ANY ANSWERS: The ABC of alphabet shares. By Nichola Ross Martin
There is a regular flow of questions on Any Answers regarding shares and dividends. Nichola Ross Martin draws them together.
ABC shares can be very useful for SME owners - they allow different rates of dividends to be paid, and are more flexible than dividend waivers. However, recent legislation has limited their use in providing employees with a source of NIC free income. So are they are still something to be considered when forming a new company?
Alphabet shares are just shares of different classes, often set up as 'A' shares, 'B' shares, 'C' shares, etc. The classes often all rank in 'pari passu' with each other (this means that they have an equal footing; for example, the same voting and rights on winding up). But they may also carry different rights, for instance entitlement to a preferential set dividend or limited rights to vote at general meetings.
Setting up companies with different classes of share is as old as the hills, and the majority of PLCs have a range of different classes of share with different rights. HMRC accept that private limited companies too are often set up with different classes of shares, and they continue to find them acceptable where there is no evidence of tax avoidance.
ABC shares are useful because income by the way of dividends can be voted separately for each class of share, so avoiding the use of dividend waivers. HMRC often say that this is evidence of what they claim is tax avoidance, but there is often very little that they can do about it. They simply do not have the power to alter a company's share structure or shareholdings, or do they?
Employees and ABC shares
On the back of the on-going crack down against employment related avoidance schemes, S.447 ITEPA 2003 is a broadly drawn section enacted to ensure that where there is a motive of tax avoidance, and the benefit is connected with an employment, dividend income from employee owned shares will be treated as employment income.
This section will affect ABC type employee shares, whatever the voting rights. This does not mean that approved or unapproved employee share ownership schemes will no longer work, and these remain a viable, if more expensive alternative.
If shares are gifted, the employee will also be taxed on the market value of the shares gifted, unless an election is made to tax them under the restricted securities rules (these usually means that they have a higher value). There is the argument that most shares in small private companies are not readily convertible assets, there being no stock exchange where they can be traded. Rights may be limited and the transfer of such shares can be vetoed by directors. This restricts their market value. Lack of space prohibits a fuller discussion of valuation of employee shares in this article.
Subscribers and ABC shares
A company can be set up with any type of share capital that its founders see fit. Once a subscriber has subscribed for his share, s.447 ITEPA cannot change the nature of the dividend income which may arise from that share if the subscriber also becomes an employee because the income is deemed to arise from share ownership, and not employment.
Practically although Revenue Officers may "huff and puff" about SME owners and their dividend income, it remains as dividend income, and directors can vote themselves whatever size dividends they like.
Care should be taken when new directors are taken on board, and ABC type shares are issued to them. If they have actual employment contracts with the company, HMRC may decide to try and invoke s.447. This section really does not sit well with ITTOIA which says that a dividend is a dividend and nothing else, and we have yet to see this point tested. It is worth consideration and it remains to be seen whether HMRC will try this line of attack on shareholding employees who are also office holders.
There may be other complications with ABC shares however:
1. The settlement provisions (s.619-648 ITTOIA 2005).
a) The case of Jones v. Garnett is continuing to the Lords, but it illustrates how HMRC's interpretation of the legislation works in practice. Husband and wife set up a company with one share each, they could be both 'A' shares or an "A" and a "B" share, it is of little odds. HMRC assess the husband on the wife's dividends, deeming him to be settlor to a settlement he has created. They say that he is the main earner, and by forgoing a commercial salary he allows his wife to receive higher dividends on her shares than would otherwise be the case.
This point has yet to be proved.
b) Parents setting up companies with minor children as shareholders are also caught by specific settlement legislation. This means that although the children are the shareholders, the income is assessed on the parents who create the income through their own efforts.
Unbrella companies are still alive and well and issuing ABC shares. Gordon Brown alluded to tackling 'this problem' (if there really is one) in the 2006 Budget. His problem though is how to pass legislation regarding dividends and SMEs that will not adversely affect all recipients of dividends. Abolishing the 0% starting rate of corporation tax has certainly made the dividend instead of salary route less attractive for many, and perhaps he will now call it a day and go after bigger fish.
Waiving a dividend can also involuntarily make you into a settlor, as you are forgoing your income in favour of another. To be successful a dividend waiver has two elements:
1. It must be made at the start of the financial year, before there is any indication of future profits. It is a deed and should be properly witnessed (by a lawyer).
2. The actual dividends paid out must not totally deplete all available profits for distribution. Such profits should remain that mean that if that shareholder had not waived his entitlement, all shareholders could have been paid out in full. It is then possible to argue that there is no settlement, as the waiving party's share of the profits are still within the company and have not benefited any one or more person.
Alternatives to ABC shares and dividend waivers
The most straightforward alternative is a partnership or Limited Liability Partnership. The flexibility is given by changing the partnership profit shares year on year. The Settlement provisions apply likewise to partnership income, and so care is required when advising married couples and income cannot be diverted to minor children either.
It seems to me that LLPs are not used more widely merely because they are still a bit of an unknown entity to many accountants, and the Limited Company route is preferred because it is just that little bit more tax efficient. It is certainly the best route if you are worried about either ABC shares or dividend waivers, you can't buy peace of mind.
Links to related Any Answers:
12th June Alphabet Shares or Dividend Waivers
17th May 2006 Employees being shareholders
26th April 2006 Dividends paid to just one shareholder?
19th April 2006 Can dividends form part of wages?
12th April 2006 Shared confusion