Guide to tax efficient school fee planning

A question we often get asked by our clients is “can school fees be paid through my business?” The simple answer to this question is “yes” but there is not a tax efficient solution that fits all scenarios, and some ‘solutions’ being marketed to business owners simply do not work.

This was recently highlighted by HMRC who consider a ‘dividend diversion scheme’ used to fund school fees as tax avoidance that falls foul of the rules.

How the Dividend Diversion Scheme works

The Dividend Diversion Scheme is targeted at owner managers of companies and involves diverting dividend income to their minor children.

The broad workings of the scheme are as follows:

• A relative of the company owner, usually a grandparent or sibling, purchases new shares in the company at a price significantly below market value.
• The relative gifts the shares to a trust for the benefit of the company owner’s children.
• The company declares substantial dividends on the new shares which are paid to the trust.
• The dividend income is used to pay the school fees and is taxed as income of the children.
• As the children are taxpayers in their own right, they are entitled to the tax-free personal allowance, the dividend allowance and the basic rate tax band.
• As a result, the overall tax charge is significantly lower than if the parent had received the dividend directly, and the tax savings increase with the level of school fees and number of children involved.

Taxation rules and issues with the Dividend Diversion Scheme

So why does this scheme not work? There is a raft of tax legislation that deals with this scenario and the crux of it is that if a parent gives an asset to their child and that asset produces more than £100 of income in the tax year, the income is taxed as if it were the parents.

The asset here is the shares in the company, and the income is the dividends used to pay the school fees, but what you might say is that the gift is not from the parents, it is from the relative, so how can the “£100 rule” bite? The legislation in this area is widely drawn and catches indirect gifts and reciprocal arrangements.

Legitimate alternatives for School Fee Planning

Clearly, in the above scheme it is the parent “calling the shots.” Why would the owner of a company issue shares at a price significantly below market value and declare substantial dividends on those shares unless there was something in it for them? Care needs to be taken with any dividend planning that includes some or all of the above steps as they are highly unlikely to achieve the stated tax result.

A variation on the above scheme that is entirely legitimate is if the company is owned by a grandparent, say. A grandparent may own a successful trading company and wish to make provision for their grandchildren’s education.

They could do this by transferring shares in the company to a trust for the benefit of their grandchildren and paying dividends on those shares. In this scenario, there is a genuine gift by the grandparent (not an indirect gift by the parent) and there are no reciprocal arrangements so the anti-avoidance legislation cannot apply.

The asset gifted to the children (via a trust) need not be shares in a company. The planning would work equally as well with other income generating assets, such as property, albeit that there are additional tax implications to consider. The key message is that the gift must not come from a parent.

It is worth pointing out that the above legislation only applies to gifts to minor children, i.e., under 18s. A parent could legitimately give shares away in their company to their adult children and pay dividends on those shares with a view to funding university fees, rent, or saving for a house deposit, for example.

School fees could also be paid by a business as part of the remuneration package of a director/employee. In this case, the fees would be taxed as PAYE earnings or a P11D benefit, depending on how the fees are paid and the contractual arrangement that exists with the school.