James Bailey points out a potential income tax pitfall for family company shareholders, particularly those who are spouses or civil partners.
In a typical family company, paying dividends is a tax-efficient way of extracting profits for the shareholders. Dividend waivers, where a shareholder gives up the right to a particular dividend, can also enhance that tax efficiency, but it is important to be clear on what waivers HMRC are likely to challenge.
Husbands, wives and minor children
A recent case involved a classic example of dividend waivers being used unsuccessfully to reduce tax liabilities. P Donovan and related appeal ((2014) UKFTT 048 (TC))* involved a company whose shares were owned by two married couples. Each husband had 40% of the shares, and each wife 10%. The husbands paid income tax at the 40% rate while their wives were basic rate taxpayers, meaning that the wives would have no further income tax to pay on dividends whereas the husbands would pay an effective rate of 25%. The husbands waived their rights to a dividend and so only the wives received the dividends in question.
HMRC challenged this on the basis that the waivers constituted a ’settlement’ (meaning, a transfer of property from the husbands to the wives). Tax law says that if you make a ‘settlement’ and you (or your spouse or minor child) can still benefit from the settled property, it is taxable on you. The Tribunal accepted that the legislation applied here, and so the husbands had to pay income tax (at their higher rates of tax) on the dividends their wives had received.
HMRC are always highly suspicious of dividend waivers, but it is important to be clear about the limitations of the legislation against ‘settlements’ – it is futile to argue, by the way, that a dividend waiver is not a ‘settlement’ as this has been established in numerous tax cases.
In order to tax the shareholder who has waived his dividend, HMRC have to show that he has ‘retained an interest’ in the income he has lost by the waiver. In the case of wives and minor children, the legislation does this for them, by deeming him to have ‘retained an interest’ in cases where spouses and minor children can benefit.
Other cases
In most other cases, the settlements legislation cannot be used, so for example, an unmarried couple who own a company, or a child over 18 who is a shareholder, can be involved in a dividend waiver without HMRC being able to challenge it – unless they can show that the person waiving the dividend stands to benefit from it. Their Trusts, Settlements and Estates Manual states at TSEM4220:
“Where the person benefiting under the arrangement is not a spouse, civil partner or minor child the settlements legislation will not apply unless there are arrangements under which the money will be paid, or used to benefit the settlor (or spouse etc).”
An example of the settlor (i.e. the waiver of the dividend) benefitting in these circumstances might be where an adult child’s dividend is used to pay his university fees, which last year were paid by his parents who have now waived their dividends.
It has often been thought that HMRC have to show that if the waiver had not occurred, the company would not have had sufficient distributable profits to pay the dividend concerned to all shareholders, but the Tribunal said they thought this was ‘not, in isolation, conclusive’. They did however find that there were indeed insufficient profits to pay everyone a dividend, though the taxpayers disputed this.
Practical Tip:
HMRC are always suspicious of dividend waivers, but bear in mind the limitations on what arrangements they can challenge. In many cases, using different classes of shares (A shares, B shares, and so on, sometimes called ‘alphabet’ shares) will provide more flexibility and less risk of a challenge. However, professional advice should be considered before using such an arrangement.
*See McLaughlin’s Tax Case Review (April 2014)
