Mitigating income tax through 'income shifting'

At the time of publication, the top rate of income tax will have been 50% (in respect of annual income above £150,000) for a complete year. Additionally, for those earning more than £100,000 a year, the basic personal allowance will have been gradually withdrawn. (The withdrawal is on a phased basis and reduces by £1 for each £2 earned above this amount.)

Against this background, many clients who pay income tax at the higher rate would like to know the extent to which they may transfer income to a spouse who pays income tax at a lower rate. This 'income shifting' can potentially take advantage of a spouses' tax-free personal allowance and their 20% lower rate tax band to produce a significant reduction in a couple's overall income tax liability (in respect of income up to £37,400 for the 2010/2011 tax year).

There is, as one would imagine, legislation (widely referred to as the "settlements legislation") that counters the diverting of income by Person A (a higher rate taxpayer) to Person B (a lower rate tax payer) and it does this by taxing Person A as if he or she still received the income. With a view to addressing perceived shortcomings in that legislation, further legislation was proposed in December 2007. However, the previous Labour administration shelved the proposals leaving open the possibility for the mitigation of income tax.

Significantly, the settlements legislation does not apply in respect of income that is generated by capital that has been gifted outright by one spouse to another. A gift is not "outright" for this purpose if (for example) it is subject to terms under which it may be returned to the person making it. Careful planning is required but, subject to this, transferring assets, shares in a company or rental property between spouses can still therefore represent an excellent means of splitting income to mitigate income tax.

Jonathan Riley is Head of Succession, Estate Planning & Tax at Michelmores. For further information, please contact Jonathan at jonathan.riley@michelmores.com