Employment Tax

Employment Tax

Houses of Straw?

KEN MOODY considers the possible pitfalls for practitioners and their clients when dividends are paid to employees.

THE SPECIAL COMMISSIONERS' decision in Forthright (Wales) Limited v Inspector of Taxes [2004] STC (SCD) 35 (confirmed in the High Court) raises a number of interesting points. The case concerned an appeal against the Inspector's refusal of a certificate entitling investors to claim enterprise investment scheme (EIS) relief under TA 1988, s 306. But what piqued my interest was that the company was blithely remunerating its employees by dividends to save National Insurance Contributions (NICs)! I also recently saw a query where a company had been formed by some individuals who had decided they would 'rather not go through the remuneration route' (as though this were purely optional) and wanted advice on creating different classes of shares to pay differential dividends 'depending upon the efforts we put in'.

There can scarcely be a practitioner in the country who has not been approached by a company client with similar proposals, so there is obviously a lot of it about. Weeding out such arrangements may be one of the reasons why the Revenue is keen for any issue of employment-related securities to be reported on the Form 42.

Curiously, the latest Revenue guidance on the disclosure of tax avoidance schemes, published as a technical note by The Chartered Institute of Taxation after discussions, states that 'straightforward incorporations, or dividends to employee shareholders' (my italics) are regarded as everyday tax advice where disclosure under the new rules is not expected.

Dividends paid to save NICs

Forthright (Wales) Limited was formed to take over the trade of supplying management services to a firm of chartered accountants from another company (Forthright Management Services Limited). The acquisition of the business was financed by the issue of 299,998 £1 'A' ordinary shares at par which, in addition to the two subscriber shares, brought the total A ordinary shares issued to 300,000.

The company also issued 'B' to 'Z' ordinary shares to employees (though the 'C' to 'Z' shares get no further mention). Evidence was given to the Commissioner that this continued a practice instigated when the predecessor company was in financial difficulties and employees had agreed to work for a nominal salary plus dividends to save NICs. There were 258 B shares of £1 issued, on which a dividend of £85,260 was paid. The Commissioner surmised that the purpose of the different classes of shares was to pay differential rates of dividend on each class. This is what happened and a dividend of £37,500 was also paid on the A shares held by the investors, of which it was found that £17,596 was paid out of monies subscribed for the shares.

Money raised by an EIS share issue must be employed wholly for the purposes of the trade, except for an amount 'which is not significant'; and the sum of £17,596 was significant — therefore the EIS claim failed.

It would appear from the case report that this was avoidable and shows, as Kevin Slevin has repeatedly emphasised, that great care is needed every step of the way to secure EIS relief. However, this article does not address the EIS issues, but concerns the implications of a remuneration structure based upon dividends.

A case of disguised remuneration?

The Special Commissioner was not given precise details of the arrangements whereby the company's employees agreed to work partly for dividends but, on the face of it, this arrangement would appear to be a blatant case of remuneration disguised as dividends. Clearly, if the arrangement was that the staff would sacrifice a given amount of salary for an equivalent amount of dividend, that would be caught by Heaton v Bell (1969) 46 TC 211. In that case, an employee was loaned a car by his employers and accepted a lower salary instead.

The House of Lords held that the correct construction of the agreement was that there was no change in the employee's wage, but that the employers were entitled to deduct each week a sum in respect of the use of the car. It followed that tax was due on the gross wage each week with no deduction for the sum relating to the car.

Even if the correct construction had been that the employee had accepted a lower wage and free use of the car, a majority of their Lordships would have held that the employee was taxable in respect of the use of the car on the amount he would have received if he had surrendered that use. Some arrangements involving dividends could even be disregarded as shams, in which case the dividends would simply be assessable as employment income, with obvious PAYE and NIC compliance implications.

I should make clear, incidentally, that I am not saying that Forthright involved any untoward actions by any of those involved — I am merely using the facts of the case as reported in order to highlight some of the issues involved.

A matter of employment law

The Revenue recently issued updated guidance on the topic of salary sacrifice which may be accessed at www.inlandrevenue.gov.uk/specialist/salary_sacrifice.pdf. The point is made that ' ... salary sacrifice is a matter of employment law, not tax law ...', and, 'the true construction of the revised contractual arrangement between employer and employee must be that the employee is entitled to lower cash remuneration and a benefit ... '.

If a salary sacrifice were to be part of an arrangement to issue shares to employees, it is essential to take advice on the employment law aspects to ensure that the revised contractual arrangements are legally effective. However, the employee must also realise that he is actually giving up entitlement to salary and that dividends cannot be guaranteed; if the company has insufficient reserves or if the directors decide not to pay a dividend for any reason, there can be no alternative entitlement to salary. Many employees will not be attracted by these conditions.

