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Alphabet shares: Get the details right

1st Dec 2015
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As part of her “Get the details right” series of business articles, Jennifer Adams considers the use of different classes of shares in an owner-managed company, colloquially termed “alphabet”  shares.

A company limited by shares is usually formed with a nominal number of ordinary shares. As the company expands or more shareholders join then alphabet shares (A ordinary shares, B ordinary shares and so on) may be of interest.

Dividend waiver v alphabet shares

When a company pays a dividend all shareholders receive payment in proportion to their individual shareholdings. For one shareholder to be paid in preference to another or be paid at a different rate, there needs to be either a dividend waiver, or different types of shares permitting different rates of dividend need to be in place; or the underlying shareholdings need to be changed. See here for updated detail on dividend waivers.

  • If a dividend waiver is to be a regular method of enabling surplus profit to be distributed disproportionately to the same class of shareholder then alphabet shares present a permanent alternative solution.
  • Dividend waivers are more likely to be questioned by HMRC, especially if there are insufficient distributable reserves to pay the full dividend without the waiver in place.
  • Dividend waivers can be unreliable as the shareholders must give their consent every time, in contrast dividends paid to alphabet shareholders do not require the consent of the other shareholders.
  • Alphabet shares allow different voting and other rights or restrictions (eg  redeemable or non-redeemable) to be assigned to different classes of shareholders as required.
  • Alphabet shares have the benefit of flexibility in paying dividends, so a payment can be made to a particular class of share without having to pay the same dividend to each shareholder.  This is of particular benefit should one or more of the shareholders be taxed at higher rates and the other(s) are either basic rate taxpayers or do not pay tax.

The “settlement” rules

Whether via dividend waiver or the issue of Alphabet shares, care needs to be taken to ensure that the arrangement is not caught by the settlement legislation. The relevant clauses are in Chapter 5 of Part 5 of ITTOIA 2005; s620 defines a settlement widely as including “any disposition, trust, covenant, agreement, arrangement or transfer of assets”. Therefore within owner-managed companies a settlement may apply where an individual enters into an arrangement diverting income one to another, resulting in a tax advantage.

When considering alphabet share structures it is particularly important to reorganise the shares correctly; a lack of voting rights, for example, will mean that the shares will be “wholly or mainly a right to income” and be caught (s626 ITTOIA 2005).

There have been a number of tax cases brought by HMRC under the settlements chapter, the most notorious one being the Arctic Systems case (Jones v Garnett (HMCR) 2007). As a reminder, in this case, Mr Jones was responsible for earning all of the profits but the share-owning structure gave the company the ability to pay large dividends to his wife. The House of Lords held that Mr Jones had indeed created a settlement in which his wife had an interest.

However, the Lords went on to say that, in their opinion, the “husband and wife” exception (s626 ITTOIA 2005) applied such that the settlement had been at a “no gain/no loss” value of an outright gift. In addition, the shares transferred did not just represent an entire or substantial “wholly right to income”, they came with other rights including the right to attend and vote at general meetings, rights to capital growth on a sale, and to obtain a return of capital on a winding-up.

Therefore, as long as a spouse or civil partner is given ordinary shares carrying the normal full range of rights, any dividends paid on the shares should be treated as their income. Had the circumstances in the Arctic Systems case have been different, for example if the shareholders had not been married or the shares had been split so as to not have the same full joint rights, then it is likely that HMRC would have succeeded in their claim.

HMRC may also seek to apply the settlement rules where the amount of dividend paid on a particular class of share could not have been so unless no (or minimal) dividends were paid on the other classes of shares. For example, if the dividend can only be paid if one class of shares receives no dividend then this may fall within the settlement legislation as a “bounteous arrangement”. (TSEM4225).

You need to make sure that:

  • The “new” shares created under an alphabet scheme are an outright gift and have the same rights as the original ordinary shares. There must be no restrictions such as being non-voting or carrying lesser rights to capital or a promise to return the shares on demand. Do not make the shares redeemable preference shares.
  • It might be advisable not to create alphabet shares just before a dividend is due or as soon as the company has posted large reserves as income transfer could be viewed as being the only reason for creation of the shares.
  • Where shares are being gifted to spouses it would be helpful to show that they have an interest in the running of the company, ideally becoming a director or at least by taking on the formal role of company secretary and administrator.
  • HMRC looks very carefully at where the dividends are paid. A joint account is acceptable but it must be into an account with the receiving spouse’s name.
  • It should be remembered that a share of at least 5% is required in order to claim Entrepreneurs’ relief on the eventual sale of the company.
  • To minimise the risk of HMRC claiming that the dividends could not have been paid unless one class of share was not allocated any dividend, it would be preferable for at least some dividend to be paid to each type of share.

