In this excerpt from the report 'Alphabet Shares: The Essential Guide for Tax Advisers', Nick Wright goes through the practical advantages of alphabet share structures over traditional dividend waivers, including the key settlements legislation risks and inheritance tax implications advisers need to consider.
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Alphabet shares as an alternative to dividend waivers
The use of alphabet shares as a dividend planning tool is most commonly encountered as an alternative to the traditional dividend waiver, a mechanism by which a shareholder formally waives their entitlement to a declared dividend, enabling remaining shareholders to receive enhanced distributions. Whilst dividend waivers and alphabet shares are sometimes used as equivalent mechanisms for achieving the same planning objective, they operate on fundamentally different principles and carry different risks.
A dividend waiver involves a shareholder who is entitled to a dividend choosing, before the dividend is paid (or in some cases before it is declared), not to exercise that entitlement. The other shareholders then receive their proportionate shares of the available profits without any payment going to the waiving shareholder. From a tax perspective, the critical question is whether the settlements legislation applies to attribute the waived income back to the waiving shareholder, which depends primarily on whether the arrangement has commercial substance beyond the tax saving.
The prohibition on most accountants and tax advisers preparing dividend waivers has been one of the drivers of the increased use of alphabet shares. By creating separate share classes with different dividend entitlements, the need for a formal waiver is eliminated. The directors simply declare a dividend on the relevant class or classes, and each class receives its designated entitlement without any shareholder needing to waive anything.
However, the shift from dividend waivers to alphabet shares does not eliminate all risk. Alphabet shares are subject to the settlements legislation in much the same way as dividend waivers. Indeed, the House of Lords in the Arctic Systems case confirmed that bounty can arise from the allotment of shares to a spouse even where those shares are subscribed at full value, if there is an expectation of preferential dividend treatment. The technical mechanism may differ, but the underlying tax analysis is materially similar.
Legal requirements for valid dividend waivers
Although this report focuses primarily on alphabet shares, a proper understanding of the deficiencies of dividend waivers helps to explain both the rationale for alphabet share structures and the risks that careful advice must address. Where clients have historically used dividend waivers, the transition to alphabet shares requires an understanding of the legal requirements that the waivers must have satisfied in order to be effective.
For a dividend waiver to be legally valid, it must:
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be executed as a deed (which is why it is a reserved legal activity);
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be completed before the relevant dividend is declared (for final dividends) or paid (for interim dividends); and
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be absolute and unconditional – a conditional waiver may not be effective.
The timing requirement is of critical importance. Once a final dividend has been declared, the shareholder has an immediate legal right to receive it, at which point a 'waiver' is, in substance, a gift of the dividend to the remaining shareholders, creating income tax liability on the waiving shareholder as though the dividend had been received. The Upper Tribunal in Gould [2024] confirmed that, under standard Table A articles, once an interim dividend is paid to one shareholder of a class, an enforceable debt arises in favour of the other shareholders of that class, which is precisely why alphabet shares, creating separate classes with independent dividend entitlements, offer a more robust solution than attempting to engineer differential timing within a single class.
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HMRC v Gould [2024] UKUT 285 (TCC) |
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Facts |
Peter and Nicholas Gould were brothers who each held shares in Regis. An interim dividend of £20m each was declared on 31 March 2016. Nicholas was paid on 5 April 2016 (in tax year 2015/16). Peter, who had spent significant time in the UK during 2015/16 and was uncertain of his residence status, wanted his dividend delayed to taxyear 2016/17 when he would definitively be non-UK resident, and it was not paid until 16 December 2016. HMRC argued Peter had an enforceable right to payment on 5 April 2016 and was therefore taxable in 2015/16. |
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Held |
The Upper Tribunal overturned the First-tier Tribunal, holding that under standard Table A articles (article 104), once Nicholas had been paid, Peter did have an enforceable debt, the equal treatment principle meant paying one shareholder created rights for the other. However, Peter won the case on the Duomatic principle;the brothers had informally but effectively agreed to vary the articles before any dividend was declared or paid, removing Peter's right to enforce payment in 2015/16. That informal agreement constituted a valid variation of the articles, was objectively verifiable from the recorded discussions and advice received and was sufficient to prevent an enforceable right arising. The waiver was also upheld as a secondary finding, the consideration being the company's promise to pay Peter in 2016/17. |
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Relevance |
The case carries two important lessons for alphabet share planning. First, it confirms that, under standard articles, a company cannot simply pay an interim dividend to one shareholder of a class without creating an enforceable debt for the others;differential timing within a single class requires a prior agreement or formal articles amendment. Second, and most relevantly for this report, the Upper Tribunal itself observed that using alphabet shares (or separate classes) would have enabled dividends to be declared independently on each class, achieving the same result far more simply and without litigation. The case is therefore a powerful practical argument for alphabet share structures over ad hoc arrangements within a single class. |
Leading cases on dividend waivers
Several leading cases have addressed the treatment of dividend waivers under the settlements legislation, providing important guidance on the factors that will determine whether HMRC's challenge succeeds. These cases remain highly relevant to the alphabet share context because the underlying settlements legislation analysis is the same.
