A recent First-tier Tribunal case has once again highlighted the dangers of using dividend waivers to reallocate income between shareholders, writes BDO tax director Jeff Webber.
HMRC does not hesitate to challenge such arrangements under the settlements legislation, and companies should therefore avoid using this or other similar methods of allocating income to particular individuals.
In the Donovan & McLaren v HMRC case, two directors regularly waived dividends, enabling their wives to receive a higher proportion of the dividends actually paid by the company, and thereby utilise their income tax basic rate bands.
The taxpayer’s representative argued that:
- A commercial decision was taken to waive the dividends, to ensure that the company maintained workable reserves and cash balances in order to accumulate sufficient of each to fund the purchase of the company’s own freehold property; and:
- It made “tax planning sense” that the benefit of the dividends was used in the correct way
However, HMRC contended that:
- There was no commercial purpose to the dividend waivers, and the retention of profits could have been more easily achieved by voting a lower rate of dividend
- The company had insufficient distributable reserves to pay the dividends if there had been no waivers
- The intention was simply to allow higher dividends to be paid to the directors’ wives than their respective shareholdings entitled, and lower dividends to be received by their husbands
- The arrangement would not have been entered into with someone at arm’s length and it therefore plainly contained an element of bounty
- The waivers of dividend by the directors and payment of dividends to their wives therefore constituted an ‘arrangement’ under the settlements legislation in S 620 ITTOIA 2005, and the exception which allowed income to be effectively transferred in the Jones v Garnett (Arctic Systems) case did not apply, because there had been no transfer of shares
The tribunal agreed with HMRC and decided that the “irresistible inference” from the facts was that the directors waived dividends as part of a plan to ensure that dividend income became payable to their wives.
This constituted an arrangement under the settlements legislation, and the exception in the Jones v Garnett case did not apply, for the reasons stated by HMRC, as had also been held in the 2008 Buck v HMRC case.
This highlights the need for companies to take care and, if necessary, appropriate professional advice when considering using dividend waivers. HMRC clearly states in its manuals that it will look closely at the use of waivers where:
- The level of retained profits, including the retained profits of subsidiary companies, is insufficient to allow the same rate of dividend to be paid on all issued share capital;
- Although there are sufficient retained profits to pay the same rate of dividend per share for the year in question, there has been a succession of waivers over several years where the total dividends payable in the absence of the waivers exceed accumulated realised profits;
- There is any other evidence, which suggests that the same rate would not have been paid on all the issued shares in the absence of the waiver;
- The non-waiving shareholders are persons whom the waiving shareholder can reasonably be regarded as wishing to benefit by the waiver; or
- The non-waiving shareholder would pay less tax on the dividend than the waiving shareholder.
If it is wished to allocate more income to another shareholder, this can currently still be done by ensuring that the required numbers of shares are held by each individual, transferring shares to a spouse or civil partner where necessary, so that the ‘Arctic Systems’ exception can apply.
The Arctic Systems case concerned a company with only one class of shares, and it should be noted that HMRC considers that the use of different classes of shares, with dividends being voted separately on one or more classes so as to benefit particular shareholders, can also constitute a settlement arrangement.
Jeff Webber is a tax director with BDO and a consultant on BDO’s Tax Support for Professionals Taxline.