Profit Extraction: Getting The Share Structure Right

As part of a profit extraction strategy, it is important to consider what share structures may be suitable. Failure to do so may well be difficult to put right years down the line.

It seems doubtful that when buying companies ’off the peg‘, many owner-managers give much thought to the share structure. It is not uncommon to come across a situation where, for example, two or three individuals go into business together with the intention that they should be equal shareholders, but then no shares are actually issued other than the subscriber share(s). A share is not usually ’issued’ until it is registered in the register of members (National Westminster Bank plc v CIR [1994] STC 580).

It is not necessarily the case that the registered shareholder is the beneficial owner (e.g. where the shares are held in the name of a nominee, such as Barclay’s Nominees). But unless there is some written agreement to that effect (e.g. a declaration of trust by the registered holder), a number of problems might potentially arise, not least that the putative joint owners might fall out.

I have come across a situation where a share structure was adopted with ’A’ and ’B’ share classes with different rights whereas, apparently, the intention was that all rights should be equal. Since dividends (albeit modest) had been paid on the ’A‘ shares, which is consistent with beneficial ownership, tax counsel advised that it could not be argued that there was an ‘implied trust’ and equalising the share rights meant value passing to the ’B’ shareholders which could have been (and still could be) taxable under the employment-related securities (ERS) rules in ITEPA 2003, Pt 7 (s 447 - ’Post Acquisition Benefits From Securities’).

The ERS rules contain many traps for the unwary, and professional advice is recommended where any changes in shareholdings, or share rights, are proposed. Shares acquired by a director or employee of a private company will be deemed to be ERS (by ITEPA 2003, s 421B(3)). This is subject to a limited exception for shares acquired from an individual (i.e. an existing shareholder) in the ‘normal course of domestic, family or personal relationships’ (e.g. by way of gift from father to son).

 

In addition, when a director/employee acquires shares in their employer and pays less than market value for the shares, they are liable to income tax on the discount under long-established case law (Weight v Salmon HL 1935, 19 TC 174). That is not usually an issue on incorporation when the company has no assets or business since the shares will be worth only nominal value. After the company has been trading for some time the shares are likely to have value and later acquisitions may give rise to income tax (and potentially PAYE and National Insurance contributions (NIC)). 

The description ’alphabet shares’ usually applies to a situation where ’ordinary’ employees are issued with shares of individual share classes A, B, C and so on, which have very low nominal value and no rights except to a dividend (at the directors’ discretion). Dividends are then paid instead of salary or bonus. HMRC would normally argue that the dividends are simply ’earnings’ (within ITEPA 2003, s 62) and that PAYE and NIC are payable. 

It is quite common for the incorporation of professional partnerships to involve the former partners holding different share classes to reflect profit shares, and to reward themselves mainly by dividends. It is not unknown for HMRC to argue that the dividends are earnings, and in a way they would be correct, but only in the sense that the profits of any private company are dependent upon the efforts of their owner-managers. I do not personally think HMRC would win the earnings argument before the tribunal where the holders of the individual share classes are the company’s equity shareholders (and assuming the dividends are lawful and properly evidenced). However, such share structures should be adopted somewhat advisedly. One suggestion would be for each shareholder to hold shares in a single class on which the same rate of dividend is paid, with individual share classes used to ’top up’. This may help to reduce the risk of HMRC successfully arguing that the dividends are earnings, at least as regards the general share class. 

One of the main reasons for incorporation of course is income tax shelter for profits retained in the company, but the issue there is that if a holder of an individual share class does not wish to draw a dividend this does not increase their entitlement to the company’s ’pot’ of reserves. There is no individual fund as it were, though I understand this might be possible. Changes in shareholdings and shares awarded to new directors may or will also have ERS implications, so there are reasons why some partnerships may prefer to remain unincorporated or to incorporate as an LLP, especially now that the sale of goodwill on incorporation will no longer qualify for capital gains tax entrepreneurs’ relief and corporation tax relief for amortisation. 

Let me tell you another story. I once discussed wives’ (modest) salaries with the senior partner of a firm of solicitors, which my employer at the time had been engaged to act for. I asked what the wives actually did. The shocked reaction was that the predecessor firm had never mentioned the wives having to do anything, whereupon I was obliged to explain that expenses had to be incurred wholly and exclusively for the purposes of the trade. That is not to say wives, children (age 13 upwards) and other family members cannot work in the business and be paid a (tax-deductible) salary, provided that this is commensurate with the duties performed. 

Arranging for a spouse to hold shares in order to pay them dividends to use up their personal allowance and/or basic rate band is, however, (currently) unobjectionable in almost all circumstances (except where dividend waivers are involved). Earlier, HMRC took the view that the ’settlements’ provisions could apply where, basically, one spouse did all the work but the other received part of the profit as dividends. That was essentially the situation in Jones v Garnett [2007] UKHL 35 (http://www.bailii.org/uk/cases/UKHL/2007/35.html), where HMRC argued that the arrangement for Mrs Jones to own half the shares (for no consideration) and receive half the dividends was a settlement, and that the settlement was one of income which, as between husband and wife, is ineffective under the settlement provisions (ITTOIA 2005, s 624). In that case, Mrs Jones’ dividends would have been assessable on Mr Jones. Thankfully, the courts distinguished the holding of ordinary shares, with normal voting and equity rights, from earlier precedent and held that ordinary shares could never be simply a right to income. Mrs Jones did some work for the company as it happens, but that is not an issue. However, I would always recommend taking professional advice in such circumstances as the situation is not entirely risk-free. 

If Mr Jones had arranged for his minor children to hold shares, that is specifically a settlement and is ineffective (by virtue of ITTOIA 2005, s 629). Arranging for adult children and other relatives/friends to hold shares and receive dividends in similar circumstances may well be a settlement – the essential ingredient being a gratuitous intent or ’bounty‘ - but the settlement rules are only in point if the settlor ‘retains an interest’ (e.g. an agreement for the shares to be transferred to him or her at some point). Again, it is advisable to seek professional advice before adopting any structure which may invoke the settlement provisions.