Tax basics: The settlement provisions and children. By NIchola Ross Martin
Nichola Ross Martin looks some of the traps in the settlement provisions for parents.
What are referred to as “the settlement provisions” for tax are now found in Chapter 5, Part 5 of ITTOIA 2005. The rules span s 619 to s 648 and they impose a tax charge on a “settlor” of a “settlement” where he or she:
- retains an interest in the property that is settled and any resulting income is or may become payable to or applicable for the benefit of him or his spouse, or if,
- makes a settlement in favour of his unmarried minor children, or if,
- receives a capital sum from a settlement he has created
A “settlement” is a wide term which includes any “disposition, trust, covenant, agreement, arrangement of assets” (excluding charitable loan arrangements and wills).
A “settlor” is a person (male or female, but referred to here as “he”) who is treated as making a settlement, and this may have been done by directly or indirectly providing funds or entering into some sort of reciprocal arrangement with another.
This article looks at tax on settlements made by parents in favour of their unmarried minor children (2 above). A “minor” child is one who is under 18, and the simplest form of parental settlement is a gift of cash to the child to set up their own bank account, but I want to look at the pitfalls involved in giving your children shares in your own trading company.
The thing which makes the rules slightly strange is that a parent is obliged to support their child, and so parents continually have to provide financial support for their off-spring. This means that the courts look at children’s settlements in a slightly different way than those involving spouses. The basic tax rules though are there to ensure that a parent cannot divert income to a child and escape or pay a lower amount of tax as a result.
It is worth noting, in passing, that the settlement provisions do not apply in a year where the settlor is not domiciled in the UK, not UK resident or ordinarily resident, but catch income which was excluded for this reason but is at some stage later remitted back to the UK.
The case of Jones v Garnett "Arctic Systems" concerns 1) above, and in those circumstances there is also an exemption which excludes property which is subject to an outright gift between spouses.
Settlements and children
Over the years many parents have come to the conclusion that they might be able to reduce their tax bills if they divert their income at source to their children. The simplest way of doing this is to put an income producing assets into the child’s name, and the child is then legally entitled to the income that arises from that asset. Minor children cannot give receipt under UK law, and so this means that someone has to look after the asset on behalf of the child until it comes of age. As this is probably the parent, you can end up with a parent controlling the asset and income. S 629 ITTOIA 2005 is in place to ensure that if parents try this tactic, they will be taxed on the income, instead of the child. It reads as follows:
(1) Income which arises under a settlement is treated for income tax purposes as the income of the settlor and for the settlor alone for a tax year if, in that year and during the life of the settlor, it –
(a) is paid to, or for the benefit of, [a relevant] child of the settlor, or
(b) would otherwise be treated (apart from this section) as income of [a relevant] child of the settlor.
This is subject to an exemption in subsection (3) which says that if the income arising amounts to £100 or less, the rule above will not apply and in that case the income is treated as that of the child.
For those in business, especially in family companies, there is the desire to give share capital to the children, so that they can then partake in dividends. These arrangements can be caught by the settlement provisions.
Gifts to children that will not be caught if they are made by other family members, and typically this will be a grandparent, but this is an area where one needs to tread carefully.
E.g. If parent “A” gives some of their own shares in their own trading company to their parents ("the grandparents") who then gift them on to a grandchild (offspring of parent A), you clearly have an arrangement or some sort.
The big “if” is whether or not this can be construed as a “settlement”, and if so then any income which arises on those shares will be taxed as if that of the parent (who is deemed the settlor). Whether the arrangement outlined here will be deemed a settlement depends on the actual facts, intentions, tax planning motives and the timing of the transactions.
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In short there has to be a certain “unity” about the arrangement for it to become a settlement.
For instance. if the gifts were executed within a very short time of each other, and there was evidence that the transactions were linked by a common intention to divert income from parent to child, and united by accountant’s advice which was also unambiguous (in that the whole was put in place to save tax), you would probably say that there was a settlement. However, there will be other cases where the chain of events may be on a commercial basis. For instance, shares may be given by the parent to his parent as the latter is investing in the company. A few years later the grandparent retires; he then gifts the shares to the grand child, or leaves them in a will.
The decided tax cases
It’s helpful to take look at some tax cases that have been decided by the courts to see what sort of arrangements involving children are confirmed as settlements:
Copeman v Coleman  22 TC 594, is an example of a basic parental settlement; a father allotted his children shares in his own company, which they purchased with their own money. Verdict: a settlement, the father was found to be a settlor and was taxed on the dividends received by the children. Basically, the father had orchestrated the whole set up, and minor children would not normally invest in unquoted companies, even if run by their parents.
