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Alphabet shares for directors

A company currently has two full time directors with shares split 60:40. Other than their connection through the company, they are unrelated.

They do not currently take salaries from the company but take rents for the company's use of the business premises and dividends, both pay higher rate tax and director A (60%) has another source of income.

Director B (40%) has a requirement for a higher level of income from the company than director A and director A is quite happy for him to do so.

It has been suggested that the current ordinary shares be split into A (60%) and B (40%) to enable different rates of dividends to be paid, but retaining rights to 60:40 capital on a sale, wind up etc.

I feel that if the directors had been say, husband and wife, then potentially the settlements legislation could be in point, but has anyone any experience of HMRC arguing the point in the scenario outlined above?

Thanks

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27th Apr 2012 18:24

Should not be a problem

We have a company which recategorised its 100 shares into 40 A (Mr. A), 20 B (Mrs. A) and 40 C (Mrs. C).  Mr. A & Mrs. C (who is unrelated to Mr. A) run the company and pay dividends on their A and C shares in addition to the general dividends paid on all the shares, which includes Mrs. A's B shares; Mrs. A takes no part in the company.

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By BKD
28th Apr 2012 09:33

"one" word .....

.... P A Holdings

and another .... ITEPA 2003 s447

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28th Apr 2012 06:34

In practice I've seen no problems with this type of arrangement even in enquiry cases.

@BKD - AFAIR PA Holdings referred to people who were effectively employees, not business owners / investors?

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By BKD
28th Apr 2012 08:29

P A Holdings

Yes, the case was essentially about the reward of employees. But what is causing many commenators concern are the judge's remarks concerning the rationale for the decision - in the eyes of most opening the door considerably wider for HMRC to attack even relatively straightforard profit extraction strategies. And there is growing concern that, egged on by P A Holdings, HMRC will seek to make greater use of s447.

Whether or not those concerns are well-founded, only time will tell (and may depend in part on whether or not P A Holdings is successfully appealed), but I would not gain any comfort simply because such arrangements have not previously given rise to problems - it is well known that HMRC do not like alphabet shares and the view is that should HMRC decide to look more closely at profit extraction arrangements, alphabet shares will be at the top of the hit list.

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30th Apr 2012 10:20

Sources please

I understand the points made, and I really don't want to further debate the seemingly entrenched positions of others, but I would appreciate references to the sources of the following comments:

BKD wrote:

But what is causing many commentators concern are the judge's remarks concerning the rationale for the decision.

I note the emphasis that has been placed on the words "character of the payment in the hands of the recipient", but by my reading that was a mere tool to identify the source of the payment; ie was it a genuine dividend, paid on shares genuinely held in a genuine company that genuinely had profits to distribute? or was it a bonus payment from the employment, with the shares being a mere vehicle to transfer it from the employer to the employees.

Please can you point me to the comments of the many commentators expressing this concern? I would like to fully appreciate the concerns that have been expressed.

 

BKD wrote:

And there is growing concern that, egged on by P A Holdings, HMRC will seek to make greater use of s447.

As has been noted, s447 can only apply if the shares are first employment-related securities. So again I'd find it useful to see the terms in which these concerns have been expressed.

 

BKD wrote:

It is well known that HMRC do not like alphabet shares...

I wasn't aware that they were a general anathema for HMRC. I've only ever known them take any sort of issue with them when they have been used to disguise what are essentially bonus payments to people who otherwise have all the trappings of an employee. I'm unsure how this common knowledge escaped me.

 

BKD wrote:

...and the view is that should HMRC decide to look more closely at profit extraction arrangements, alphabet shares will be at the top of the hit list.

Again these views interest me, and I would very much like to get my own take on them.

I've not seen a great deal commented on this; an article by Keith Gordon in Tax Adviser, that to a certain extent questioned the validity of parts of the decision, and an article by a David Kirk (of whom I know little), which makes a slightly different (interesting, but not necessarily correct) point. I also understand that Rebecca Benneyworth may have been talking about it at some of her lectures, but she's not someone I'd make a point of listening to. Perhaps I was living in a cave for a while and missed it all?

