Updated for 2025. The UK settlements legislation, now in ITTOIA 2005, aims to stop people diverting income to family members on lower tax rates while retaining the benefit themselves.
The leading case, Arctic Systems (Jones v Garnett), confirmed that many spouse-owned company arrangements fall within a statutory exemption for outright gifts of shares.
Proposed “income shifting” laws after that case were shelved, so HMRC still relies on the settlements code and general anti-avoidance rules.
The Settlements Legislation was originally enacted in the 1930s, with subsequent amendments in the 1990s.
The rules were formerly contained in Section 660 of the Income and Corporation Taxes Act 1988, and are still sometimes referred to by that name in older case reports and commentary.
Its primary aim was to prevent people from passing assets and income to family members to reduce their tax liabilities, whilst intending to reclaim those assets at a later date.
However, until relatively recently, HMRC had not applied the rule to company dividend payments. In the mid-2000s, HMRC began to assert that the Section 660 rules could be applied to dividend income received by individuals.
In other words, where a limited company director has his non-fee-earning spouse as a joint shareholder, any dividends she receives from the company should be taxed as her husband’s income. Some taxpayers received tax demands amounting to tens of thousands of pounds, backdated several years.
At the time, HMRC appeared to target personal service companies, particularly one-man-bands, particularly if dividends were paid to family members who were not actively involved in the running of the company, or if the amount of income generated by a husband and wife was not in proportion to the number of shares owned by each person.
The Arctic Systems (Jones v Garnett) case
The ‘income shifting’ debate in recent years has taken place against the backdrop of a long-running court case between Arctic Systems (owned by a husband and wife) and HMRC, which lasted several years and has helped define Section 660A.
In this case, HMRC objected to how a married couple, Geoff and Diana Jones, remunerated themselves with a mixture of salaries and dividends, which had the effect of reducing their joint tax liability.
The couple spent over five years battling the Revenue’s efforts to reinterpret the law retrospectively and mount a tax raid on companies that are jointly owned by one revenue-earning partner and one non-earning partner.
The Joneses arranged their affairs so that in 2000/2001, Mr Jones paid himself a £7,000 salary and his wife received almost £4,000 from the £91,000 turnover.
After expenses and corporation tax, the couple shared the remaining £60,000 equally in dividends.
HMRC, which won a tax tribunal and High Court ruling but lost an appeal by the Joneses to the Court of Appeal in 2005, had argued that Mr Jones had not drawn an adequate salary and, because he was solely responsible for the income generated by the couples’ company, he should have received a greater share of the profits. As a higher-rate taxpayer than Mrs Jones, he would then have been subject to tax at a higher rate.
In 2007, the House of Lords ruled in favour of Geoff and Diana Jones.
PCG (formerly the Professional Contractors Group), which represented contractors and freelancers, supported Geoff and Diana Jones in their House of Lords appeal and stated that the total cost of the case was likely to be over £500,000.
Costs were awarded against HMRC at the 2007 hearing, which means that the UK taxpayer had to foot the bill.
Abandoned plans for new income shifting rules
Following the House of Lords decision, the government consulted in 2007 and intended to legislate from 2008 to counter arrangements described as “income shifting”. In practice, the policy was deferred in the 2008 Pre-Budget Report and then left on the shelf.
Summary of key points
Arctic Systems (2007) remains the leading case. The court accepted there was a settlement, but the spousal “outright gift” exemption applied, so the dividends stood. See the judgment: House of Lords, Jones v Garnett.
The government’s 2007–2008 plan to legislate specifically against “income shifting” was deferred in 2008 and never enacted. See the Commons briefing.
Today, HMRC relies on the settlements legislation in ITTOIA 2005, notably s624, s626 and s629.
Settlements legislation in 2025
The modern rules are in Part 5, Chapter 5 of ITTOIA 2005. In brief:
s624 can treat income arising under a settlement as the settlor’s income where the settlor retains an interest.
s626 sets an exception for outright gifts between spouses or civil partners, provided that the gift includes the entire bundle of rights and is not wholly or substantially a right to income.
s629 generally taxes income from settlements for the benefit of a minor, unmarried child on the parent if it exceeds the small de minimis amount per parent.
Situations where HMRC may challenge
Although the post-2007 legislation never materialised, HMRC continues to tackle perceived income diversion using the settlements code and general principles. Current hotspots include:
Dividend waivers. If one shareholder waives a dividend so that another (often a spouse or child) receives a larger payment, HMRC may treat this as a settlement of income.
Alphabet shares and dividend “streaming”. Different share classes are not inherently problematic, but if they are used mainly to route income to a lower-taxed spouse without transferring genuine ownership rights, HMRC may apply the rules.
Gifts made shortly before declaring a dividend. A last-minute transfer that effectively passes a right to income only may fail the s626 exemption.
Arrangements involving minor children. Over the small de minimis per parent, income is taxed on the parent by virtue of s629.
Arrangements generally considered low risk
Genuine 50:50 ownership of ordinary shares by spouses or civil partners, each holding full voting and capital rights, with dividends paid pro-rata and no manipulative waivers.
Commercial remuneration for work actually done. If a spouse is on payroll for real duties, record the role, rate and hours in the usual way. The Settlements rules are aimed at bounteous arrangements, not arm’s length pay.
Practical self-check for company owners
Does your spouse or civil partner hold ordinary shares with full rights acquired as an outright gift of property rather than a right to income only?
Are dividends paid pro rata to shareholdings, without contrived dividend waivers?
Have you avoided gifting shares immediately before a dividend is declared?
Do you have contemporaneous records of duties carried out by each person and any salary that is actually due?
Are you clear that arrangements involving minor children are generally taxed on the parent under s629?
Illustrative examples
OK. On incorporation, spouses each subscribe for ordinary shares with full rights. Both contribute to the business in different ways. Dividends are paid pro-rata. No waivers are used.
Risky. One shareholder executes a dividend waiver, allowing a lower-taxed spouse to receive a larger dividend this year.
Caught for children. A parent routes dividend income to a minor child via a settlement. Over the small de minimis, s629 taxes the income of the parent.