What are the practicalities?

  • For companies formed before 1 October 2009, all the memorandum clauses (including the object clause and authorised share capital clause) are deemed to be included in their articles as from that date. Such a company will be restricted by its authorised share capital and the directors will not be able to issue more shares than that authorised amount. Therefore the articles may need to be amended by special resolution to specify the respective rights of each of the different shares. This might be an opportunity to review the articles in full including abolishing the authorised share capital or even to adopt the newer model articles.
  • Amend model articles by special resolution at a general meeting to enable the different classes to be created ranking pari passu in all respects (ie full and the same voting rights and an entitlement to capital surpluses on a winding up) except for the different dividends for each class.
  • File the special resolution within 15 days. As there may be a number of amendments to the model articles, the revised articles will also need to be submitted to Companies House.
  • File a separate special resolution to recategorise the existing shares into A and B shares or create further shares as required.
  • File a ‘Return of allotment of shares ‘ (form SH010) with Companies House
  • If there is a shareholders agreement in place consider amending if it imposes restrictions on introducing new share classes, certain pre-emption rights or a requirement for consent over and above that as set out in the Companies Act 2006 to alter the share capital. Unanimous agreement of all shareholders is required to amend the agreement. Check that the Agreement clauses do not conflict with the revised articles. There is no need to file the Agreement with Companies House. See here for further detail on shareholder agreements.
  • Submit AP01 (new director) or AP03 (new company secretary) if receiving spouse is not either already.
  • Ensure that the dividends are each paid into a bank account in the name of the receiving spouse.

And finally - suggest the company gets full tax investigation insurance in case the new arrangements are questioned by HMRC.

About the author
Jennifer Adams FCIS TEP ATT (Fellow) is Associate Editor at AccountingWEB. A professional business author specialising in corporate governance and taxation, she has written for many of the leading specialist providers of legal, tax and regulatory publications. Jennifer runs her own accounting and consultancy business with offices based in Surrey and Dorset.

Replies (23)

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By gbuckell
01st Dec 2015 18:28

ITEPA 2003 s447

What is your view on the possible application of ITEPA 2003 s447?

HMRC's view can be found at

http://www.hmrc.gov.uk/manuals/ersmmanual/ERSM90060.htm and http://www.hmrc.gov.uk/manuals/ersmmanual/ersm90210.htm

Thanks (1)
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By julieclare
02nd Dec 2015 11:14

New dividend tax rules

Thank you for this comprehensive article. In view of the new tax rules for dividends coming in 6 April 2016 I am considering the use of alphabet shares for one of my clients. Mum and dad own all the shares and 2 sons now work in the business. Would be useful to give sons different shares and take advantage of £5k tax free dividends.

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By Montrose
02nd Dec 2015 11:56

Watch IHTA s98 as well

Where the company concerned is not a trading company[ ie where BPR cannot apply], there is a risk of IHT applying on the grounds that there is an alteration to the rights applying to one or more class of shares where a decision is taken to pay dividends differentially. A sting in the tail is that this cannot be a PET[see s.98(3)].

I have also seen it suggested that the structure itself is a "settlement" for IHT purposes by virtue of IHTA s43

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By cfield
02nd Dec 2015 15:57

Involvement in company affairs

An excellent article Jennifer, but why is it advisable for the donee to have some sort of interest in the running of the company? I see nothing in the legislation that makes this a prerequisite or even advisable for the purpose of claiming the spouse gifts exemption.

It may well help there not to be a settlement in the first place if the dividends were a reasonable reward for their efforts, but as it doesn't matter about this if the gifts exemption applies, it seems like over-kill to me.

They only need to be company secretary to qualify for Entrepreneurs Relief (and hold the shares for at least a year of course).

Thanks (1)
By stratty
02nd Dec 2015 16:18

Joint Bank Account

I assume that payment of dividends into a joint bank account would be ok?  For example in the name of Mr and Mrs xyz?