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28th Apr 2012 12:24

PA Holdings - appeal

In the event that this case goes to the Supreme Court, it is unlikely that the verdict reached in the Court of Appeal will be overturned.

With regard to the question posed, it certainly is possible that the dividends paid to director A could be classed as a bonus (ie salary).

You would need to look at the particular circumstances, ie how often were these dividends (?!) paid. What is the supporting paperwork regarding the decision to pay the dividends. Why wasn't a dividend paid to the other director?

The answer is because one has a requirement for a higher income. I will leave you to work out yourself what HMRCs view would be on this.

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I don't agree

With the greatest respect to BKD and Tony, I can't agree.

It was decided as long ago as 1935 that what HMRC's view is on a matter, is entirely irrelevant:

"a man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow tax-payers may be of his ingenuity, he cannot be compelled to pay an increased tax." Duke of Westminster v Commissioners of Inland Revenue (19TC490)

What LJ Moses said in PA Holdings was that a payment couldn't be both earnings and a dividend; it was either one or the other. That assertion cuts two ways!

He then applied the Ramsay principle to look through the pre-ordained series of transactions (payment made to EBT so that PA got a CT deduction, EBT buys redeemable shares in Jersey NewCo on behalf of employees, NewCo distributes the funds to the employees and then redeems the shares) to assess the economic reality. The employees had been paid a dressed-up bonus.

When a company distributes profits to its existing shareholders, then in accordance with the assertion of LJ Moses it must either only be a dividend or only be earnings. Why have they ordered their affairs the way the have? Because they own the company.

For S.447 to apply, the shares must be employment-related shares as defined in S.421B(8); which is actually a circular definition (they're employment-related securities if S.447 applies; S.447 only applies if they're employment-related securities!), but essentially they need to have been acquired pursuant to a right or opportunity available by reason of the employment (or directorship).

In the OP's case, they're either reclassifying existing shares or exchanging new shares for old.  To the extent that any new shares get issued, they're being acquired pursuant to existing rights as shareholders.

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By Hansa
28th Apr 2012 13:21

I agree with Mr Kesby.

... as a detail, use may be made of Preference shares in such a structure (in practical terms little different to "A", &  "B" shares I agree) as they do however, by definition, suggest an alternative dividend structure.  What's in a name?  

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By BKD
28th Apr 2012 14:05

Steve

I'm not sure what you disagree with, since I was commenting only on the comments of others. If  you have any disagreement, it is with them.

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@BKD

Apologies.  I'd drawn an incorrect inference that you were agreeing with them

I don't think we'd have quite the recession we've got if it weren't for commentators commenting on how bad the recession was going to be! :)

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28th Apr 2012 15:26

Good points from Steve Kesby.  Alphabet shares are getting very common now that the 40% tax bracket is on target to begin about 20 pence per hour above the National Minimum Wage if recent Budgets continue for many years more.

It can get messy though.  Last year I won a new client with A,B,C,D,E,F shares and various transfers between the shareholders.  Alphabet soup!

When I set these up myself I always go for shares which rank pari passu and have full voting rights in all circumstances, as protection against attack under settlements legislation.  But I'd be interested on other views on all of this.  I go for quarterly dividends too.

My logic is that the following is my initial defence against any attacks:

1.  Royal Dutch Shell and HSBC are just two of the many stock market examples of companies which have more than one class of share commonly traded.  One of the key drivers for this was originally different tax legislation in the UK and Holland in the case of Shell, for example.  So HMRC if you want to attack the share structure of Mr. Mischief Limited please ensure you attack RDSA and RDSB too for consistency.  Don't want to?  Thought not.

2.  NYSE listed  companies pay quarterly dividends.  So does Mr. Mischief Limited.  Want to attack my quarterly dividends as salary?  Then go and attack Vodafone. Don't want to?  Thought not.

Other views on this are welcome.

 

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By BKD
28th Apr 2012 16:37

Apples and oranges

I think it is a little naive to compare multinational corporations, with their institutional and public shareholders and their various classes of shares (which tend to have different rights) with alphabet shares in a small private company where the shares have identical rights and exist solely for the purpose of paying different rates of dividends.

