By Contractor Weekly
What is it?
The Settlements Legislation is a piece of tax legislation which is now contained within Chapter 5, Part 5 of Income Tax (Trading and Other Income) Act 2005, although it is better known by its old legislative reference, S660A.
It is used by HMRC to try and counter contractors diverting their income to family members who pay tax at a lower marginal rate than the individual themselves. A common example of this is the gifting of shares in the contractors personal service company.
A bit of Background on S660A
S660A began its life in the 1930s as a part of trusts legislation. Back then it was not intended to be used in the manner that it is nowadays but HMRC saw potential to resurrect this near-dormant piece of legislation to counter what they perceived to be a growing threat - the settlement of income on spouses or civil partners for the purpose of avoiding paying higher rate tax.
HMRC started using S660A as a weapon against contractors in early 2000s but this was short lived following the 2007 House of Lords judgement in the Arctic Systems case. HMRC had argued that the establishment of a company with a spouse as shareholder was an “arrangement” within the meaning of the legislation and that Mr Jones sought to confer a benefit on his wife by diverting dividends to her to use personal allowances and lower/basic rate bands.
Initially Mr. & Mrs. Jones lost their case but after taking it all the way up the chain of appeal to the House of Lords, the initial decision was overturned.
Who can be caught by S660A?
S660A will not apply to all contractors who are splitting their income. For example, a contractor whose spouse/civil partner performs a significant amount of the work for the company and brings in an equivalent amount of income to the shares they receive would be unlikely to be subject to a S660A enquiry. This however is not a prerequisite as we shall see.
Similarly, a company where both partners have purchased their shares instead of one party being gifted them is also unlikely to be heavily scrutinised. However, even gifts of shares between spouses/civil partners will not be caught as the Settlements Legislation provides for a specific exemption for outright gifts of assets provided the gift:
- is unconditional;
- carries a right to the whole of the income; and
- is not substantially a right to income.
What happens if I get caught by S660A?
Depending on individual circumstance, if you were to be caught by S660A then HMRC would treat the diverted dividend income as your own and tax it at higher/additional rates, if applicable. This would amount to an effective rate of tax of 25% on the dividends where the individual is a higher rate payer. In addition, interest is charged on tax paid late at the rate of 3%.
What you can do to avoid being caught by S660A
Whilst there is no sure-fire way to enable yourself to never be caught by S660A (aside from only having a single person in the company own 100% of the shares), broadly speaking (but not exhaustive by any means) you can try the following -
- Avoid having different types / classes of shares. If your company issues alphabet shares, i.e. 'A' and 'B' shares, that have different rights attached to each, this arrangement can fall foul of S660A. The ideal and best way to ensure S660A compliance would be to operate using ordinary shares.
- For shares, other than ordinary shares that attract identical rights, then each party's contribution in earning profits for the business should be commensurate with their shareholding. This way HMRC will find it difficult to argue that the parties' income levels are disproportionate.
- Try to avoid waiving dividends without sound commercial reasons. If HMRC catch wind that one of the shareholders is waiving dividends so the second shareholder can receive more in the way of payment (and thus use more of their lower rate allowance), this will be challenged.
- Try to ensure that all dividends are paid at the same rate. If the higher rate tax payer is taking (for example) £0.50 per share, but the lower rate tax payer is taking £1.00 per share so that more of the lower rate tax payer’s tax band is used, HMRC will attack this arrangement.
- Do not attempt to use unmarried minors (children under the age of 18) as shareholders to avoid paying higher rate taxes. As there is no real way for them to be considered fee earners of the company, HMRC is likely to see straight through this.
Whilst S660A is not so commonly used since the Arctic Systems case, it still lurks in the background so as to cause some concern for contractors. If you have any doubts as to your S660A risk, I would strongly suggest seeking professional advice.
Published September 2015