Setting the equity straight from the beginning
When you set up your business there are many issues to think about and one often overlooked is how will the equity structure work when the business reaches the point of being able to pay out dividends? HMRC will be looking at arrangements which involve the diverting of dividends away from higher tax payers to lower rate tax payers (typically wives). The ideal share structure permits flexibility in terms of who can receive dividends and when but to work well, documented arrangements need to be put in place at the start of the trade because varying the equity structure once the underlying business has accrued value can cause tax problems.
There are three main problem areas which crop up in practice which we have highlighted below, namely:
- Husbands and wives;
- Providing shares to employees and directors; and
- Voting of dividends.
Husbands and wives
HMRC will challenge dividend waivers between husbands and wives where they hold the same class of shares but in different proportions. If the challenge is effective, the dividend waiver will be treated as if it had not taken effect and part waivers are not permitted. What can sometimes happen in cases where husbands and wives hold different numbers of shares is that the effect of a dividend may push a taxpayer into higher tax rates and to avoid this the husband and wife shareholders attempt to waive the dividend so as to equalise the tax treatment. In cases where HMRC consider that the husband (but could equally be the wife), has used his entitlement to dividends as part of a plan to ensure that dividend income is payable by the wife who may have low or no earnings, the dividend will be treated as a “settlement” for income tax purposes in which the settlor retains an interest. If the dividend is treated as a “settlement” this means the diversion of dividends does not take effect and the settlor is taxed on the full dividend. The difficulty can also arise when interim dividends have been paid during the year but the distributable profits at year end are not sufficient to cover the interim dividend payments.
How to avoid the problems with dividends paid to husbands and wives: There are several potential solutions depending upon the circumstances. Transfers between husbands and wives and civil partners are free of capital gains tax meaning that the shareholdings could be adjusted by way of share transfer. Another idea would be to create separate classes of shares on which different rates of dividends can be voted by the directors. Depending upon the circumstances, the bigger picture may need to be considered such as the position on, for example, death or divorce but these issues can usually be dealt with in the articles or, if privacy is required, the shareholders agreement.
Employees and Directors
HMRC will tax any benefit received by employees or directors in the form of shares or options. The basis of the tax charge varies according to the type of share benefit provided. If properly structured, the gains made on realisation can be eligible for capital treatment which carries a lower rate of tax than income. Any dividends paid on the shares will compare favourably in terms of tax compared with an equivalent receipt of salary. In many cases employees and directors are awarded a different class of share to the existing shareholders and such shares include mechanisms for the sale of shares if the employee/director leaves the business. Once an employee or director has paid income tax on the share award, if the value of the award subsequently goes down in value, the tax paid by the employee/director is not refunded by HMRC.
How to avoid the problems with employee/director shares: Options are attractive as the tax charge does not arise until the option is exercised meaning there is no tax charge if the option is allowed to lapse because, for example, the shares have declined in value. The most popular type of option are the EMI options and employers are well advised to consider if the company and the employee/director fall within the qualifying conditions set down by HMRC since the tax benefits for both employees/directors and the employer under EMI can be very substantial.If the conditions for EMI tax relief are not met or if there is a desire to award shares rather than options there are a range of other alternatives to consider.Some of these alternatives include “Employee Shareholder Shares” which provide the employee/director with shares which can be sold free of capital gains tax, although an upfront tax charge will arise on awards of over £2,000, subject to a cap of £50,000. Employee Shareholder Shares are a new addition to the tax legislation and will grow in popularity over the years we suspect. In cases where the shares could attract a sizeable income tax charge on award, flowering shares built in ratchets or milestones can be the way forward because they can be used to reduce the income tax liability for the employee/director. Care is required on how the restrictions are attached to the shares as there can be adverse tax consequences if not structured properly.
Dividends have to be declared and voted by the directors of the company and paid out of distributable reserves.If the business is performing in line with the income drawn out as a dividend and the directors are able to pass a majority vote there should be no difficulties. However, problems can arise in practice where all of the components are not satisfied. With the increasing powers bestowed upon HMRC, and to help avoid any shareholder backlash, it is ever more essential that detailed board minutes documenting the decision making process by the board of directors is kept.
How to avoid the problems with voting of dividends: Where shareholders are relying on dividends they should consider setting out perimeters in the articles or shareholders agreement. Whilst the decision of directors cannot be overwritten, it is possible to set the guidelines and if directors depart from the guidelines without good reason there can be ramifications for the directors they would probably wish to avoid. It is possible to provide for a dividend re-investment policy setting out how much must be retained within the business as working capital.Shareholders can influence the voting of directors if they have the power to control the board via the appointment of representatives and or the casting vote. The position on removal of directors needs to be considered as the provisions in the Companies Act may not be adequate. It is usually easier to put in place these structures at the commencement but with requisite shareholder approval changes can be made during the life of the business. Minority shareholders have potential claims and should not be over looked.