The issue is not about share structure nor is it about dividend policy - it is about the nature of payments. Moses J has made it clear - at least in the eyes of some - that it is the nature of the payment in the hands of the recipient that will determine its tax status, regardless of how the payment is described. If it is a reward for work done, then that is what it is, and will be taxed as such.

As Steve indicates, I'm not saying that I am in full agreement with the commentators. Whilst suggesting that the risk of HMRC attack may have increased, few if any have - as far as I am aware - expressed an opinion on the likelihood of a successful HMRC attack.

My advice to clients will be - carry on with alphabet shares if you want, but do so with the knowledge that there is opinion (by no means unanimous) that the arrangements may be more liable to HMRC scrutiny than before.

I guess we need to wait for Arctic II.

 

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28th Apr 2012 17:11

Fair enough.  All my alphabet share clients have full tax investigation insurance, so at least if HMRC ever waste silly amounts of taxpayers money on it we can put up some sort of a fist.

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I don't think there can be an Arctic II

I respect the fact that BKD is simply restating the views expressed by others in tax publications, but I do think it's useful to such a debate to express why those views make such little sense.

I agree that you definitely can't compare an OMB with a multinational corporation.  Neither should its alphabet shares be compared with the shares in the PA Holdings remuneration vehicle.  I'm very sure that our judiciary wouldn't be hoodwinked by such a proposition from HMRC and would be quick to distinguish the facts.

The whole point is that in the OMB the use of alphabet shares doesn't change things a great deal.  Either the dividends being paid to the owners (even on a single class of shares) have the character of remuneration or they have the character of entrepreneurial reward.

The fact that the owners choose not to remunerate their effort too highly, and only extract profits when there are profits to extract is in the very nature of the entrepreneur.

The use of alphabet shares simply enables the entrepreneurial reward to be extracted in different measures at different times.

If PA Holdings is in point, it's in point for all dividends paid by the OMB, not just those being paid on alphabet shares.  I really can't see that PA Holdings has opened any floodgates though.

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By BKD
29th Apr 2012 12:15

to clarify

 

Neither should its alphabet shares be compared with the shares in the PA Holdings remuneration vehicle.  I'm very sure that our judiciary wouldn't be hoodwinked by such a proposition from HMRC and would be quick to distinguish the facts.

But that is the point - there is no suggestion that alphabet shares would be compared with P A Holdings shares. It has been made clear that the decision in the case would not in itself have caused much alarm - what has triggered the concern are the closing words of one of the judges. What is at point is the nature of the payment in the recipient's hands, and nothing more.

The whole point is that in the OMB the use of alphabet shares doesn't change things a great deal.  Either the dividends being paid to the owners (even on a single class of shares) have the character of remuneration or they have the character of entrepreneurial reward.

Exactly - it is the nature of the payment in the recipient's hands - however it may be described - that is in point.

The use of alphabet shares simply enables the entrepreneurial reward to be extracted in different measures at different times.

Yes - but the obvious question is why would different dividends be paid to different shareholders (other than based on their pro-rata shareholdings). There are a number of answers to that question, but one of which (which I have in fact heard from clients) is that they want to ensure that Mr B is properly rewarded for his efforts. Were that statement to be made to HMRC, I wouldn't be suprised it they were to mention the words of  Moses J.

If PA Holdings is in point, it's in point for all dividends paid by the OMB, not just those being paid on alphabet shares. 

And that point has been recognised by the various commentators, though like you they consider it less likely that such arrangements will be challenged - at least for now. The various commentators (most of them well-respected figures in the tax world) have given various examples of scenarios that they consider to be more or less open to scrutiny following not the decision itself in P A Holdings, but the judge's words.

To repeat my view, I am not advising clients that their alphabet share arrangements are suddenly defunct, merely telling tham that there is a body of opinion that suggest that HMRC may take a closer look at their affairs.In that sense I do agree with the various commentators, even if there is considerable doubt as to HMRC success.

