Dividends have lost some of their appeal thanks to the changes announced in the 2015 Summer Budget, and implemented from 6 April 2016. Basically, the effective income tax rate on dividends has increased by 7.5% across the bands, significantly narrowing the efficiency margin. However, where the alternative is a bonus subject to employees’ and employers’ National Insurance contributions (NICs), they are still relatively tax-efficient, and are likely to remain the preferred method of extracting profits (broadly above the personal allowance) for many family-owned companies.
This article will consider some of the issues which commonly arise with dividends, and which can catch out the unwary.
What is the benefit?
First, a quick summary of the main ‘yield’ percentages when comparing salary (or bonus) with dividend, depending on the applicable main rate of tax; these rates will not always apply – different rates will apply at the margins, around the NIC upper earnings limit, (currently £43,000), and where adjusted net income exceeds the £100,000 limit and the taxpayer starts to forfeit tax-free personal allowance:
Tax Band Salary/Bonus Dividend Difference
Basic Rate (20%) 59.75% 74.00% 14.25%
Higher Rate (40%) 50.97% 54.00% 3.03%
Additional Rate (45%) 46.57% 49.52% 2.95%
Note that there is a healthy margin of 14.25% in favour of dividends where the shareholder is a basic rate taxpayer, but this is quickly whittled down to a pretty modest 3% or thereabouts, at higher income levels.
Beware insufficient company reserves!
The company may pay out as dividends only what it can afford to, when measured against its distributable profits – basically all the after-tax profits it has ever made since incorporation, after all previous dividends it has paid out. The company has a higher duty to its creditors, etc., and dividends are supposed to be a distribution of the company’s profits, so it makes sense that the company must first have sufficient accumulated profits, (after counting all other liabilities) in order to pay out the dividend.
It does not necessarily matter if a company is making losses, or has just made losses in the latest accounting period; what matters is whether there remains an overall distributable surplus. The test is usually against the company’s last set of approved accounts (although later accounts may be used in some cases). If dividends prove excessive, HMRC will consider them interest-free loans to participators, that must be repaid (there may be a temporary corporation tax charge under CTA 2010, s 455, and a benefit-in-kind tax charge for an interest-free loan if the shareholder is, or is related to, an employee).
Get the balance right
Taxpayers often assume that they can vote dividends in the amounts they see fit, for various family shareholders. By default, dividends must be voted in proportion to shareholdings. This is arguably subject to the company’s Articles of Association, but it would be most unusual for the Articles to deviate from this standard.
Example 1: Dividend entitlement
Ahmed has 40 shares in A&R Records Limited, while Rihanna has the remaining 60 shares.
The directors agree to pay out an interim dividend of £500 per share, which means:
Ahmed is entitled to 40 x £500 = £20,000; and
Rihanna is entitled to 60 x £500 = £30,000.
Ahmed wants his full £20,000. But what if Rihanna doesn’t want £30,000 in dividends – say because she has other income of £25,000 and doesn’t want to start to lose child benefit? (child benefit starts to be clawed back, basically, when adjusted net income exceeds £50,000).
Dividend waivers
One of the ways to get around this is to ‘waive’ one’s entitlement to a proposed dividend by means of a dividend waiver, in respect of some or all of one’s shares. The waiver can be in respect of a future dividend, or several future dividends, or apply for a given period.
Example 2: Partial dividend waiver
Facts as above, except this time Rihanna has a dividend waiver in place, in respect of 10 of her 60 shares:
Ahmed is entitled to 40 x £500 = £20,000; and
Rihanna is entitled to 50 x £500 = £25,000 – the dividend due on her 10 waived shares is ignored.
Pitfalls with waivers
A waiver is a formal document: it is a legal deed of waiver so must be drawn up correctly, and must be signed and witnessed accordingly.
Waivers cannot be implemented retrospectively; they must be in place before entitlement to the dividend arises. From a tax perspective, HMRC will say that a late waiver simply means that Rihanna has given away a right to income on which she is already taxable, so it is tax-ineffective.
They should not last for more than twelve months, because inheritance tax (IHT) legislation excludes only a waiver within twelve months before any right to the income has accrued, from being considered a ‘transfer of value’ for IHT purposes (IHTA 1984, s 15).
The distributable profits should be able to support the pre-waiver dividend – if the distributable reserves in A&R Records above were such that Ahmed could get his £20,000 dividend only if Rihanna waived £5,000 of her dividend, then (and even if Rihanna’s waiver were otherwise valid) HMRC could try to argue that Rihanna has ‘settled’ some of her income on Ahmed (so she should be taxed on part of Ahmed’s dividend as well as what she actually received). The case Buck v Revenue and Customs [2008] SPC00716 is commonly used by HMRC to justify this approach (see our previous article Avoiding Settlements for more information on when this may apply).
Alphabet shares instead?
If waivers are likely to be a regular feature, then it may be better to issue a separate class of shares to the affected shareholder, that may well rank ‘pari passu’ (on an equal footing) with the original class of shares, but effectively circumventing the presumption that all shares of a particular designation are equally entitled to a dividend. It is generally recommended that such shares rank pari passu so that they are demonstrably and significantly more than just a right to income.
Example 3: Dividends on ‘A’ and ‘B’ shares
Ahmed has 40 ‘A’ shares and Rihanna has (say) 100 ‘B’ shares in A&R Records Limited; the shares have equal voting rights, etc.
The directors agree to pay an interim dividend of £500 per share on the ‘A’ shares, and £250 per share on the ‘B’ shares:
Ahmed is entitled to 40 x £500 = £20,000; and
Rihanna is entitled to 100 x £250 = £25,000
Clearly, Rihanna is not tied to having the same rate per share as Ahmed, if she has different shares. It should be noted that ‘alphabet share’ designations are practically far more straightforward to arrange when a company is brand new, rather than several years old. There can be tax implications to re-classifying shares, particularly if the shares are ‘restricted’, or if they change in value thus.
Pitfalls in relation to timing of dividends
A common pitfall with otherwise valid dividends is that the dividend paperwork must also be in order – and timeous.
In particular, interim dividends may be varied at any time up until they are actually paid, and if payment is effected by journal entry rather than with a money transfer (cheque, bank credit, etc.) HMRC’s position is that it is not effected until it is written up in the company’s books and accounting records. In HMRC’s company taxation manual (at CTM15205), HMRC is quite clear that if the journals are written up later on, the dividend will be treated as paid on that later date – even if in a later income tax year.
Practical Tip:
Despite the government’s best efforts, dividends remain a very important component of the profit extraction/remuneration strategy of most family companies. There are, however, numerous opportunities to go wrong, and it is important to work with your tax adviser or accountant to develop (and stick to!) a compliant regime that works for your business.
