UNEARNED INCOME

What types of unearned income can be split and how should it be done?

Any type of income can be split as long as the asset that produces the income goes with it.

We’ve already explained in Part 1 that a gift of income from one spouse/civil partner to the other is caught by anti-avoidance rules, known as the “settlements legislation”, unless the asset which produces the income is also transferred.

Example

Harry, who is a higher rate taxpayer, owns 10,000 shares in BigCo Plc. In 2022/23 he receives dividends from BigCo of £30,000 a year. Sally, his wife, only has income from a part-time job which pays her £13,000 per year. Harry’s tax liability on the dividends from BigCo is £10,125 (£30,000 x 33.75%). He transfers the right to the dividends to Sally so that she will be taxed on them. He works out her tax bill on the dividends will be just £2,450 (£2,000 at 0% + £28,000 at 8.75%) and so between himself and Sally they save tax of £7,675.

Harry will be disappointed that the settlements rules mean that because the gift to Sally is for income only the dividends are treated as being his for income tax purposes.

If Harry had done his homework or consulted a tax advisor, he could have saved himself the time and effort of making a tax-ineffective transfer.

If Harry transfers the dividend-producing shares to his wife, he can achieve his goal of shifting the income to her for tax purposes.

What’s the special rule for taxing joint income for married couples and civil partners?

One of the oddities of independent taxation is that for tax purposes the rules attribute income from a jointly owned asset as belonging 50% to each spouse/civil partner even if they own the asset in unequal shares. In effect, this rule can partly override (with exceptions) the tax treatment explained above.

Example

Jamal owns three high-street properties which he lets. His annual taxable income, i.e. net of tax-deductible expenses, from the properties is £20,000. He also has income from employment of £100,000 per year, which means he’s a higher rate taxpayer. Jamal’s wife Latika has income from her employment of £40,000 per year and is therefore a basic rate taxpayer. Both are entitled to personal allowances but no other tax reliefs.

The properties have been in Jamal’s family for generations and so he’s torn between transferring a share of them to Latika to save tax and keeping sole ownership. On advice from his accountant, he opts for a compromise. He transfers 5% of each property to Latika. As a result, from the date of transfer she becomes entitled to 5% of the annual income, £1,000, but is taxable on 50%, £10,000.

The example uses income tax rates and bands applicable to English, Welsh and Northern Irish taxpayers. Slightly different rates apply for Scottish taxpayers, but the principles are the same.

Before transfer of property	Jamal (£)	£	Latika (£)	£	Joint tax liability (£)
Salary	100,000		40,000
Rental income	20,000
Total taxable income	120,000		40,000
Less: personal allowances	2,570*		12,570
Taxable	117,430		27,430
Tax at 20% on	37,700	7,540	27,430	5,486
Tax at 40% on	79,730	31,892
Total tax		39,432		5,486	44,918

 

The position after the transfer is much better:

After transfer of property	Jamal (£)	£	Latika (£)	£	Joint tax liability (£)
Salary	100,000		40,000
Rental income	10,000		10,000
Total taxable income	110,000		50,000
Less: personal allowances	7,570*		12,570
Taxable	102,430		32,430
Tax at 20% on	37,700	7,540	32,430	6,486
Tax at 40% on	64,730	25,892
Total tax		33,432		6,486	39,918

An analysis of the calculations shows that:

transferring a small share of the ownership, say 5% of an asset, to a spouse/civil partner can make a disproportionately larger change to their overall tax liability. In Example 15 a £10,000 shift in income reduces the joint tax bill by £5,000 (£44,918 - £39,918)

*the rate of saving in Example 15 is greater than the highest rate of tax paid by either spouse/civil partner because not only does it reduce the income on which higher rate tax is paid, but it increases the entitlement to personal allowances (because it reduces the income in excess of £100,000).

Does the 50% rule apply in every situation?

The 50% rule can be overridden if the couple elect to be taxed on their respective share of the income from an asset proportionate to their share of the ownership. If such an election were made in the example above, Jamal would be taxed on 95% of the income from the properties and Latika, 5%. That would considerably reduce the tax saving made by the small transfer of ownership.

If the incomes were reversed so that Latika was the higher rate taxpayer, but the property is still owned by Jamal and the 5% transfer made, an election to be taxed on their beneficial entitlement to income would be advantageous.

Warning. Once an election is made it cannot be revoked and so it can become a tax-inefficient arrangement if there is a change in the total amount of taxable income of one or both spouses/civil partners.

Taxpayers must make the election in a prescribed format. The most convenient way is to use HMRC’s Form 17.

How is a Form 17 election made?

