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.