IT Contractors Tax – Reducing High Rate Tax by Income Shifting

IT Contractors may be tempted to gift shares in their company to their family members, such as their spouses, civil partners, sons, daughters, parents or grandparents. Generally IT contractors will pay a higher rate tax on the element of dividends exceeding the basic rate band, being around £40K per tax year. Dividends drawn exceeding this amount would incur an additional 25% personal tax charge collected through the self assessment tax return. Total IT contractors tax dividends extracted within a tax year under this amount would effectively incur no additional personal tax charge.

Contractors Tax

Effectively IT contractors taxed in the higher rate band would be paying 45% tax. This constituting the 25% higher rate personal tax charge and the 20% corporation tax on profits from which the dividends are extracted. If total dividends however remain under the basic rate band only the 20% effective Corporation Tax rate would be paid, with no further personal tax charge.

A contractor may therefore be tempted to shift their income to another family member to use their basic rate band, in affect avoiding the higher rate 25% IT contractors tax. Although this could significantly reduce the tax burden, the HMRC have Settlement Legislation (S624, ITTOIA 2005) to address such income shifting. This particular applies if the family member is not a fee earner for the company.

If the family member is not a spouse or civil partner, the HMRC could treat the dividends shifted by the IT contractor to a non-fee earning family member as their  income. This will also apply to a  business partner, family member or friend that  does not earn any revenue for the company.

The Arctic Systems case where the HMRC tried to prove that an IT contractor made a settlement to his wife,  therefore stating that he should be taxed on the whole amount of dividend and not taking into account his wife’s basic rate band, was a case lost by the HMRC. This case therefore set a precedent that shares gifted to spouses of civil partners and dividends subsequently received by them will not generally have Settlement Legislation applied to them.

However for non-fee earning individuals the dividends distributed to them,  is likely to be assessed on the fee earning contractor by the HMRC. The HMRC can also back date assessments going back at least six IT contractors tax years. Such additional assessed tax would also have interest and penalties added.