Well, let us be frank, dividend waiver has nothing to do with charity! The person waiving the dividend will usually have a financial or tax reason in mind. That said , normally when companies declare dividends, these are paid as a certain sum on ‘per share’ basis to all shareholders entitled to a dividend on a particular date. It could be £50 per share, £100 per share or such similar sums. And tax indeed is one of the most common reasons why a shareholder (often in higher tax bands) would want to have his/her dividend entitlements waived off. Hence the taxman’s interest! So, if not carefully done, dividend waivers have the potential to be classed as an arrangement or a settlement by the taxman. This article briefly examines how dividend waivers could be caught by the settlement legislation in certain circumstances.
Dividend waiver
Let us consider an example of a ‘close company’ having an ordinary share capital £100 divided into 100 shares owned by two shareholders A and B 50 each. The company has a distributable surplus of £10,000 and if it were to declare the whole surplus as dividend both A and B would get £5,000 each. If A were to waive his entitlement, B would get £ 5,000 and the A’s dividend would be retained within the business.
But let us consider a scenario where A waives his entitlement and the company declares £200 per share. That would make B richer than what his original entitlement would have entitled him to (i.e. £ 5,000). This is one situation where settlement legislation kicks in, arguing that the waiver was arrangement to provide an undue advantage to A.
Settlement legislation
Settlement legislation is contained in Chapter 5 of Income Tax (Trading and Other Income) Act 2005 (ITTOIA). This legislation would apply if B in the above example was a spouse or a civil partner. As a result, the settlor will be deemed to have retained an interest in the property (s 624.). Where B is a minor child or a step child (who is neither married nor in a civil partnership of the settlor) the income will be deemed to be that of A (s 629). So normally unless B is the spouse, civil partner or a minor child or a minor step child of A, the settlement legislation shouldn’t apply. But there is hardly anything normal about tax rules. The fact that S 625(1) of the Act refers to situations where ‘that property or any related property is, or will or may become, payable to or applicable for the benefit of the settlor or his spouse or civil partner in any circumstances whatsoever’ make it clear that even where B is not a spouse or a minor child this legislation can apply. One example would where B is a brother and A is likely to benefit from the arrangement.
Impact of settlement legislation
Should settlement legislation apply the income treated as settled will be taxed as the income of the settlor, i.e. in the above example that of A.
Buck v HMRC (Stafford Robert Buck v Revenue & Customs [2008] UKSPC SPC00716
This was a case involving a private company owned by the husband and wife. The husband Mr Buck owned 9999 shares whereas the remaining 1 share was held by his wife. Mr Buck waived his entitlement to dividend so that Mrs Buck could be given a larger dividend than what her 1 share could ordinarily have entitled her to. HMRC successfully argued before the Special Commissioners that a) there was no commercial reason for the waiver as Mr Buck’s entitlement was effectively distributed on to Mrs Buck, and that b) the waiver would not have taken place had the other shareholder not been his spouse. As a result it was treated as a gift of income and therefore, the settlement legislation was applied.
HMRC view
HMRC manual TSEM4225 lists circumstances when the settlement legislation may apply:
• 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.
• The non-waiving shareholder would pay less tax on the dividend than the waiving shareholder
So can a waiver then work?
There are some basic rules that should be followed whilst planning to waive the dividend. These are summarised below:
1. The waiver should be applied before the dividend becomes due. Interim dividends are authorised by the directors so the waiver should be applied before the board meeting authorising payment of the interim dividend is held. If it is about final dividend the waiver should be applied for before the board meeting recommending a dividend is held. In order to make sure that the waiver is outside the scope of the provisions of Inheritance Tax Act 1984 (particularly s.3 – transfer of value) the waiver deed should be executed within 12 months before any right to the dividend accrues (s.15).
2. The waiver should not result in an undue benefit to the other shareholders. In other words the waived dividend should be retained within the business (See this case).
3. There must be a commercial reason behind the waiver – for e.g. leaving funds with the company for expansion etc.
4. Dividend waiver should be used either for a particular period or for a particular occasion. If it is going to be a regular feature then alternative strategies must be adopted – see below.
5. The person waiving the dividend should not gain anything in return either directly or indirectly.
Waiver documentation
Appropriate waiver documentation is essential. It should be a formal document in writing executed as a deed; signed, dated and witnessed. It should be lodged with the company well before the dividend becomes due and as a best practice placed at the meeting of the Board at which either the dividend is approved or recommended.
Setting up alphabet shares
If waiving the dividend is going to be a regular feature then a permanent alternative to distribute the surplus disproportionately to the same class of shareholders is to issue alphabet shares. However, it is important that alphabet shares are not caught by the ‘wholly and substantially’ a right to an income clause of the legislation. This provision can be avoided where all the alphabet shares carry equal voting rights and rights to capital upon winding up etc as such rights greatly outweigh the right to income (Jones v Garnett). To put it differently, don’t right away create alphabet shares just before a dividend is due or as soon as the company has posted huge P & L reserves!
