It is not uncommon in married couples (or civil partnerships) for one spouse (or civil partner) to be a higher or additional rate taxpayer, and for the other to pay tax at the basic rate, or to pay no tax at all. Tax planning in such circumstances typically involves the higher earning spouse gifting an income producing asset (e.g. an investment property, or company shares) to the lower or non-earning spouse. The aim is to reduce the overall tax burden, by diverting income from the higher taxpaying spouse to the spouse paying income tax at a lower rate, or perhaps to utilise the other spouse’s personal allowances.
It all seems sensible and straightforward tax planning. On the face of it, the tax implications generally appear straightforward as well.
Beware the ‘settlements’ rules
Gifts between spouses living together in the tax year are normally made on a ‘no gain, no loss’ basis for capital gains tax (CGT) purposes (TCGA 1992, s 58(1)), such that no CGT charge arises. For inheritance tax (IHT) purposes, gifts between spouses domiciled in the UK are generally subject to an unlimited exemption (but where the recipient spouse is not UK domiciled, the gift is only exempt up to the extent of the donor spouse’s unused nil rate band at that time (IHTA 1984, s 18(2)), unless the recipient elects to be treated as domiciled in the UK (IHTA 1984, s 267ZA), thereby bringing his or her worldwide estate within the scope of IHT). No stamp duty land tax (SDLT) is payable on a gift of (say) an investment property (although there may be an SDLT charge if, for example, there is a mortgage or loan on the property, which is taken over by the recipient (FA 2003, Sch 4, para 8)). Similarly, there is normally no stamp duty on a lifetime gift of (say) family company shares (SI 1987/516, Category L).
However, care is needed to avoid making a ‘settlement’. The settlements rules are anti-avoidance provisions, which can sometimes apply (among other things) to gifts between spouses. The rules broadly bite where the ‘settlor’ (i.e. the spouse gifting an asset) retains an interest in the asset given away (ITTOIA 2005, s 624(1)). The settlor is treated as having an interest if there are any circumstances in which the settlor or the settlor’s spouse can benefit from the gifted asset (s 625(1)). There are some exceptions to the settlements rules, including an important one for gifts between spouses or civil partners (see below).
The term ‘settlement’ and ‘trust’ are often used interchangeably, as if they have the same meaning. However, ‘settlement’ has a much wider meaning, and includes “any disposition, trust, covenant, agreement, arrangement or transfer of assets” (ITTOIA 2005, s 620(1)). In other words, a settlement does not require a formal trust, and can apply in non-trust situations.
In the above scenario of a gift between spouses, the effect of the settlements rules is that income caught by the rules is treated as the income of the spouse making the gift.
The spouse ‘let-out’
As mentioned, there are certain exceptions to the settlements rules. An important exception relates to outright gifts between spouses (or civil partners). The settlements rules do not apply to such gifts if two conditions are satisfied. First, the gift must carry the right to the whole of the income. Secondly, the gift must not be wholly or substantially a right to income (ITTOIA 2005, s 626(1)-(3)).
The first condition is largely self-explanatory. But what does “wholly or substantially a right to income” mean? HMRC’s guidance in the Trusts, Settlements and Estates manual includes the following example (at TSEM4205):
Example 1 – Gift of shares
“An engineering company has 100 ordinary £1 shares. Mr P and Mr O own 50 ordinary shares each. They create a new class of B shares which carry no voting rights and no assets in a winding up. They then issue 50 B shares to each of their wives. Dividends voted on those B shares would be treated as the income of Mr P and Mr O rather than their wives as the B dividends are from shares that are wholly or substantially a right to income and so not exempted from section 624 by section 626” (TSEM4205, at Example 5).
HMRC guidance does not generally constitute the law. However, the above example is based on a tax case (Young v Pearce; Young v Scrutton  STC 743). In the example, the wives’ shares carry the whole of the right to the dividends on their ‘B’ shares. However, the shares are “wholly or substantially a right to income” because they have no other rights attaching to them.
By contrast, the HMRC guidance (at TSEM4205) includes another example of a husband and wife company which is not affected by the settlements legislation (see Example 6 at www.hmrc.gov.uk/manuals/tsemmanual/TSEM4205.htm). In that example, shares gifted from husband to wife are ordinary shares with rights to capital. Unlike the example above, the gift is not therefore of property which is wholly or substantially a right to income. The underlying principle behind this HMRC example is the well-known ‘Arctic Systems’ case in the House of Lords (Jones v Garnett  UKHL 35). In that case, Lord Hoffman said:
“…the Revenue say that the property given, ie the share, was 'wholly or substantially a right to income'. It is true that the value in the share arose from the expectation that it would generate income. But that is true of many shares, even in quoted companies. The share was not wholly or even substantially a right to income. It was an ordinary share conferring a right to vote, to participate in the distribution of assets on a winding up, to block a special resolution, to complain under s 459 of the Companies Act 1985. These are all rights over and above the right to income. The ordinary share is different from the preference shares in Young (Inspector of Taxes) v Pearce, Young (Inspector of Taxes) v Scrutton  STC 743, which conferred nothing except the right to 30% of the net profits before distribution of any other dividend and repayment on winding up of the nominal amount subscribed for their shares. Those shares were substantially a right to share in the income of the company.”
Thus income which might otherwise be taxable on the spouse making the gift (under ITTOIA 2005, s 624) will not be treated as such if the gift falls within the ‘outright gift’ exception (in s 626). But a gift of shares needs to provide more than just a right to dividends.
‘Outright gift’ pitfall
The gifted asset (e.g. investment property or family company shares) must be an unconditional gift with no strings attached.
Furthermore, there must be no circumstances in which the gifted asset (or any related property) is, or may become, payable to the spouse making the gift. ‘Related property’ includes income from the gifted asset (ITTOIA 2005, s 625(5)). Nor must the gifted asset be (or become) applicable to the spouse making the gift (ITTOIA 2005, s 626(4)).
Example 2 – Gift of investment property
Mr Edwards is a higher rate taxpayer. He owns a buy-to-let property, which generates rental income each year. Mrs Edwards is a basic rate taxpayer.
Mr Edwards decides that he would like to gift the property to Mrs Edwards. However, he does not wish to make the gift permanent (e.g. in case his (or Mrs Edwards’) tax position changes). The gift of the buy-to-let property is therefore made subject to an agreement which would allow the property to be returned to Mr Edwards at his request.
The property is not an outright gift (i.e. it is conditional, and there are circumstances in which the gifted property may return to Mr Edwards). It is therefore subject to the settlements rules. The rents received by Mrs Edwards are treated as Mr Edwards’ income for tax purposes.
The above example is based on HMRC’s guidance at TSEM4205 (Example 4a). In addition to the Trusts, Settlements and Estates manual (www.hmrc.gov.uk/manuals/tsemmanual/TSEM4000.htm), HMRC’s Helpsheet 270 (‘Trust and settlements - income treated as the settlor’s) offers guidance on the settlements rules generally (www.hmrc.gov.uk/helpsheets/hs270.pdf). However, remember that HMRC's guidance does not carry the force of law.
Most straightforward, outright gift between spouses (or civil partners) should not be affected by the ‘settlements’ rules, but care is needed. For example, make sure that income from the gifted asset is paid directly to the recipient spouse or into an account in their sole name, and not into an account held by, or jointly with, the spouse making the gift (ITTOIA 2005, s 626(4)(b)).
Mark McLaughlin CTA (Fellow), ATT (Fellow), TEP
The above article was first published by Tax Insider (www.taxinsider.co.uk).