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Here at ETC Tax we work with a number of Owner Managed Businesses (“OMBs”) and Small-Medium Sized Enterprises (“SMEs”).
More recently there has been a surge in individuals who historically entered into schemes designed to extract the fruits of their labour whilst attempting to bypass the taxman. Unfortunately, these individuals have since fell foul of the April 2019 loan charge – provisions designed to sweep up the failed attempts of HMRC to tackle such schemes.
This article is not concerned with such types of planning, but rather considers more basic tax planning which often goes wrong! That is, dividend planning, and in particular – utilising dividend waivers and alphabet shares.
There is a common misconception that dividend waivers are ineffective for tax purposes. However, whilst there are a number of potential pitfalls, it remains a more than viable option in the right circumstances.
What is a Dividend Waiver?
When a company realises its profits, the directors – who are often the shareholders in a typical OMB/SME company – may decide to vote a dividend in order to partake in the successes of the company with a trip to the pub or, if feeling particularly flush, a rooftop cocktail bar.
However, it may be the case that certain directors do not wish to receive dividends. This could be for a variety of reasons including:
Indeed, one of the major benefits of operating via a company is that it provides you with the flexibility to turn the income tap on and off at one’s desire. However, where there are multiple shareholder/directors, this is where the dividend waiver becomes an effective tool.
Dividend waivers were often used in family scenario’s as a means of transferring income between spouses and/or minor children (more on this later). But this should be approached with caution.
How to Waive a Dividend? Samples & The Formalities
As with all tax planning arrangements, one should evidence the arrangements with the appropriate paperwork. Get it wrong and one can wa(i)ve goodbye to the pursued benefit.
Historically, dividend waivers might have been drawn up with a simple letter declaring one’s reluctance to take a dividend and included within a board minute.
Today, however, this is not good enough. Nor is it tomorrow or at any other time in the foreseeable future.
The preparation of a deed of waiver is a ‘reserved legal activity’ In short, this means that only those who are members of the Bar or Law Society are entitled to draw up such deeds.
When to Waive a Dividend/ Timing
This deed should be in place before the right to receive a dividend arises. For interim dividends, this is the day before the dividend is paid. For final dividends, this is before the entitlement to the dividend (usually at the AGM) because at that point, the shareholder has an enforceable right to the declared dividend.
A dividend waiver should be used for genuine commercial reasons. For the accounting and tax persons among us, you will no doubt be aware that the desire to avoid or mitigate tax is not a commercial reason.
By waiving dividends, the company is retaining funds for a specific or earmarked purpose. Where this is the case, the shareholder should record his motives for doing so. However, one should be cautious of challenge by HMRC.
In Donovan & McLaren v HMRC (2014) the director/shareholders undertook a series of waivers so that their spouses could utilise their personal allowances and basic rate bands. It was recorded that the motive behind the waivers were such that the company could maintain cash reserves for the purchase of a freehold property.
The tribunal, quite rightly, stated that this could have been more easily achieved by voting a smaller dividend. It was held there was no commercial reason for the waiver, it would not have taken place on an arm’s length basis and the arrangement was entered into wholly for the purpose of reducing the tax liability of the taxpayers.
Though, there were other factors at play here and, in particular, the settlements legislation.
Dividend Planning – Dividend Waivers & Inheritance Tax
The person waiving a dividend is giving up a right which carries value. However, the legislation provides that in most circumstances, a waiver of a dividend, provided the waiver is made in the twelve months to the right accruing, should not give rise to a transfer of value.
It is a minor point, but one that is nonetheless overlooked.
Of course, this point should be considered in the context of the specific circumstances surrounding the waiver.
What Can Go Wrong When Waiving a Dividend?
It is no secret that HMRC have been using the settlements legislation to attack dividend waivers which result in a larger dividend being payable to one party. This is particularly the case where the declared dividend would not be payable but for the dividend waiver or where there is a series of dividends over a number of years.
The argument is as follows:
This same argument is applied where a spouse waives a right to dividends enabling the company to pay a higher dividend to the other spouse.
An Example Of Dividend Waiving
Husband and Wife own 50 shares each with equal rights in a successful trading company which has end of year distributable reserves of £200,000. Husband is a man that munches (lunches) and wife is paying tax at the additional rate of 45%.
The company therefore declares a dividend of £3 per share. However, Wife waived her dividends (with a deed draft by a lawyer) and Husband duly received his £150,000 dividend.
But for the dividend waiver, the company would not have been able to pay a dividend of £3 pound per share (£300,000 In total). The effect of the waiver is that the husband received a dividend which would otherwise be unpayable – the ‘enhanced dividend’.
The element of the excess of £50,000 (£1 per share) is squarely within HMRCs crosshairs – the bounty. The element which constitutes ‘bounty’ is attributed and taxed on the wife.
Indeed, HMRC may only challenge dividend waivers where there is a bounteous arrangement. In broad terms, this is where an enhanced dividend is payable as illustrated above.
The key test here is whether the company would have had sufficient retained profits to pay the dividends on the shares which are subject to the waiver. If there isn’t, there is bounty and the settlement provisions bite.
This test is cumulative as well as in-year!
Furthermore, the settlement provisions may only apply where the beneficiary of the bounteous arrangements is the waiving person’s spouse or minor child. Dividend waivers in favour of other family members such as adult children, or perhaps business partners, may be tax effective.
Although, one should tread carefully where dividend waivers are used as part of a wider arrangement to replace employment income as this would likely be facing the foothills of the employment related securities & disguised remuneration legislation.
Dividend Waivers — They do Work!
Whilst dividend waivers do work, provided they are commercially justified, properly documented and executed and not excessive, they are not the ‘go-to’ for longer-term dividend planning between the owners of a business.
Indeed, repetitive waivers potentially give rise to numerous other issues.
A common alternative in practice is the use of alphabet shares. These are different classes of shares, with or without varying class rights, denominated by a letter of the alphabet for each class of share i.e. A shares, B shares, C shares etc…
It would normally be prudent to get this structure in place from the inception of the company.
I’ll not go into this within this article. So, keep an eye out for our next newsletter for an overview of alphabet shares and how they are effective in dividend planning.
If you would like to read more about dividend tax changes & implications Click Here…