Can A Dividend Be Recategorised As Salary?

Lee Sharpe looks at one of the risk areas for director shareholders of family companies.

Many ‘small’ companies are both owned and managed by the same group of people (or almost the same). The company’s directors are also its shareholders, referred to here as ‘director shareholders‘. 

Many director shareholders will be well aware that dividends tend to be more tax-efficient than salaries; the main reason for this is not strictly tax but National Insurance contributions (NICs). A company can claim corporation tax relief on salary payments, but not on dividends paid out to shareholders. So initially, salary would be more tax-efficient. But when the company has to increase the total paid out to cover the amounts lost to employers’ and employees’ NICs, dividends become comparatively cheaper.

This article will take a brief look at where dividends can lose their NIC-free status, so that they become the worst option.

Most people consider NICs to be different from income tax (and other taxes) in that NICs are supposed to pay for state pensions and the NHS. It could be said that such people have longer memories than most politicians would like, since successive governments have broken down the internal divisions between the administration of taxes and NICs until there is one so-called ’common fund’ for both receipts (excepting some that is ring-fenced for the NHS).

But while it may feel like pretty much the same thing, the mechanism by which the government relieves taxpayers of NICs (so to speak) remains slightly different. 

Many readers will be familiar with HMRC v P A Holdings Limited [2012] STC 582. In this long-running case, the employer devised a complex arrangement to reward employees who also held ‘thin’ shares (with negligible rights other than to income) in a separate company, which had been set up as part of the arrangement. Employee bonuses were channelled into this other company, which in turn paid dividends to the employees. This, in theory, meant that they escaped NICs, being taxed as dividends in the hands of the employee shareholders.

At the First-tier Tribunal and Upper Tribunal hearings, the tribunals held that the payments were both dividends and earnings. For income tax purposes, this meant that they should be taxed as dividends, thanks to a priority rule (found now at ITEPA 2003, s 716A). But, because NICs legislation had no such priority rule, there was nothing to stop NICs being charged on the bonus payments, even though they were arguably also dividends. This was bad news for PA Holdings. 

Worse was to come: The Court of Appeal held that the income could not be categorised as both a dividend and as earnings (despite the seemingly inescapable inference to draw from ITEPA 2003 s 716A), and these payments were in fact just earnings for the purposes of both NICs and income tax – and therefore subject to ordinary income tax and NICs. 

Subsequently, JH Donald (Darvel) Ltd v HMRC [2015] UKUT 514 reinforced the PA Holdings case. This involved further complex arrangements that allegedly converted employee salary into dividend income. Unfortunately, the Upper Tribunal was satisfied that it was the employment relationship that drove the payment, and the character of the receipt in the hands of the recipients, rather than the immediate source of the income; so again, subject to income tax and NICs, and a ‘dear do’ for the taxpayer.

There have been concerns that these rulings could mean that dividends should be re-categorised as earnings – subject to income tax and NICs – for all director shareholders, even of smaller owner-managed and family companies. Certainly, there is the chance that HMRC would like to use the case to attack shareholder/directors who have traditionally taken modest salaries and large, tax-efficient, dividends (or NIC-efficient, if you insist). 

However, the above cases involved highly complex arrangements. They also involved people who had started off as ‘ordinary employees’, who had then been given special ‘thin’ shares that held basically no rights other than to an income. People who set up their own companies, or who receive a proportion of ownership of a family company, are unequivocally owners, or part-owners, of that company, and are entitled to a dividend in respect of their investment in that company. Their shares almost always carry a right to vote, and a right to assets on a winding up of the company – in other words, not just a right to income, as with the ‘thin’ shares described in the aforementioned tax cases. 

I have not encountered setups like those examples in the cases above when dealing with family companies. However, I have seen companies that make use of ‘alphabet’ share categories, (e.g. 50 ‘A’ shares, 30 ‘B’ shares, 20 ‘C’ shares). I do NOT think that using alphabet shares is inherently wrong, but there could be cases which need to be considered more carefully. 

Colin has set up and owns his IT company outright. For many years, he has taken a modest salary and substantial dividends. In my opinion, his dividend income cannot be considered to be anything other than dividend income, and taxable as dividend income. 

Colin has a key employee, Derek, who has worked for Colin for many years, earning around £45,000 a year. Let’s say that Colin re-designates his shares into ‘A’s with voting rights, etc., and ‘B’s without voting rights, etc., and then transfers 20 ‘B’ shares to Derek. Derek then has shares that are essentially a right to income and nothing more. Derek agrees to enter into an arrangement with Colin whereby he no longer takes a salary of £45,000, but of £10,000, and a dividend of £30,000 a year, through those ‘B’ shares. 

There would be other tax implications to such an arrangement (transactions in employment-related securities, for example) but focusing on the dividends that might then follow, it seems there is a real risk that Derek’s dividend income could be re-classified by HMRC as earnings, both for PAYE and NICs. 

Similarly, if Colin decided to hire a new employee, Divina, for a role that normally commanded £40,000, but where Divina and Colin agreed to a salary of (say) £8,000 and ‘B‘ dividends with an income of £30,000 a year, HMRC could again look at the PA Holdings and Darvel cases and argue that Divina’s dividends are in fact salary. 

There is a fundamental difference between earnings and dividends. Earnings are a reward for work done, while dividends are a distribution of a company’s net profits. While larger companies might be reasonably confident that annual profits will be consistent, this is not normally the case for small companies. If Colin’s company has a bad year, and Derek and Divina have to put up with dividends of only £15,000 each, have their earnings fallen? What if profits rise the following year, and they take dividends of £50,000 each – is it really right to say that all of that dividend income is in fact earnings, and none of the increase is a return of company profits to its shareholders? Employees can have profit-sharing arrangements that pay out as normal salary. But these are generally bonuses over and above an existing wage. I am no lawyer, but my understanding is that an employee’s salary entitlement cannot be simply halved in a ‘bad year’, in the way that dividends can.

Nevertheless, I think companies that have utilised BOTH alphabet shares AND limited rights on shares for ‘ordinary’ employee rewards should seek advice on the implications of the above cases for their tax position. Then again, we may find HMRC’s appetite for challenging dividends in such cases is tempered by the new dividend regime, which significantly narrows the gap between dividends and salary in terms of tax-efficiency.