Alphabet Shares: Why Use Them? Traps And Pitfalls

 

When a company pays a dividend, all shareholders receive payment in proportion to their individual shareholdings. For one shareholder to be paid in preference to another or be paid at a different rate the company needs either to have different types of shares, or the underlying shareholdings need to be changed, or the use of dividend waivers is required (e.g. all shareholders have the same type of share but one shareholder ‘waives’ his right to the dividend).  

 

Alphabet shares are the most straightforward method, especially if created on incorporation. The classes often rank as equal in all other aspects with, for example, the same voting and rights on a future winding up of the company.

 

Alphabet shares are not restricted to being used just for differing levels of dividend. They may also be used to give entitlement separate from the rules for ordinary shares (for example, preferential dividends, or limited rights to vote at general meetings), but their main use is to enable payment in respect of a particular class of share without being required to pay the same dividend to each shareholder. This may be of particular benefit if one or more of the shareholders is a higher or additional rate taxpayer and the other(s) either basic rate taxpayers or do not pay tax. 

 

Dividends are a return on capital invested. HMRC often try to contend that, rather than being a dividend, a payment to a shareholder (particularly a director shareholder) is in reality a payment for salary rather than a return on capital. The reason is easy to see - an employment ‘reward’ should be taxed under PAYE as salary and subject to NIC rather than as a ‘return in investment’ dividend with a tax credit of 20% and no NIC. 

 

 

What is the ‘settlements’ legislation?

In the above example, HMRC could also seek to challenge the arrangements on the basis that the payments fall foul of the ‘settlements’ legislation, thus denying the allocation of dividends away from James (the higher rate taxpayer) to the lower tax rate shareholder (Jane).

The relevant tax legislation (ITTOIA 2005, Pt 5, Ch 5) covers income derived from a settlement, and defines a settlement widely as including ‘any disposition, trust, covenant, agreement, arrangement or transfer of assets’ (s 620). Therefore within owner managed companies a ‘settlement’ situation may apply where an individual enters into an ‘arrangement’ of diverting income one to another, resulting in a tax advantage. 

These anti-avoidance provisions are actually designed to prevent a person diverting their income to such effect, and there have been a number of tax cases brought by HMRC under them, probably the most well-known being the ‘Arctic Systems’ case (Garnett v Jones [2007] UKHL 35 (link here).

In that case, Mr and Mrs Jones were equal shareholders in a company wherein Mr Jones was responsible for earning all of the profits. The House of Lords found that an arrangement in the nature of a settlement had been created when they subscribed for one share each and set up their company ‘Arctic Systems Limited’. However, an exception from the anti-avoidance provisions applied as there was an outright gift, which was not wholly a right to income. Therefore the dividends paid to Mrs Jones were permitted as her income only. 

HMRC may also seek to apply the ‘settlement’ rules where the level of dividend paid on a particular class of share could not have been paid without no or minimal dividends paid on the other classes of shares. If the dividend can only be paid if one class of shares receives no dividend then this may fall within the ‘settlement’ legislation as a’ bounteous arrangement’ and could be challenged by HMRC.

Alphabet shares for employees 

Alphabet shares can be used to give company employees dividends as part of their remuneration package. Structured correctly, such schemes can be an incentive for employees as well as being a tax-efficient means of payment. The shares are usually non-voting and may be redeemable at par value (i.e. £1 on a £1 share) thus allowing them to be returned should the employee cease working for the company. 

HMRC’s view

Care in setting up such schemes is paramount. HMRC have already been to court and won in the case HMRC v PA Holdings Ltd [2011] EWCA Civ 1414 (link here).

In this case, PA Holdings Ltd created a series of different share classes in a subsidiary company to pay bonuses to employees as dividends rather than employment income. The Court of Appeal found that the payments were emoluments and as such subject to NIC.

Alphabet shares and CGT

Transfers of ‘Alphabet’ shares between shareholders who are married (or civil partners) will normally be covered by TCGA 1992, s 58(1). This section permits one spouse to gift the shares to the other at a ‘no gain/no loss’ value (assuming that the spouses are living together). The transferee spouse acquires the shares at the original cost to the transferor spouse at the date of transfer. 

Practical Tip:

Alphabet shares permit flexibility in the payment of dividends, allowing for future changes in the dividends paid to each shareholder without having to change the shareholding.

If it is intended to sell the business in the future, it should be remembered that a share of at least 5% is normally required in order to claim entrepreneurs’ relief for capital gains tax purposes.

To prevent a challenge by HMRC that the dividends could not have been paid unless one class of share was not allocated any dividend, it would be preferable for the company to have sufficient distributable profits so that dividends were capable of being paid on all classes of shares.