HMRC argued that the payments made to Mrs Jones were disproportionate to her contribution to the business and the income was in fact taxable on Mr Jones, who was effectively shifting his own income to his wife to be taxed at lower rates.
This would breach the settlement provisions, which are a set of anti-avoidance rules designed to stop individuals from avoiding tax by artificially diverting their income to other family members to take advantage of their unused tax allowances and bands.
The rules only apply when an individual retains an interest in either the income or the underlying asset that produces the income, in which case they are taxed on the income as if it remained theirs.
There is an exemption when property is gifted outright between spouses, but this exemption does not apply to gifts which are wholly or substantially a gift of income.
The House of Lords ruled that ordinary shares are not wholly or substantially a gift of income, therefore the exemption did apply, and the dividends paid to Mrs Jones were taxable on her.
Following this ruling, an owner-manager can give ordinary shares to their spouse and dividends will be taxed on each spouse according to their shareholding.
Non-voting shares and dividend waivers should only be used carefully because of the risk of Settlement Provisions applying.