Beware dividend waivers and share structures

Beware dividend waivers and artificial share structures warn Harris & Co accountants Northampton, the specialist small business accountants.

In some respects, it is surprising that the case of Donovan & McLaren v HMRC [2014] UKFTT 048 (TC) ever made it as far as the First Tier Tribunal. The company had four shareholders: two husbands who each owned 40% of its shares, and their wives who each owned 10%. The dividend payments should have been in proportion to each person’s shareholding, but were not because the husbands had waived their right to certain payments. Rather than the husbands receiving four times as much as their wives, all four directors received approximately equal dividend payments. And as the wives were basic-rate taxpayers, the Treasury was deprived of considerable revenue.

The directors claimed that the waivers were not an attempt at tax avoidance but a commercial decision. However, HMRC successfully argued that there could be no commercial justification for waiving dividends as the company made insufficient profits to pay at the same rate to all shareholders. In other words, had the husbands not waived their rights, the company could never have made such a large dividend payment to the wives. This fact alone should have won the case for HMRC. But it further strengthened its claim with the contention that because dividends had been waived over a period of several years, the action was not a commercial decision, but an ongoing arrangement to avoid tax by shifting income from higher-rate to lower-rate taxpayers.

Few observers will be surprised at the Tribunal’s outcome. What is noteworthy is that HMRC has had quite a few victories recently, and in this case, it used one of its key anti-avoidance weapons – settlements legislation – to good effect. Where HMRC believes that income has been intentionally diverted from one taxpayer to a lower-rate taxpayer, it can use this legislation to ‘settle’ the income back onto the higher-rate taxpayer.

However, HMRC has not always used the legislation successfully. In 2007, in the landmark Arctic Systems case (Jones v Garnett [2007] STC 1536), it failed to convince the courts. Since then, however, much has changed. In today’s fiscally constrained world, public opinion has hardened against what was once seen as fair tax planning.

Further evidence of how far the goal posts have already shifted can be seen in the case of  HMRC v PA Holdings [2011] EWCA CIV 1414, where the Court of Appeal supported the Treasury’s view that dividends paid to employees through a restricted share plan were subject to national insurance contributions.

Such victories have emboldened HMRC and it has made it clear that it will challenge all tax planning structures that it views as artificial. We take this to relate to any structure that has been established without a commercial rationale. HMRC’s view is that dividends are intended to be a reward for equity investment, not a means of remuneration.

In this new landscape, professional advisers must march to a new tune. Higher standards are expected and ignorance of the law will not be acceptable as a defence, if indeed it ever was. Last year, in the case of Mehjoo v Harben Barker ([EWHC QB] (A Firm) & Anor [2013] EWHC 1500 (QB) (05 June 2013)), the court confirmed that the duty of care is not restricted to a literal reading of letters of engagement. Professional advisers are expected to seek out specialist advice as required.

As the framework of case law develops, what was once seen as clever tax planning is now being portrayed as old-fashioned dishonesty. The Donovan case was an easy win for HMRC, and it will surely use this legal precedent to pursue other companies operating similar schemes.

Many tax advisers will be tempted to counsel clients against any use of dividend waivers, but such blanket action would be an overreaction. There are instances when it is the right course, but this is something that must be considered carefully and be correctly documented. In these changing times, more is being expected of companies. What is also becoming clear is that more is also being expected of their advisers.