 

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29th Apr 2012 12:15

ir 35

very interesting debate - I was at a Rebecca Benneyworth update course last week where the LJ Moses ruling was discussed - my view is that there is very big leap from outlawing the PA Holdings scheme which was an avoidance of PAYE/class1 on employees remuneration (IR35) and on the other hand owner managers paying out their company profits by way of dividend (as I explain to my clients this is a reward for genuine risk)

- this was message I get from Dawn Primarolo's comfort speech to the Standing Committee in JUne 2005

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By BKD
29th Apr 2012 12:42

I agree, Nick - on the point about genuine risk

But, to play Devil's Advocate ...

... take the example of a company with 2 shareholders putting in equal effort. One with 10,000 Ord £1 shares and the other with 10 £1 B shares. Both on minimal salaries. To recognise the equal efforts, both receive the same amount of dividend. I'm not sure that the "reward for genuine risk" argument applies here - particularly in respect of the B shares. And, let's be honest here - we all know that a director of an OMB taking a £6k salary and a £38k dividend is rarely receiving his dividend solely as a reward for genuine risk (especially if he is the one doing most of the work) - you might argue with HMRC that this is the case, but for those of us living in the real world ........

Arguably, the above arrangement would already be caught by s447 so in that sense P A Holdings changes nothing. But I could not disagree with anyone that suggested that HMRC may now take LJ Moses' words on board and consider the character of the payments - disregarding their description.

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30th Apr 2012 10:27

I agree with BKD

I have noted that alphabet arrangements are becoming more popular. I think there is a gap between arrangements where, for example, the owners own shares, say, 75:25 but want to share rewards equally and ones where employees are issued single shares with no rights other than scope to receive dividends.

Reference has been made to Dawn Primarolo's comments in 2005 quoted in HMRC's manual at http://www.hmrc.gov.uk/manuals/ersmmanual/ersm90060.htm. This suggests that my second example is well within s447 but it is not wholly clear whether the first example is outside it.

The reality is that, in my experience, HMRC is not aggressively using s447. Will the P A Holdings case be the excuse to up the pressure? Only time will tell. My advice to clients at present is that use of alphabet shares, even in the less aggressive manner, remains risky.

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By TROGGY
01st May 2012 09:08

Thank you for everyone who has contributed to the debate.

I accept that this would not be risk free, but then very little is and I certainly am not aware of any HMRC activity in this area at present.

We need what will hopefully be a short term fix for the client and this seems the most obvious route, although any advice will of course be caveated with a "health warning".

Thank you again.

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By Exector
02nd May 2012 11:24

There is a useful review of the case and consideration of possible implications in a variety of scenarios, produced by Philip Fisher in the Tax Journal of 20 January 2012.

 

That may be of assistance to Mr Endeavour and to others.

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04th May 2012 12:18

Employment Related Securities

It would first be pertinent to decide whether the shares in question are employment related.  Several comments above have assumed/suggested that they are not.

The definition is in s421B ITEPA, which contains an automatic assumption (421B(3)) that shares will be employment related unless they are made available by an individual "in the normal course of domestic, family or personal relationships" - which may or may not be the case, I don't know the precise circumstances, but clearly they could be subject to scrutiny.

Steve Kesby's quote from the Duke of Westminster case ignores the fact that legislation (rather a lot) has been enacted since 1935 which specifically provides that HMRC can intervene - in the matter we are discussing, s447(4) ITEPA provides for this where:

"something has been done which affects the employment-related securities as part of a scheme or arrangement the main purpose (or one of the main purposes) of which is the avoidance of tax or national insurance contributions."

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04th May 2012 12:54

Its a grey area

Each case should be decided on its own merits, but I would watch situations where:

1) ABC shares are awarded to new directors or employees - they are employment related securities, after all;

2) where the company or its advisers have advised that a bonus is paid as a dividend: this sounds like a scheme to avoid NICs;

3) where a director is offered a package of a basic pay, topped up with dividends, again hard to argue that the dividends are not part of an earnings package.

PA Holdings is a case involving employees and not owner-managers. So rather than think about employee share ownership LLPs are another option. There is no employers' NICs on partnership profits.

Virtual Tax Partner support for accountants: www.rossmartin.co.uk

 

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04th May 2012 13:16

how about the case where 2 non shareholder directors  buy 90% of the shares in their employer company off the retiring 100% shareholder and then proceed to go the usual low sal/hi div route

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04th May 2012 13:29

Congratulations to all contributors

This has been one of the more interesting and informative reads I've seen on accountingweb for a while!!!  It makes a change to a lot of the really basic topics that often appear on this site.

