This note outlines the key features of planning using “alphabet shares”. It is not intended to be comprehensive and in some areas over-simplifies for clarity. You should not regard it as a substitute for professional advice appropriate to your personal circumstances.
Because of the impact of National Insurance Contributions, it is usually more tax-efficient to extract value from a company by way of dividend than to do so by way of salary or bonus. And where there is just one class of share in issue and dividends are paid to all shareholders pro rata to their shareholding, extracting profit in this way is fairly uncontroversial. It is, of course, important that any dividends are lawful and are paid in accordance with the requirements of the Companies Act – but that is another story…
Most of the tax complications from dividends arise where it is not desired to pay dividends to all shareholders pro rata to their holdings of a single class of ordinary share. We can identify at least three situations in which this might arise:
- “Family dividends”
- “Remuneration dividends”
- “Quasi partnership” companies
Each of these has its own tax consequences and we look in more detail at each of these below.
Because everyone has his or her own personal allowances, basic rate and higher rate tax bands it can often be tax-efficient to arrange matters such that taxable income is “shared” between members of a family (typically husband and wife, civil partners or co-habiting couple but sometimes more widely). Where this is done using a single class of ordinary share, with dividends paid pro rata to share ownership, there are unlikely to be tax problems (even where the family members play no active part in the business) unless either
- Dividends are paid to minor children; or
- There are arrangements under which income ostensibly paid as dividend to one person finds its way back to another. For example, arranging for an elderly parent with little income to hold shares in your company on the understanding that any dividends will be returned to you (or used to benefit you in some way) will not work.
Where you want “family dividends” to be paid other than pro rata to holdings of ordinary shares there are two choices. One is to use dividend waivers – that is, to remove a shareholder’s legal right to a particular dividend or series of dividends with the intention that the dividend “pot” is shared out among other “non-waiving” shareholders. Care is needed with the mechanics for a valid dividend waiver (outside the scope of this note) but in principle it is perfectly possible. An alternative way of securing a substantially similar result is to create separate classes of share and to vote dividends only on the chosen share classes. This may be particularly attractive if waivers are likely to be a recurring feature rather than a one-off. Often the classes so created are designated A, B, C shares etc.: hence the terminology “alphabet shares”.
Whether the method chosen to route disproportionate income to family members is the use of waivers or alphabet shares, the outcome in tax terms is likely to be the same. Where the intended effect is to divert income from a person to the person’s spouse, civil partner or minor child the planning will not be effective. Where the beneficiary is not a spouse, civil partner or minor child the planning should be effective unless there are arrangements under which the money will find its way back to or otherwise used to benefit the “diverter”.
There is a great deal of complex legislation which is potentially in point where employees are given shares in their employing company. Very broadly, this aims to impose a charge to Income Tax on the value of the shares when they are awarded. But what if one awards to an employee shares which have no real value – perhaps no fixed rights to dividend, no rights to vote and no rights to participate in the assets of a company on its sale or winding-up? And what if one then declares a discretionary dividend on those shares to replace salary or bonus? Is that effective in saving National Insurance Contributions? Such is the thinking behind “alphabet shares” for employees, with each employee having his or her own class of share on which a separate “dividend” is paid. Sadly, it is now clear that such planning will not work, under a dual attack from case law and legislation. The courts have held that where a dividend is in substance a reward for work done in an employment, the dividend will rank as “earnings” for NIC purposes and NIC will be due. Worse still, under a strict reading of the anti-avoidance law in this area, an attempt to avoid NIC in this way could even result in a higher tax charge than simply paying remuneration in the first place. So, however attractive they may have been in the past, “remuneration dividends” are nowadays not a good idea at all.
Quasi partnership companies
The third area is where a company is owned by a number of co-owners, each genuinely owning a share in the business – that is, where the business is essentially in the nature of a “partnership” albeit carried on through the legal structure of a limited company. Ordinarily, the co-owners will each hold ordinary shares in the company with full voting, dividend and equity rights and where dividends are paid on these shares pro rata to the shareholding no problem should arise. But sometimes the co-owners may want to share profits in a way which is proportionate not to the equity ownership but to the contribution each has made. One way of doing this is to make the adjustment by way of bonus: that is perfectly acceptable but not always very tax-efficient. Another is to pay disproportionate dividends, either by way of dividend waiver or by creating a different class of share for each owner (“alphabet shares”) and voting differential dividends on each class.
The treatment of such differential dividends is not completely beyond doubt. One analysis is that, provided the classes of shares carry full equity and voting rights, they can be distinguished from “alphabet shares” awarded to employees and there should be no risk that NIC should be due on the dividends. On the other hand, if it can be shown that the additional dividend which is paid on any particular class of share (above and beyond the strict pro rata entitlement) has its roots in the work which the individual shareholder has done for the company we have started to see HMRC putting forward the view that the additional element of the dividend (but not the basic pro rata element) has the character of “earnings” and is subject to NIC. There are counter-arguments: in particular must remain open to some doubt whether dissection of a single dividend in this way is possible. For the time being the position remains uncertain and the payment of differential dividends to reward differential effort should be treated with caution.