If a company has one class of ordinary shares it means that when a dividend is paid it must be paid in proportion to the shareholdings.
For example, if there are 100 ordinary shares and Shareholder 1 owns 80 and Shareholder 2 owns 20 and the directors approve a total dividend of £10,000 then this dividend should be paid as £8,000 to Shareholder 1 and £2,000 to Shareholder 2.
Sometimes it is beneficial to have more flexibility than this when it comes to paying dividends so something to consider is creating shares of different classes, typically “Alphabet Shares”.
This is a term given when there is more than one class of ordinary shares in issue and named A, B, C etc.
In the example of Shareholder 1 and Shareholder 2 above, the 100 Ordinary shares could be converted to 80 Ordinary A shares and 20 Ordinary B shares.
In order to reduce the risk of tax anti-avoidance rules being broken it is important to ensure the shares have equal rights - i.e. they have the same rights to voting, dividends and capital distributions.
If there are two classes of ordinary shares dividends can be voted separately on each class of share.
They do not have to be paid pro-rata to the holdings which gives more flexibility when deciding on levels of dividends to pay.
This share structure must be executed properly and this will usually require the adjustment of the company’s Articles and resolutions will need to be passed, with forms to be filed with Companies House to formalise the structure.
There are some risks with Alphabet Shares however which we will explain.
HMRC does not like to see dividends being paid out of proportion to the shareholding, particularly when the spouse who receives the highest dividend is non-working if this deprives the other shareholder of their fair share of dividends.
So let's go back to the example of Shareholder 1 and Shareholder 2 and assume Shareholder 1 owns 80 A shares and Shareholder 2 owns 20 B shares, and Shareholder 1 runs the company with Shareholder 2 doing little or no work for the business.
If dividends are being paid out in the opposite proportion i.e. 80% to Shareholder 2 instead of 20%, then HMRC could challenge this and say this is being done to avoid paying higher rate income tax by Shareholder 1 and argue that the income is being split disproportionately and seek to redress the balance by assessing some of Shareholder 2's dividends on Shareholder 1.
If this strategy happens continuously then the risk of a HMRC challenge increases.
The question then, is how close to the shareholding split should you stick when paying out dividends?
This is not a black and white area but our advice is to try and ensure the dividend mix is as close as possible to the shareholding and if possible just stick to it exactly.
The most risky area of Alphabet Shares is where large dividends are allocated to a non-working shareholder and low dividends are allocated to the working shareholder - this is even riskier if there would not be sufficient retained profits in the business to support a theoretical higher dividend that would need to be paid to the working shareholder if dividends were paid in proportion to the actual shareholdings.
When it comes to low salary/dividends and splitting income with a spouse there is always going to be some degree of risk, as there is with all tax planning, but the risk can be reduced by following best practice guidance.
In summary our advice on this topic is:
- If you can avoid an Alphabet share structure it's probably best to do so, but this means you need to rigidly stick to paying out dividends in proportion to the shareholdings
- If you do go ahead with an Alphabet share structure then in order to reduce the risk of a HMRC challenge:
- make sure all shareholders have some working role in the business and are all directors and/or a company secretary
- try and stick as close to the shareholding % holdings as possible when paying out dividends
- if you pay a dividend to one shareholder that is in excess to their % shareholding of the business, ensure there are sufficient retained profits in the business that could support the theoretical dividend owed to the shareholder that has received less than their % shareholding of the business
- ideally when you pay a dividend, pay at least some level of dividend to all shareholders
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