In Crossland v Hawkins  39 TC 493, a father assigned his acting contract to a company set up by his wife and accountant. His father-in-law gave his children cash, and the children purchased the remaining shares. Verdict: the father was settlor of a settlement in favour of his children. Although he took no part in setting up the share transactions, he had assigned his contract, and in so doing he was provided funds that were more of less guaranteed in the future - the father was both a direct and indirect settlor.
Butler v. Wildin  STC 22, is a slightly unusual case: A company was set up and shares allotted to children with the assistance of grandparents using the childrens’ own money (again given by grandparents). The childrens’ fathers then worked for the company for no remuneration and by guaranteeing a bank loan enabled the company to purchase land and make a huge development gain. They were held to be settlors of a settlement in favour of their children, however, shares were later allotted to further children (who were born after incorporation) and their shares were not deemed part of the settlement as they were not party to the original arrangement. The case is often quoted but the outcome was reached by agreement of the parties before it reached the court of appeal. It is interesting one of the law lords in the Jones v Garnett case (Lord Hoffman, I think) said “I am not saying it (the decision in Bulter v Wildin) is wrong, but it is an unsatisfactory decision in terms of material…Vinelott (the judge presiding) did his best”. You can see what he means; basically one set of children, the ones who purchased shares at the outset were caught by the settlement provisions, but the ones who were not born when the land deal was made and company formed were not. Like Hawkins, the fathers were not involved in the setting up of the company, but they did directly provide funds.
Allowing the children to subscribe to shares on the formation of a parent's company (with grandparents assistance) will in most cases be viewed as a settlement by HMRC. A company will be formed for a pre-planned purpose, there will be some “hope value” for shareholders at the onset. This may not be as clear cut as in Butler v Wildin, where there was a one off land deal, or where there was a confirmed film contract as in Crossland v Hawkins, and so income was more or less guaranteed when the shares were allotted. Any sort of trading company may have trading ups and downs for years before dividends can even be contemplated. Nevertheless, when dividends are paid out to minor children it will be necessary to examine how they came to be shareholders and consider the settlement provisions.
HMRC’s view on grandparents’ shares
These examples are from HMRC's November 2007 guidance in their Trusts, Settlements and Estates Manual at para EM4300.
Example 14 – direct gift of shares to minor children
Mr. and Mrs. X each own 50 of the 100 issued ordinary shares in X Ltd. They each decide to give 10 shares to each of their children aged 12 and 15. The children each then hold 20 shares, 10 from each parent. We would treat the dividends paid to the children as the income of their parents.
Example 15 – gift of shares to trust of which minor child is a beneficiary
A director owns all the shares in a family company. He sets up a discretionary trust for his 10-year-old daughter and transfers 25% of his shareholding to the trustees. A dividend is paid and the trustees make a discretionary payment to the child. We would treat the payment from the trust to the child as the income of the parent.
Example 16– children –indirect gift of shares from parent
Mr J owns all 100 issued £1 shares in J Limited. Mr J is the sole company director and is the person responsible for making all the company's profits because of his knowledge, expertise and hard work. On starting up the company, Mr J allowed his mother to
subscribe £40 for 40% of the shares but shortly afterwards she gifted them to her grandchildren.
The circumstances are such that the decision to issue 40 shares at par is a bounteous arrangement (as were the shares in Jones v Garnett). The true settlor here is Mr J rather than the children’s grandmother. Section 629 therefore applies and attributes the dividends received by the children to Mr J for tax purposes.
Recent Any Answers
I was interested in posting no. 169502 this query concerned the tax treatment of a genuine partnership between father and minor son. It’s unusual, but overall it illustrates that where a child is in business in their own right, you need to ensure that you have full facts, and good records to prove who is doing what and who is earning what. Given that there are provisions to tax parent settlors, anyone who is in business with their child should expect at least a couple of questions from HMRC too.
It is worth getting to grips with these rules, thanks to Jones v Garnett there is a wider understanding of the some of the pitfalls of settlements, but there is still often a very fine line between deciding whether a company share transaction via a grandparent will create a settlement or not. As I always say, weigh up each case according to its facts.
Links to related articles: The settlement provisions and family business
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