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08th May 2012 09:02

RE: How about the case

In Nick Farrow's scenario above, it less likely (though not impossible) that s447 would be invoked.

Firstly, assuming the employees bought the company at market value then there would be no initial charge, though nevertheless the shares acquired will be Employment Related Securities.

As the shares acquired would seem to be ordinary shares, it is hard to argue (from HMRC's point of view) that

"something has been done which affects the employment-related securities as part of a scheme or arrangement the main purpose (or one of the main purposes) of which is the avoidance of tax or national insurance contributions."

Clearly there is no "scheme or arrangement" intended - the employees have simply bought the company.

By implication, the individuals have then chosen to reduce their salaries and take dividends instead, but this is nothing that the original owner wouldn't have been doing.  They can also argue that their roles are no longer the same, they have different responsibilities and that the new structure simply reflects the risks of ownership.

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08th May 2012 09:57

many thanks Martin - that is my view too

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08th May 2012 17:45

Are they employment-related securities?

I thought that in order to be employment-related securities, the right or opportunity to acquire them had to arise by reason of the employment and that the right or opportunity to acquire the securities was deemed to be by reason of the employment unless:

the person by whom that right or opportunity has been made available is an individual.the right or opportunity is made available in the normal course of the domestic, family or personal relationships of that person.

So in Nick's example, is the retiring investor not an individual? and is he not selling his shares in the normal course of his personal relationships (as an investor wanting to sell some of his shares to whoever wants to buy them for a decent price)?

When my granny goes to Tescos to buy potatoes, her right or opportunity to acquire those potatoes come not by reason of the fact that she sits at one of Tescos tills three afternoons a week.

No! her right or opportunity to get her hands on Tescos lovely King Edwards comes through the normal course of her enjoyment of the same personal relationship with Tescos that every other one of their spud purchasers enjoys. IMHO.

I don't really see how the relationship between a willing vendor of shares and a willing purchaser (who just so happens to be an employee, who just so happens to have a vested interest in acquiring them) differs from Tesco willingly selling King Edwards to my granny, who's willing to buy them, because King Edwards roast so well?

If Nick's chaps now choose to redesignate their shares into A and B shares so that one takes more dividends than the other (because he puts in more effort - sssh!), then that's a scheme or arrangement to which S.447 would apply if they were employment-related securities. Should the position not be argued at the perimeter fence, rather than right outside the front door?

Is it helpful opinions being expressed that might galvanise the views of HMRC staff?  Do sooths come true because they were always destined to be? or is it because soothsayers keep on saying them?

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08th May 2012 17:52

thanks Ernest

they will not be redesignating as A&B shares as that would be potentially provocative

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By blok
04th Sep 2012 10:38

I cant/wont compete with the above comments but as a practical solution to the OP problem how about this?

A sets up his own newco 1

B sets up his own newco 2

A & B swap their existing 60:40 shares for new shares in newcos 1 & 2 respectfully.

All future dividends in oldco are passed up to newcos tax free in the ratio 60:40.

A & B are then free to extract as they please from newco.  A can retain his dividends for a later date ( or a winding up)

You do need to consider the ER and BPR conseqeunces if this is a substantial business.

I did this recently and got HMRC approval in advance that the share for share worked and that there was commercial reasons for thsi (A&B were falling out over profit extraction policy.).

 

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21st Dec 2012 14:52

As this is the discussion of the year....

 

As mentioned above

 

s447(4) ITEPA provides for this where:

"something has been done which affects the employment-related securities as part of a scheme or arrangement the main purpose (or one of the main purposes) of which is the avoidance of tax or national insurance contributions." 

 

So tell the clients in writing .... if you call them A B AND C  then you may fall foul of this, which is my understanding and therefore in my opinion if you  use alphabet soup be prepared for it to explode in your face one day.......and that way when/if  it does you say....I told you so and you cant sue me,

 

Beccause chaps its not if we are right or wrong at the end of the day its whether we get sued or not....

 

happy xmas

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