Dividends or bonuses?

It may be more realistic to issue shares to employees to pay what would otherwise be discretionary bonuses. However, assume that the Revenue will be privy to whatever is communicated with regard to the payment of dividends. If these are discussed in the context of the remuneration package (e.g. 'we do not pay bonuses, but you may receive a dividend instead'), that would obviously be unhelpful in establishing the payments as dividends. The use of 'B' to 'Z' shares so as to link the dividends with individual performance or status would also be indicative of disguised remuneration. If the arrangements are to be effective, it seems to me that the remuneration package should be based upon whatever may reasonably be supported as the 'industry' norm. The possibility of dividends should be something on top of, and not part of, the remuneration package (though naturally this will reduce the effectiveness of the arrangements if the aim is to save NICs). Of course, if the employees are also the equity shareholder-directors, who is to say what the balance should be between what they pay themselves for their services as employees or receive by way of dividends as proprietors? However, that situation is qualitatively different from paying dividends on shares with limited rights held by 'ordinary' employees.

It should be borne in mind of course that remuneration levels may also affect other matters, for example pension payments and benefits, statutory redundancy and other termination payments. The 'knock-on' effects need to be fully considered if the adviser does not wish to be exposed to potential negligence claims. The issue of shares to employees may also be part of a wider strategy to motivate and retain key personnel and it almost goes without saying that the 'horse' (the commercial considerations) should come before the 'cart' (tax deliberations) and not vice-versa.

Problems with 'funny' shares

One fundamental problem in providing commercial justification for shares issued to employees under the sort of arrangements described above is that they frequently do not give any genuine stake in the company. The amounts invested will usually be nominal and therefore the dividends paid will not represent a commercial return (and must therefore be for something else). Moreover, the shares will often have no voting rights, be subject to forfeiture on cessation of employment or to, often very restrictive, pre-emption rights. Shares in a company have often been described as a 'bundle of rights', but 'funny' shares carrying virtually no rights (let alone a bundle), except the right to receive a dividend should the directors decide to declare one, are arguably not shares at all in the accepted sense.

A huff and a puff

I am not forgetting here that shares may be issued to employees as an incentive and it does not necessarily follow that dividends on the shares are disguised remuneration. However, in many cases that is the reality and, if so, it would not take much more than a 'huff' and a 'puff' from the Revenue to 'blow the house down'. Where the facts are unclear, the Inspector will request copies of correspondence, notes, minutes and e-mails (including any professional advice not subject to legal privilege). Indeed, the lack of any such evidence is in itself suspicious and suggests that the true arrangements are being concealed.

It is interesting to speculate what effect the arrangements in Forthright had in terms of the employees' contracts of employment. If the employees had contractual rights to receive the dividends in lieu of remuneration, that would point strongly to their being employment income in line with Heaton v Bell. Therefore an analysis of the effects of the proposed arrangements on the terms, both express and implied, of the employees' contracts of employment is essential as a first step, though such advice is probably seldom sought. An undecided point in Forthright was an argument that dividends could be both remuneration and Schedule F income, but that Schedule F takes precedence (TA 1988, s 20). This, however, seems to beg the question, since if the payments were disguised remuneration, so that the arrangements were effectively a sham, the payments would not be dividends in the first place.

Shares taxed as employment income

Assuming that the amounts paid as dividends are not attacked as disguised remuneration, we then need to consider whether any tax charges arise in respect of the shares themselves. Where shares are issued to an employee by reason of employment, the difference between the market value of the shares and what the employee pays for them is taxable as employment income per Weight v Salmon 19 TC 174.

Some commentators have suggested issuing a new class of shares, having no rights to past profits or assets derived therefrom and (either through the articles or a shareholders' agreement) no preferential rights to future profits or assets. It is further suggested that the new shares are unlikely to be worth more than par value at the time of issue. Therefore, if the employee subscribes par value, there should be no income tax liability and this should also exclude the notional loan provisions in ITEPA 2003, Chapter 3C.

I have also come across a suggestion of issuing a new class of ordinary shares of 1p nominal value, with no voting rights, no rights to capital on a winding up and subject to pre-emption rights requiring them to be offered back to the company or to other members for only their nominal value on termination of employment (whilst of course dividends are paid on the shares in the meantime). This arrangement seems particularly provocative given that it is fairly obvious that the purpose of issuing the shares is to pay dividends — what other reason could there be? It does not follow necessarily that the dividends are disguised remuneration, but if that is the reality, again, a huff and a puff and — no house.

