ending! Mr and Mrs Froud have set up a trust in which their two children, aged sixteen and twenty respectively, are beneficiaries. Mr and Mrs Froud themselves are excluded from benefiting. The trust receives dividends from shares in Mr and Mrs Froud’s property investment company. 

 

Trust income paid to the twenty-year-old child is outside the rules, whereas income paid to the sixteen-year-old would be caught. So, the trust retains income (being careful not to add it to capital) which would otherwise have been paid to the sixteen-year-old, until such time as that child reaches the age of eighteen, when the income which has been ‘warehoused’ in the trust is paid out, without the application of the settlements provisions.