Before considering the practicalities of making an election on Form 17, the couple need to be aware that they cannot make an election for some types of jointly owned asset or income. The exceptions are:

• income to which neither spouse/civil partner are beneficially entitled, e.g. where the underlying assets are held in a discretionary trust for either spouse/civil partner
• partnership income
• income from commercial letting of furnished holiday accommodation
• income from shares in a close company. A close company is one which is controlled by five or fewer individuals
• income which for tax purposes is treated as income of a third party, even if it arises from property held in joint names
• property held as beneficial joint tenants where the couple are both jointly entitled to the whole of the property and income (they must own the property as tenants in common for a Form 17 election to be effective)
• property that is not held in unequal shares (the couple cannot choose to have the income taxed on an unequal basis because they think it would be to their advantage).

Prior to 2012 HMRC took the view that a Form 17 election could not be used for interest paid on joint savings and similar accounts. It quietly removed that restriction, which had been printed in its Form 17 guidance. Therefore, if both spouses/civil partners have contributed the balance in an account, they can make an election to be taxed on the share of the interest they are entitled to. For an account to which each spouse/civil partner has contributed and withdrawn multiple sums during an interest period, it’s almost impossible to determine their respective entitlements. The couple can work around this by each spouse/civil partner agreeing how much each other’s share of the interest is. Ideally, the agreement should be written and witnessed.

Are there any other complications?

Before a spouse/civil partner can change the ownership proportions of an asset, they must first determine whether they are owned as joint tenants or as tenants in common.

Holding property as joint tenants (also referred to as joint beneficial owners or beneficial joint tenants) both spouses/civil partners are entitled to the whole of the asset, so they are equally liable to debts that relate to it and equally entitled to income it generates. Owning an asset as tenants in common means only having an entitlement to a defined share of the asset, e.g. 50%, 10%, 1%.

If (for legal and tax purposes) the couple want to divide the income from an asset which they own as joint beneficial owners other than 50/50 they must sever the joint tenancy and own it as tenants in common in the proportions in which they want to share the income and value of the asset. For land and buildings this is achieved by completing and filing a Form SEV with HM Land Registry. For other assets a solicitor can help with the paperwork.

How can a couple use a Form 17?

The timing of completion and submission of Form 17 are important. If the couple get it wrong, the form won’t be valid and each spouse/civil partner will each remain liable to tax on 50% of the income from the asset for which the election was intended.

A Form 17 election is effective from the date of the latest signature on the form, but only if HMRC receives it within the following 60 days.

Warning. HMRC applies the 60-day deadline strictly. If the Form 17 election arrives later or goes missing it will refuse to apply it.

Can the couple reverse the election?

The strict position is that Form 17 elections remain in force all the time the couple married, or in a civil partnership, and living together, or until they change how much of the asset they each beneficially own. They can’t simply revert to being taxed on the 50/50 basis.

Changing the ownership shares of the property by even a small amount, say from 70%/30% to 71%/29%, automatically overrides the Form 17 so that the 50/50 rule applies unless the couple make a fresh Form 17 election. While they don’t need to tell HMRC about the change of ownership, it may become aware of it from the change in proportion of income the couple declare on their tax returns. HMRC may ask for evidence of the change of ownership.

ALLOWANCES AND TAX RELIEFS

How might tax allowances and reliefs be used for tax planning?

If either, or both, spouses/civil partners are entitled to tax reliefs or allowances in addition to their personal tax allowances, they will reduce the respective amounts on which each of them pays tax.

If the couple can split their income, it might be possible to change who gets the tax reliefs to achieve the same result, or at least some tax saving.

Rick and Isla are both employed. His annual taxable pay is £50,000 and hers is £85,000. They have no other income. That makes Rick a basic rate taxpayer and Isla a higher rate taxpayer. They both have pension plans to which they each contribute £8,000 per year. Rick makes annual gift aid donations of £2,000 (before tax relief at source); Isla makes none.

Table 1 shows their tax position according to the facts above. Table 2 shows their tax position if they made changes to their pension and gift aid arrangements.

Table 1

Before transfer of property	Rick (£)	£	Isla (£)	£	Joint tax liability (£)
Salary	50,000		85,000
Less: personal allowances	12,570		12,570
Taxable income	37,430		72,430
Tax at 20% on	37,430	7,486	45,700	9,140
Tax at 40% on			26,730	10,692
Totals		7,486		19,832
Total joint tax liability					27,318

 

Note. Basic rate tax relief (20%) is given at source on pension payments and gift aid donations. Higher rate taxpayers (40%) are entitled to a further 20% relief (40%, less given at source 20% = 20%) which is achieved by increasing the amount of income on which basic rate tax is charged. In Table 1 Isla’s basic rate band is extended by her pension payments of £8,000 to £45,700. Rick’s basic rate band would be extended by his pension payments and gift aid donations, but of course this would only save him tax if he paid tax at higher rates.

