Are Some Dividends Really Earnings?

 

Some family and owner-managed companies seek to reward their managers by the ‘split payment’ method, i.e. salary as well as dividends. This article looks at whether such schemes work, and highlights a recent tax tribunal case which casts further doubt on their effectiveness.

 

The type of scheme we are looking at here goes beyond the usual minimum salary/dividend route for directors. Rather, we are looking at schemes relating to payments made to managers who are employees of the company. It is not surprising that HMRC have stepped up their interest in such schemes, on the basis that the arrangements could potentially achieve significant savings (e.g. dividends are not subject to either employees’ or employers’ National Insurance contributions (NICs)). 

 

The recent tax case James H Donald (Darvel) Ltd v HMRC [2015] UKUT 514 involved three schemes, each designed to avoid the NIC that would have been payable had payments been made as salary. 

 

The first of the three schemes involved issuing shares to employees from a specially incorporated ‘services’ company. The employees agreed that they would be paid salaries equal to the national minimum wage. The consequential savings to the company were paid out to employees in the form of dividends.

 

The second scheme involved the creation of a limited liability partnership (LLP), which comprised another company and several senior employees. Remuneration previously paid to said employees was distributed by the LLP as part profit share/part dividend. The employees had originally worked for the company, and each resigned to become members of the LLP. 

 

The third scheme was aligned with the second scheme in an attempt to escape the taxable benefit of company cars, by arranging for them to be provided via the LLP. If the second scheme failed, then so would the third scheme.

 

The case was initially heard at the First-tier Tribunal, who found in HMRC’s favour, ruling that payments under the first two schemes were emoluments and as such the third scheme also did not work. The company appealed, claiming that the tax laws imposing income tax on dividends took precedence over the tax laws that charged emoluments to income tax. Therefore, once identified as dividends, payments could not be taxed as emoluments.

 

The Upper Tribunal disagreed. It looked at the schemes as a whole and the end result, considering the arrangement in its entirety rather than at the individual steps undertaken to create the schemes. The Upper Tribunal found that the dividends received were income in the hand of the LLP ‘partners’ and that that income derived from an employment relationship. 

 

The conclusion was reached that the payments could only have been made as a result of the services provided as employees of the original company. The members’ share of the LLP profits and dividends were, in reality, reward for their services to the original company, what form those payments took was irrelevant. 

 

• The P A Holdings case

In making their deliberations, the Upper Tribunal noted the similarities of the second scheme to the scheme considered in the Court of Appeal case PA Holdings v HMRC [2011] EWCA Civ 1414 (link here). In that case, the defendants had also sought to replace earnings with dividends from shares, and they also lost their case.

 

P A Holdings Ltd was a large business that created a discretionary employee bonus scheme with a similar objective as in the James H Donald case and with a similar view to saving NIC for both employees and employers, and thus attracting a lower rate of tax payment overall. A series of different share classes in a subsidiary company was used to pay annual staff bonuses as dividends, rather than as employment income. 

 

The practicalities of the scheme were to first transfer funds into an employee benefit trust. The trust then purchased shares in another company, and by a series of steps, shares in an offshore company were awarded to the employees. The employees received their bonuses s dividends and redeemable shares. HMRC sought to show that the receipts were really earnings derived from employment; the employment being of the original company. 

 

This case was referred to in the James H Donald case as being the authority that the Tribunal needed to focus on deciding the ‘character of the receipts in the hands of the recipients’ in reaching its conclusion, rather than looking at the form of the individual transactions. The point is that where the facts suggest that the income has derived from an ‘employment’ relationship, then the court may disregard the individual steps taken to distance that relationship. 

 

It was held that the source of the receipts was the various individuals’ employment with the original company. Having made that ruling, as the payments were, in substance, income from employment, they could not be dividends.

 

• Control 

Arrangements where a director/shareholder takes dividends instead of bonuses are probably less likely to be challenged, due to the fact that directors control the company. This is one area where the James H Donald case fell down. The Tribunal highlighted the fact that the Mr Donald had sole responsibility for the management and control of both the original company and the LLP. The LLP members (i.e. the managers/senior employees) had no control over the future of the company or how it was run – Mr Donald did. 

 

These two cases need to be distinguished from salary sacrifice schemes, where an employee sacrifices his right to receive part of his entitlement under his contract of employment. Usually, the sacrifice is made in return for the employer’s agreement to provide the employee with some form of non-cash benefit (e.g. childcare vouchers, or increased pension contributions). The 'sacrifice' is achieved by varying the employee’s terms and conditions of employment relating to pay. Where an employee agrees to a salary sacrifice in return for a non-cash benefit, they give up their contractual right to future cash remuneration. 

 

The James H Donald case should be taken as a warning to companies considering replacing the earnings and/or bonuses of employees with dividend payments (although in any event increases in rates of tax on dividends to be introduced from April 2016 will make it less beneficial to pay dividends rather than salaries under PAYE). HMRC will be looking at companies who make use of separate classes of shares held by employees (under ‘alphabet share’ schemes) and any expectation of receiving income equal to salary being sacrificed could come under attack from HMRC.