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, the company needs either to have different types of shares, the underlying shareholdings need to be changed, or the use of dividend waivers is required (e.g. all shareholders have the same type of share but one shareholder ‘waives’ their right to the dividend). 

In the past dividend waivers were sometimes used to pay dividends in different proportions, but this is often ineffective from a tax mitigation viewpoint because of rules about “settlements” which apply to waivers between spouses and their dependent children.

So what are Alphabet Shares?

Alphabet shares are shares of different classes (often termed “A shares”, “B shares”, “C Shares” etc), each having different rights with respect to dividends.

They are often used to enable a company to pay dividends at different rates per share to individual shareholders. They are also used in family companies and joint ventures and other situations where particular rights (e.g. to appoint a director) are given to specific shareholders.

Alphabet shares are not restricted to being used just for differing levels of dividend. They may also be used to give entitlement separate from the rules for ordinary shares (for example, preferential dividends, or limited rights to vote at general meetings), but their main use is to enable payment in respect of a particular class of share without being required to pay the same dividend to each shareholder.

This may be of particular benefit if one or more of the shareholders is a higher or additional rate taxpayer and the other(s) either basic rate taxpayers or do not pay tax.

Alphabet share arrangements are particularly effective when setting up a new trading company from scratch, they can usually be set up from the start with relatively little complication and without fear of challenge from HMRC.

When changing the shares of an existing company, however, care must be taken to prevent HMRC invoking the settlements rules. Also, if shares are issued to family members at less than their market value and “by reason of their employment”, the transaction may need to be reported to HMRC on form 42 and an income tax charge may result.

To prevent problems with the settlements rules, generally any shares that are to be issued or gifted to family members should have full voting and capital rights, since shares that carry the right to a dividend (but no voting rights etc) represent a right to income (rather than anything more substantial). The gift of a right to income to a spouse or dependent child falls within the settlements rules.

If existing shareholders wish other family members to become shareholders, this is often best achieved by reclassifying and gifting some of the existing shares, rather than the company issuing entirely new shares. A gift of shares to family members does not need to be reported to HMRC on form 42 and, assuming the company is a trading company (rather than an investment company), any chargeable gain on the gift can be held over.

HMRC’s stance

Dividends are a return on capital invested. HMRC often try to contend that, rather than being a dividend, a payment to a shareholder (particularly a director shareholder) is in reality a payment for salary (subject to higher Income Tax rates than dividends and National Insurance) rather than a return on capital (subject to lower Income Tax rates than salary and no National Insurance).

Example 1: Husband and Wife Company

Derek and his wife Charlotte are shareholders in a company. Derek is the sole fee earner and is a higher rate taxpayer because he receives other investment income. He does not take any salary from the company and owns 50 ‘A’ shares with no entitlement to dividend. Charlotte is a basic rate taxpayer who owns 50 ‘B’ shares, but with an entitlement to receive dividends.

In this situation, HMRC may query why, if Derek does all the work, he does not receive all the distributable profit as an ‘employment reward’ taxable under PAYE at higher rates and liable to National Insurance. However, so long as the share rights have been structured correctly, there should be no contention.

Example 2: Family Company

Janet holds 100 ordinary shares in her trading company XYZ Ltd. She is married with two adult daughters. She reclassifies the shares into 80 A shares, 10 B shares, 5 C shares and 5 D shares, each holding the same rights with respect to voting and capital, but with independent rights to dividends.

Janet then gifts the B shares to her husband, and the C and D shares to each daughter. If the market value of the shares gifted to each daughter exceeds their original cost, there will be a chargeable gain.

The gift to her husband will be exempt from capital gains tax (CGT) under the spousal transfer exemption, and the gains on the gifts to her daughters can be held over provided both parties make a hold over claim within the prescribed timescales.

Dividends can then be voted independently with respect to each class of share.

Janet still retains 80% of the issued share capital and 80% of the voting rights, and therefore retains, for all practical purposes, complete control of the company.

If and when XYZ Ltd is sold or liquidated, there will also be CGT consequences for the shareholders. Unless Janet’s husband or daughters happen to be directors or employees of the company and meet other qualifying criteria, any gain they make on the subsequent disposal of their B/ C/ D shares may not be eligible for Entrepreneur’s Relief (“ER”), in which case they would pay CGT at rates of up to 20%, rather than, potentially, just 10%.

With four shareholders as opposed to just one, collectively they might benefit from four CGT Annual Exempt Amounts, but the benefit of that would need to be weighed up against any potential loss of ER.

A company that wishes to adopt alphabet shares will need to ensure its articles of association contain appropriate provisions spelling out the rights attached to each class of share; legal advice is therefore normally required. The wider consequences, particularly in terms of shareholder control, also need to be carefully considered.

The ‘settlements’ legislation explained

The relevant tax legislation (ITTOIA 2005, Pt 5, Ch 5) covers income derived from a settlement, and defines a settlement widely as including ‘any disposition, trust, covenant, agreement, arrangement or transfer of assets’ (s 620).

Within owner managed companies a ‘settlement’ situation may apply where an individual enters into an ‘arrangement’ of diverting income from one to another, resulting in a tax advantage.

These anti-avoidance provisions are therefore designed to prevent a person diverting their income to obtain a tax advantage.

In example 1 above, HMRC could also seek to challenge the arrangements on the basis that the payments fall foul of the ‘settlements’ legislation, thus denying the allocation of dividends away from Derek (the higher rate taxpayer) to Charlotte (the lower tax rate shareholder).

Taxes Cases

There have been a number of tax cases brought by HMRC under the settlements legislation, the most infamous one being the Arctic Systems case (Jones v Garnett [2007]).

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 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.

Alphabet shares for employees

Alphabet shares can be used to give company employees dividends as part of their remuneration package. Structured correctly, such schemes can be an incentive for employees as well as being a tax-efficient means of payment. The shares are usually non-voting and may be redeemable at par value (i.e. £1 on a £1 share) thus allowing them to be returned should the employee cease working for the company.

Make sure that:

1. 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.
2. 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.
3. 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.
4. 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.
5. It should be remembered that a share of at least 5% is required to claim Entrepreneurs’ relief on the eventual sale of the company.
6. To minimise the risk of HMRC raising an enquiry, it would be preferable for at least some dividend to be paid to each type of share.

Alphabet shares permit flexibility in the payment of dividends, allowing for future changes in the dividends paid to each shareholder without having to change the shareholding.

In the context of family companies, and in particular, when looking to reward non-minor children, alphabet shares and dividend waivers can still be used effectively. There remains no one-size-fits-all solution though – bespoke, careful tax planning remains (as always) the key.

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