Buck v HMRC (2008) SpC 716
The Buck case provides one of the clearest examples of the settlements legislation applying to a dividend waiver arrangement. Mr Buck held 9,999 shares in the company and his wife held one share. Shortly before the year end, Mr Buck waived his dividend entitlement, and dividends of £39,371 and £27,774 were paid exclusively to Mrs Buck in successive years.
Given that Mrs Buck held only one share out of 10,000, the payments she received were wildly disproportionate to her shareholding. The courts had no difficulty concluding that the settlements legislation applied and that the dividend income was taxable on Mr Buck. The case is noteworthy not merely for its outcome, but for the clarity with which it illustrates the kind of arrangement that will inevitably attract adverse treatment, i.e., one in which the disproportion between the dividend paid and the economic interest held is so extreme as to make the absence of commercial rationale self-evident.
It was also noteworthy in this case that the dividends paid to Mrs Buck represented almost all of the available reserves for those years, despite Mrs Buck only holding 0.01% of the share capital.
The shares held by Mr and Mrs Buck were of the same class. Despite the spousal exemption within the settlements legislation (see the Arctic Systems case analysis below), the shares held by Mrs Buck were of such a small minority that they were deemed to represent nothing more than a right to income, and therefore the spousal exemption could not apply. This is sometimes referred to as ‘thin’ shares.
Donovan & Anor v Revenue & Customs [2014] UKFTT 048 (TC)
The Donovan case is of particular interest because it confirms that the availability of distributable profits sufficient for dividends to be paid to all shareholders is not, in itself, sufficient to establish the commercial substance of an arrangement. The First-tier Tribunal held in HMRC's favour, not because there were insufficient distributable reserves, but because the arrangement lacked any genuine commercial purpose beyond the tax saving.
This case reinforces the principle, repeatedly affirmed in this area, that the settlements legislation is concerned primarily with economic substance rather than legal form. A dividend waiver that is technically effective as a matter of company law, and that is effected in circumstances where the paying company has more than sufficient distributable profits to pay dividends to all shareholders, will nonetheless fall within the settlements legislation if the dominant purpose of the arrangement is to divert income to a lower-taxed family member.
Inheritance tax implications of dividend waivers
The inheritance tax implications of dividend waivers are frequently overlooked. Under IHTA 1984, s 3, a gratuitous transfer of value from one person to another constitutes a potentially exempt transfer (PET), unless it falls within one of the available exemptions.
A dividend waiver may constitute a transfer of value where the waiving shareholder, by forgoing their dividend entitlement, causes an increase in the value of the shares held by other shareholders (and therefore in their financial position). HMRC's position is that extended waiver periods, particularly waivers that run for more than 12 months, may fall outside the normal commercial practice exception and constitute gifts for IHT purposes.
To minimise IHT risk, dividend waivers should be time-limited to periods of less than 12 months. Where longer-term arrangements are contemplated, the use of alphabet shares – which achieve differential dividend treatment through the constitutional structure rather than through periodic waivers – is significantly preferable.
Practical advantages of alphabet share structures
Having examined the risks that apply to both dividend waivers and alphabet share structures, it is worth summarising the practical advantages that properly structured alphabet shares offer over the waiver alternative:
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Advantages of alphabet shares over dividend waivers |
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1. No requirement for a deed of waiver, the constitutional structure itself enables differential dividends |
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2. Avoids the 'reserved activity' issue, no specialist legal qualification needed for each dividend cycle |
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3. Greater certainty – the right to differential treatment is built into the constitutional document |
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4. Long-term sustainability, the structure can be maintained indefinitely without annual renewal |
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5. Cleaner IHT analysis – no periodic waivers that might constitute transfers of value |
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6. Flexibility – each class can receive any amount (including zero) without the mechanics of a waiver |
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7. Stronger commercial substance – the constitutional basis creates a legitimate expectation of differential treatment |