Thanks (0)
7om
By Tom 7000
02nd Dec 2015 17:54

watch out for
ESM3510 - Managed Service Companies (MSC):

And finally - suggest the company gets full tax investigation insurance in case the new arrangements are questioned by HMRC....thats a bit scary too

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Jennifer Adams
By Jennifer Adams
02nd Dec 2015 18:38

I've used the word 'helpful'...

cfield says that  I see nothing in the legislation that makes this a prerequisite or even advisable for the purpose of claiming the spouse gifts exemption.

No- there is nothing in the legislation and I purposely used the words' helpful' and ' suggest' in the article.

In Arctic Systems how much work was actually undertaken by Mrs Jones was mentioned:

 Mrs Jones  did the book keeping, dealt with the bank and the insurance company, paid  tax  and VAT and attended to correspondence. This took four or five hours a week.' ie she took an interest in the company.

You cant assume that the spousal exemption will apply automatically.

 

Thanks (2)
By cfield
02nd Dec 2015 18:53

Might not be enough though

JAADAMS wrote:

You cant assume that the spousal exemption will apply automatically.

No, you can't, but if the dividends ever did come under attack because they messed up the spouse exemption, I doubt if a few board meetings and a bit of admin work would be sufficient to avoid it being a bounteous arrangement.

Thanks (1)
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By leicsred
03rd Dec 2015 20:46

Shares gifted
Is it advisable for the shares to belong to the profit earner first and then be gifted. Or is it just as effective if the alphabet shares are subscribed to by the husband and wife on incorporation?

Thanks (0)
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By AndrewV12
12th Dec 2015 13:39

Good points well made

A good article highlighting the options available to Directors and Accountants.

Thanks (0)
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By chatman
03rd Nov 2017 07:54

If you start off with, say 2 ordinary shares owned by H and W, and you issue one A ordinary share to W and one B ordinary share H, would it be advisable to cancel the original ordinary shares to avoid a situation where no dividends are paid on one class of shares (the original ordinary shares)?

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By Martin B
09th Jul 2019 09:41

Alphabet shares: Get the details right

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Replying to Martin B:
7om
By Tom 7000
10th Jul 2019 10:48

Indeed, if only we knew what they were!

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Morph
By kevinringer
24th Oct 2019 15:51

I know this is an old article. I've taken on a new client. The two shareholders are not connected other than through the company. They each subscribed to 10 ordinary shares when the company was formed. All shares were of the same class. I want them to have alphabet shares. Reading the above they need a special resolution to recategorise the existing shares into A and B shares. Is that all?

Thanks (0)
Replying to kevinringer:
7om
By Tom 7000
25th Oct 2019 16:13

well if you are then going to pay different divs on different classes, have you moved some value from one shareholder to the other and is that a disposal for CGT and is it a taxable benefit for the recipient under employment related securities....

You need to be calling your tax help line here before it explodes in your face.

The you can tell us what they said....

I would be more tempted to do a waiver....is it the lesser of 2 evils?

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Replying to kevinringer:
7om
By Tom 7000
25th Oct 2019 16:13

well if you are then going to pay different divs on different classes, have you moved some value from one shareholder to the other and is that a disposal for CGT and is it a taxable benefit for the recipient under employment related securities....

You need to be calling your tax help line here before it explodes in your face.

The you can tell us what they said....

I would be more tempted to do a waiver....is it the lesser of 2 evils?

Thanks (0)
Replying to kevinringer:
7om
By Tom 7000
25th Oct 2019 16:13

well if you are then going to pay different divs on different classes, have you moved some value from one shareholder to the other and is that a disposal for CGT and is it a taxable benefit for the recipient under employment related securities....

You need to be calling your tax help line here before it explodes in your face.

The you can tell us what they said....

I would be more tempted to do a waiver....is it the lesser of 2 evils?

Thanks (1)
Replying to Tom 7000:
By cfield
25th Oct 2019 16:56

Waivers are usually more prone to attack than alphabet shares as they can still be a settlement and the spouse gifts exemption doesn't apply. That's because the waiver itself is wholly or substantially a right to income. It does not confer other benefits such as voting rights as ordinary shares do. Unlike dividends, waivers are not income derived from property qualifying for the gifts exemption. They are a separate arrangement.

Alphabet shares are fine if you get the basics right. Obviously they must confer all those other ownership rights, but on top of that you've got to make sure the dividends do not exceed the maximum that would have been supported by the company's distributable reserves if the highest rate had been paid on both/all share classes. This usually means leaving some retained profits.

