Contractors trading via a limited company and income splitting with a non-earning or low-earning spouse, and who then find that the Section 624 (formerly 660) settlements legislation applies, could be seriously financially worse off.
Sharing dividend income from a limited company with a non-earner or low-earner has been a classic tax planning strategy used by contractors and small business owners. It is useful as it can make use of a spouses's tax allowances to potentially save significant sums that would be taxed at the fee-earner’s top rate.
However, unless the non-fee-earner is a spouse or civil partner qualifying for a spousal exemption, HMRC could treat all the company’s fee income as that earned by the contractor, and tax them accordingly.
For an accurate personalised calculation of what the settlements legislation could cost, use Contractor Calculator’s Income Shifting Calculator.
Does the Section 624 settlements legislation apply?
The settlements legislation will apply if a contractor gives shares in their contractor limited company to a partner, family member or friend who does not work in the business yet receives an income.
In most cases, the settlements legislation won’t apply to a spouse or civil partner living with the contractor. The Arctic Systems case confirmed a ‘spousal exemption’ when a contractor gifts ordinary shares with full voting and capital distribution rights on a cohabiting spouse or civil partner who plays an active shareholder’s role.
Spouses and civil partners may be at threat from the settlements legislation if the contractor gifts different share classes or the gift is not an ‘outright gift’. That means that any income from the shares must be for the spouse to share as they wish and not just a mechanism to divert money back to the same shareholder.
If it applies, what will the settlements legislation mean?
The settlements legislation potentially considers the gift of shares from a fee-earning contractor to a non-fee-earner, such as a partner, family member or friend, as a ‘bounteous settlement’. In such cases any income arising from that settlement should continue to be taxed as if it were the fee-earning contractor’s.
Instead of the contractor and partner/family member/friend sharing income and maximising the use of the tax allowances, suddenly there is the threat that HMRC could tax all the income on the fee-earning contractor, thus hugely increasingly their tax bill.
And what is worse is that HMRC can backdate its assessments, so that if a contractor and their partner had been operating in this fashion for six years, then the last six year’s worth of the non-earning partner’s income would be added to the contractor’s for those years. The resulting back taxes would then have interest and penalties added.
How much extra back tax could the settlements legislation cost?
Contractors caught by the settlements legislation could first find backdated taxes applied, and then would have to adjust their current earnings as if they were the sole earner. Both sets of additional tax liability figures look daunting.
The table below show how much back tax a contractor might have to find, depending on their hourly rate, if they had been splitting income from their limited company with a non-fee-earner on a 50/50 dividend split basis:
| Hourly rate | Tax bill |
|---|---|
| £25 | £1,238 |
| £35 | £4,763 |
| £50 | £10,438 |
| £60 | £12,113 |
So, a contractor on a modest £50 an hour splitting income with a non-fee-earner found inside of the settlements legislation would face a back taxes bill of £10,438 for each year, plus interest and penalties.
How much could a contractor’s current income be affected?
The impact on take-home pay can be considerable for a contractor who has previously been splitting income with a non-fee-earner and then decides to take the full share of fees to avoid the possibility of the settlements legislation being applied by HMRC for that tax year.
The table below shows how much a contractor’s monthly take-home pay net of tax decreases if they had been splitting income from their limited company with a non-fee-earner on a 50/50 dividend split basis:
| Hourly rate | Monthly net income decrease |
|---|---|
| £25 | £103 |
| £35 | £396 |
| £50 | £869 |
| £60 | £1009 |
That means a contractor on a modest £50 per hour would lose £869 per month from their net earnings as a result of stopping income splitting with a non-fee-earner.
There are strategies for contractors who wish to continue income splitting with a non-fee-earner other than a spouse. Contractors should contact their accountant to discuss their options as a matter of urgency, and certainly before taking action that could prompt an HMRC investigation.