Excessive remuneration to directors: Tips and traps

Lee Sharpe looks at what can happen if directors pay themselves too much in family company scenarios.

Generally speaking, HMRC will be only too happy that any employee takes a large(r) salary, because it will mean that HMRC sees higher revenues from income tax and National Insurance contributions (NICs) through the payroll. 

So, it might seem strange to hear HMRC argue that remuneration is excessive. But this is not just about HMRC; company officers have duties according to company law. 

Companies Act 2006 allows a shareholder to petition the court on the grounds that ‘the company's affairs are being or have been conducted in a manner that is unfairly prejudicial to the interests of members generally or of some part of its members, including at least himself’. Companies Act 2006, s 994 has been successfully applied to owner-managed companies, such as in the cases re: Booth [2017] EWHC 457 (Ch), and Maidment v Attwood and others [2012] EWCA Civ 998.

In the first case, the company had been in existence for several generations, and acrimony had built up for decades between the majority shareholder side of the family, who were actively engaged in the business, and other members of the family who held passive minority interests (but who nevertheless held more than a quarter of the company’s share capital). The director/shareholders had enjoyed very substantial salaries and their remuneration packages included luxury cars and at one stage, a yacht; the minority shareholders had not received any income from dividends since 1987.  

The directors argued that they had not paid out dividends for nearly 30 years because they needed to retain substantial amounts of cash in the business; generally speaking, in the absence of any formal agreement or clear understanding between the shareholders, companies are not under any obligation to pay out dividends. 

However, the court found the director/shareholders’ stated need for liquidity somewhat at odds with their approach to their own remuneration, which far exceeded the amount that reasonable directors acting in the best interests of the company overall, could have thought fair remuneration for the work they undertook; in effect, the director/shareholders were distributing the company’s profits through salaries, etc., to the exclusion of the minority shareholders. The court also found that, in the absence of the relief afforded the minority shareholders by CA 2006, s 994, the directors’ conduct would have justified an order for the company to be wound up instead. 

It is not safe to assume that HMRC will happily allow excessive remuneration to be paid simply because of the increased yield in income tax and NICs, because HMRC can still disallow any payment made by a trade if it has not been incurred wholly and exclusively for the purposes of the trade (ITTOIA 2005, s 34; CTA 2009, s 54). 

In other words, and simply put, HMRC can potentially take the PAYE tax and NICs but still refuse tax relief on the payment, against business profits. The rules that determine that a payment is one of earnings subject to PAYE and to NICs work independently of whether or not that payment is allowable for tax purposes.

In the case of self-employment or partnership, the proprietors’ profits are what they are; HMRC will instead look at wages, etc. paid to spouses, civil partners and/or other relatives to see if they are commensurate with the work they have done. 

Where HMRC decides that such an expense has not been incurred wholly and exclusively for the purposes of the trade, it is generally the ‘excess’ that is disallowed – any amount that is justifiable in terms of a reward package should still be allowed. 

With companies, HMRC will generally accept that a director/shareholder of his or her own company may choose to remunerate broadly at whatever level is desired, so long as the company remains profitable. For example, HMRC’s Business Income manual (at BIM47106) states:

‘Where the controlling director is also the person whose work generates the company’s income then the level of the remuneration package is a commercial decision and it is unlikely that there will be a non-trade purpose for the level of the remuneration package.’

However, the guidance then goes on to suggest that remuneration packages for other employees may be more rewarding for inspectors’ efforts. 

A further pitfall for director/shareholder is that HMRC may try to argue that the remuneration of a close friend or relative employed in the company ‘belongs’ to the controlling director and should be treated as taxable at the controlling director’s (presumably) higher rates, instead. 

Typically, where this involves a spouse or civil partner (or occasionally a minor child), HMRC can try to use the ‘settlements’ anti-avoidance legislation (ITTOIA 2005, s 619 et seq.) to tax income as if it were that of the controlling director/shareholder. The best defence against this is to demonstrate that the remuneration paid actually reflects the work undertaken by the spouse or child, and ideally is in line with amounts paid to employees undertaking similar work for the business – of course, this is not always possible, depending on the size of the business in question. 

It is very common for close relatives of the main director/shareholder to enjoy certain ‘perks’ that other employees do not. Examples include company cars, medical insurance or club membership. 

These may be taxed on the main director/shareholder if HMRC believes that the only reason that an employee received that benefit is because of their special relationship with the director/shareholder, and it could not be justified otherwise.

While not taxable benefits, pension payments on behalf of directors and other employees will still need to have been incurred wholly and exclusively for the purposes of the trade in order to be allowable. 

Since 2017, rules were introduced to restrict the pensions annual allowance of high earners – broadly, those earning more than £100,000 are potentially affected, such that as a person’s income rises, the amount that can be paid into a pension for tax relief is tapered down to as little as £10,000 in a tax year. 

It is conceivable that a director/shareholder might want to boost overall family pension entitlement by arranging for substantial contributions to be made on behalf of a lower-earning spouse or civil partner in the same business. Here again, if the pension contribution appears excessive as part of the overall remuneration package, HMRC may try to disallow the perceived excess (see BIM46035).

Where the payment is deemed to be excessive and the recipient is also a shareholder, HMRC may treat the payment as a distribution of profits – effectively as a dividend. 

This would not necessarily prevent the charge to NICs from persisting as a ‘payment on account of earnings’, as has been demonstrated in cases such as PA Holdings v HMRC [2011] EWCA Civ 1414.

The key points are not to assume that a payment is deductible from taxable profits just because it has been taxed as earnings, and to ensure that there is adequate commercial justification for any payment made by the business but particularly where HMRC might perceive a link to a higher-earning director/shareholder. This does not mean that there is anything wrong with paying wages to a spouse or civil partner but that the payment must be commensurate with the work undertaken. 

It would seem sensible to record the reasoning behind such payments at the time they are made or (as in, say, the case of a monthly salary) the annual rate is fixed or reviewed.