After talking to an accountant and pension advisor:

·         Rick ceases to make gift aid donations

·         Isla starts to make gift aid donations to the same charities that Rick donated to

·         Rick reduces his pension contributions to £4,000 per year

·         Isla increases her pension contributions to £12,000 per year.

Table 2

After transfer of property	Rick (£)	£	Isla (£)	£	Joint tax liability (£)
Salary	50,000		85,000
Less: personal allowances	12,570		12,570
Taxable income	37,430		72,430
Tax at 20% on	37,430	7,486	51,700	10,340
Tax at 40% on			20,730	8,292
Totals		7,486		18,632
Total joint tax liability					26,118

An analysis of the calculations shows that:

·         the tax saving of £1,200 (£27,318 - £26,118) is the result of extra higher rate tax relief for Isla of £400 (£2,000 x (40% x 20%)) on gift aid donations, plus £800 (£4,000 x (40% x 20%)) on the increase in pension contributions.

While joint outgoings remain the same, shifting tax-deductible outgoings to the spouse/civil partner who pays the higher rate of tax has reduced their overall tax bill.

Can planning be used to mitigate the High-Income Child Benefit Charge?

If either partner receives child benefit and one or both of them has adjusted net income of more than £50,000, the one with the highest income must pay the HICBC. This is equal to 1% of the amount of the child benefit for every £100 of income over £50,000. When the income reaches £60,000, the charge will claw back all the child benefit.

The adjusted net income is the total of all taxable income (adding back relief for payments to trade unions or police organisations deducted in arriving at this figure), less:

• losses from trading
• pension contributions (before tax relief); and
• gift aid donations (before tax relief).

It’s possible to reduce the HICBC if the spouse/civil partner liable to pay it can reduce their adjusted net income for the year to below £60,000 or reduce it further below £60,000 if it was already lower. This could be achieved by increasing pension contributions or gift aid payments. This can be done by reorganising such payments without increasing them.

Example

Fred, who’s a sole trader, and Wilma are married with two children. Wilma receives child benefit of £36.25 per week (£1,885 per year). Fred’s adjusted net income is £60,000 for a year after taking account of pension contributions of £8,000 and gift aid payments of £500. Wilma’s adjusted net income is £45,000; she doesn’t pay into a pension. The HICBC applies and, based on Fred’s income, amounts to £1,828, i.e. it results in a 100% clawback of the child benefit.

Fred could reduce the HICBC without increasing their joint income by taking over Wilma’s gift aid and increasing his pension contributions. Even without increasing his pension contributions he could still reduce the HICBC by paying his contributions one year earlier and in the following year paying no contributions. He could also use the carry-back relief for gift aid to the same end. This would mean that every other year Fred’s HICBC is reduced by £1,603 (£1,885-£282). In the interim years Fred is no worse off than usual where the HICBC claws back the child benefit in full. On average, Fred saves £801 per year at no extra cost.

What is the marriage allowance and how is it claimed?

The marriage allowance was introduced in 2015 to help married couples and civil partners make more tax-efficient use of their personal tax-free allowances. It does this by allowing one spouse/civil partner to transfer part of their personal allowance to the other.

Warning. HMRC sometimes refuses claims for the marriage allowance which are valid. Its guidance says that to be eligible the spouse/civil partner making the transfer must have income of less than the personal allowance (£12,570 for 2021/22 and 2022/23) and the other spouse/partner’s income must “usually” be less than £50,270 the basic rate tax threshold. This is not strictly correct. Remember that HMRC’s guidance is it’s own interpretation of the legislation.

The legislation actually says that the spouse/partner receiving the marriage allowance must not be liable to tax at a rate higher than the basic rate. As mentioned earlier, the basic rate band can be extended by certain tax reliefs, for example, gift aid payments and personal pension contributions.

Because the marriage allowance is a fixed amount (for 2020/21 it’s £1,250 and for 2021/22 and 2022/23 it’s £1,260) it can’t be reduced to make it more tax efficient. It can even create a tax bill for the transferring spouse, though there will still be an overall saving.

Example

For 2022/23 Mark’s income is £45,000 and his wife Bridget’s is £12,000. They claim the marriage allowance. This means the full £1,260 is deducted from Bridget’s personal allowance (reducing it from £12,570 to £11,310). Mark’s personal allowance increases to £13,830 from £12,570. This saves him tax of £252 (£1,260 x 20%). But Bridget now must pay tax of £138 she would not have done if the marriage allowance had not been claimed. That’s because she only has tax-free allowances of £11,310 to deduct from her pay of £12,000 leaving £690 taxable at 20%. The net tax saving is just £114 (£252 - £138).

Warning. There’s one last quirk to watch out for. A claim for marriage allowance made during the year to which it applies will continue to apply for all subsequent years until either the conditions for claiming it cease to be met or the claim is withdrawn. By contrast, if a claim is made after the end of the tax year it only applies for that year.