Not just for the latest dividend either. You've got to check that for all dividends to date. I do this by means of a Dividend Tracker spreadsheet showing cumulative dividends. If you don't do this, then any "excess" dividends could be construed as a de facto waiver and fall foul of the gifts exemption.

It is also wise to make sure the cumulative dividends per shareholder reflect the actual split of shareholdings in in the long run. There was a legal case a few years ago where this principle was in the Judgement (although it was a minor point). It is best to make sure this happens at least once a year for regular dividends.

Frankly, if you want to vary the dividend rates, it is best to do some tax planning work and make sure the actual shareholdings reflect the desired dividends. Then alphabet shares can be used with slightly different rates to fine-tune them.

Thanks (1)
Replying to cfield:
Morph
By kevinringer
26th Oct 2019 07:07

I used to do waivers routinely until recently when I learned that preparation of a Deed of Waiver is a ‘reserved legal activity’ under the Legal Services Act which means it can only be done by members of the Bar or the Law Society (or who work for an employer who is authorised as such). Preparation by accountants or anyone else not authorised is a criminal offence with a maximum custodial sentence of 2 years and/or a fine. See http://www.legislation.gov.uk/ukpga/2007/29/section/12. So I don't do them any more. I could get a solicitor to do them but there's a cost. That's why I favour alphabet shares.

For my new client I was considering converting their existing shares into alphabet shares. This seems problematic. Instead, how about leaving the existing shares as they are and issue 10 new Ordinary A to one shareholder and 10 new Ordinary B to the other shareholder so each will have their original 10 ordinary shares plus 10 new alphabet shares. Would this be a better solution?

Thanks (0)
Replying to cfield:
7om
By Tom 7000
26th Oct 2019 18:25

It's not husband and wife though it said in the question. Not sure how that can be a settlement...

It's soooo complicated with lots of pitfalls

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Jennifer Adams
By Jennifer Adams
26th Oct 2019 12:27

Kevinringer - re dividend waivers - you are absolutely right - since this article was written 4 years ago they have now been deemed a 'reserved legal activity' and as such you have to get a solicitor involved at, as you say... the cost..

Alphabet shares are still perfectly acceptable and do-able without getting a solicitor involved. Its not a difficult process.

Always look at the articles of assoc 1st to check that they are permitted. If not then amend. The Model Articles need amending as the article states.

Thanks (1)
Replying to Jennifer Adams:
7om
By Tom 7000
26th Oct 2019 18:44

This is from ICAEW guidance. If you do waivers for free, then you are exempt.

You have to do forward planning. You plan what people want and then if necessary a proper document thats witnessed . Get the client to do it themselves?

Either way though it's all fraught with worry....

Reserved instruments activities

This covers the preparation of any instrument of transfer or charge for the purposes of, or for making an application or lodging a document for registration under, the Land Registration Act 2002. It also includes the preparation of documents relating to real or personal estate or to court proceedings in England and Wales and specifically to transfers of land. It excludes wills, most agreements not intended to be executed as a deed (which means many contracts are not reserved instruments), powers of attorney and with some exemptions transfers of stock. (See paragraph 3.4.5 for further details on deeds) It will, however, include the preparation of trust deeds, other than will trusts. (See paragraph 3.4.5 for further details). If the reserved instrument activity is performed without expectation of fee, gain or reward, then it can be performed by a Member who is then classified as an exempt person. (See Appendix 1 for further details on exempt persons).

Thanks (1)
Replying to Tom 7000:
7om
By Tom 7000
26th Oct 2019 18:49

It says this in the appendix..

A personal favour.... which means you probably don't have any PII

Just get a lawyer to do them.....keep.life easy.

One exception to this is that if the reserved legal activities of probate, reserved instruments and notarial activities are provided ‘otherwise than for or in expectation of a fee, gain or reward’ then the person providing this is classified as an ‘exempt person.’ It is, however, hard to quantify what can be classed as a ‘gain’ or ‘reward’ and both terms can be very widely interpreted. Furthermore, if the activity is provided as part of a bundle of activities for which a fee is charged, then it is likely to be very difficult to separate out the component parts to determine that no fee was charged for any particular activity. Members must not seek to recover the cost of such work in other fees nor perform such activities as a component part of a bundle of services for which a single charge is made. Members should be clear, in their engagement letter and elsewhere, that when such activities are carried out for clients, they are provided as a personal favour and not as part of the professional services covered by their terms of engagement.

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