Mark McLaughlin warns that alphabet share structures are not as straightforward as some might think.
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It is not uncommon in owner-managed businesses for a company’s shares to be divided into different classes (e.g., ‘A’, ‘B’, and ‘C’ shares) for tax planning purposes. Such shares are known colloquially as ‘alphabet shares’.
The tax objective of alphabet shares is to enable dividend payments at different rates to different shareholders in a flexible and tax-efficient manner, based on the individual shareholders’ monetary needs and tax positions.
Tax troubles?
Alphabet shares might seem straightforward in principle. However, problems can arise if such share structures are not set up and implemented properly. For example,
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Some alphabet shareholders adopt a tax strategy of ‘low salary, high dividends’. However, for employees who are shareholders, it is important that the source of purported dividend payments is the shares rather than the individual’s employment. Dividend payments which are effectively a substitute for salaries or bonuses are vulnerable to challenge from HM Revenue and Customs (HMRC) and potential recategorisation as employment income (e.g., see PA Holdings v HMRC [2011] EWCA Civ 1414), resulting in different income tax rates and National Insurance contributions, particularly if the arrangements are complex or aggressive.
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Another possible line of attack by HMRC for employee shareholders is under the ‘employment-related securities’ provisions (ITEPA 2003, Pt 7), particularly as ‘post-acquisition benefits from securities’ or under the ‘securities with artificially enhanced market value’ rules. HMRC’s Employment Related Securities Manual at ERSM60030 includes an example (‘Alphabet soup’) where dividends paid on shares (with no rights other than that the employing company can award dividends at its discretion) are considered to be caught by the latter rules.
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Irrespective of whether the shareholder is also an employee, HMRC could challenge dividends under the ‘settlements’ income tax anti-avoidance rules, particularly in family companies. HMRC’s Trusts, Settlements and Estates Manual at TSEM4225 includes an example of a married couple, in which Mrs I owns ‘A’ shares and Mr I owns ‘B’ shares (both shares ranking equally). The company makes profits of £25,000. A dividend of £20,000 is voted on the ‘B’ shares, while no dividend is voted on the ‘A’ shares. HMRC considers that there is a ‘bounteous’ arrangement as the dividend on the ‘B’ shares could only be paid if no dividend was declared on the ‘A’ shares. Consequently, part of the dividend paid to Mr I is attributed to Mrs I under the settlements rules.
Dividend payments on alphabet shares should therefore be planned and administered carefully, to avoid potential tax traps.
Don’t overlook company law
Dividend payments must comply with company law in the first place. The company law requirements are beyond the scope of this article, but (for example) a dividend or distribution to shareholders may only be made out of profits available for the purpose (CA 2006, s 830).
For dividends to be paid at different rates, alphabet shares must genuinely be shares of different classes. For company law purposes, shares are of a single class if the rights attached to them are in all respects uniform. Paying different dividends in the following 12 months is not, of itself, sufficient to create a separate class of share (CA 2006, s 629). Thus, simply re-labelling the same shares as A, B, C, etc., shares may be problematic.
Practical tip
Don’t dabble or ‘DIY’ in alphabet shares! Seek legal advice, if necessary, on the company law aspects, and expert tax advice to prevent any unexpected and unwelcome tax surprises.