Valuation of shares

The idea that the shares are worth only par on issue seems somewhat asymmetrical. If someone were to offer me 100 £1 ordinary shares in a company on which I could reasonably expect to receive a dividend in the region of £5,000 a year, reserves permitting, I would obviously be prepared to pay a not insubstantial sum for those shares. If the same offer were made except that I had to do £5,000 worth of work for the company, I might want the work, but I would not be willing to part with much for the shares.

However, if I am to argue that the dividend is not for services rendered, but is paid to me in my capacity as a shareholder, then it would follow that my shares could be worth quite a bit and if, as an employee, I pay less than market value for them I should be taxed on the difference. Where a dividend of some thousands of pounds is paid within spitting distance of the issue of shares for which only a nominal amount was subscribed, it is scarcely credible that this was not pre-arranged. As I say, it should be assumed that the Revenue will be privy to whatever that arrangement was and therefore:

Where substantial dividends have been actually paid on the shares since their issue (and bear in mind by the time the matter 'hits the fan' there is likely to be something of a dividend history), in the absence of other evidence the Revenue may infer what the arrangement was and value the shares accordingly. Shares Valuation Division is known to value minority holdings in private companies based upon their 'investment value'. This approach takes a price earnings ratio from a comparable public company, which is then discounted as appropriate. The resulting value may be much higher than a valuation based upon the company as a whole using the earnings basis with traditional discounts for the size of the minority holding. Therefore, it is by no means impossible that a substantial share value may be assessed as employment income as an amendment by the Inspector to the employee's self assessment. Obviously this is subject to appeal to the Commissioners, but all relevant evidence would then need to be presented, possibly involving oral evidence given under oath. Thus, before embarking upon that course, it would be necessary to ensure that the evidence was favourable to the arguments presented on behalf of the client. Then, of course, there would also be an unwelcome degree of 'hassle' involved.

Let me emphasise that it is not a question of placing a gloss on the circumstances to support a particular argument: it is a question, first and foremost, of accurately representing the facts. Any tax practitioner who values his or her livelihood and liberty needs to exercise extreme caution and at all costs avoid getting drawn into 'smoke and mirrors' games with the Revenue in order to mollify the client: it simply isn't worth it. In this context, Chris Tailby, on behalf of Customs (see 'VAT Disclosures — Main Purpose', Tax Journal, 23 August 2004) makes some observations which are both very serious and amusing concerning attempts to 'pull the wool' in a VAT context.

Market value

ITEPA 2003, s 421 imports, from 6 April 2003, the CGT definition of market value which requires one to assume a hypothetical willing vendor and a willing purchaser who will then be entitled to hold the shares subject to the articles of the company. The earlier definition was 'the amount which may reasonably be expected to be obtained in the open market' and it was thus possible to argue that the shares were not saleable in the open market. This change will affect not only the valuation of the shares on issue, but also the valuation for other 'chargeable events' under the employment related securities legislation — in particular the restricted securities provisions in ITEPA 2003, Part 7 Ch II.

For example, if the articles or a shareholders' agreement contained pre-emption rights whereby the shares would be transferred on termination of employment for nominal amounts, what would be the taxable amount on the occurrence of that event? It would seem that market value would apply so that the employee may be taxed on an amount considerably in excess of what has been received as employment income. Of course, this depends upon whether a joint election to ignore restrictions, under ITEPA 2003, s 431, was made for valuing the shares in relation to the chargeable event arising on issue. This would take any future gain out of the income tax régime and into CGT, allowing business asset taper relief to be claimed.

Restricted securities

Detailed comment on the restricted securities legislation in ITEPA 2003, Part 7 Chapter II is beyond the scope of this article. As already indicated, however, it is highly likely that the issue of shares under informal share arrangements as in Forthright will be restricted securities. It is therefore important to consider the implications carefully.

Commercial arrangements

I do not wish to completely pour cold water on the possibility of issuing shares to employees on which dividends may be paid (other than via a Revenue approved scheme). Where the arrangements are commercially driven and the shares issued are genuine equity holdings, so that the future prospects of the company and the employee are entwined, these may also be tax-effective. Excluding an employee from benefiting from the company's past performance has a commercial logic, particularly where shares are issued for nominal value, and the prospect of future participation may well act as an incentive to a high-flying entrepreneurial type of individual (though the enterprise management incentive scheme would be worth considering here).

A substantial bill

However, my suspicion is that many, if not most, such arrangements are half-baked and would, as mentioned above, probably collapse at the first 'huff 'or 'puff' by a lupine Inspector. I also suspect that employment law considerations would rule out giving shares to the general workforce in most cases and therefore the idea does not get past first base. As I have stressed, any dividends paid to employees must be independent of their contracts of employment and if the legal analysis of the proposed arrangements cannot support that conclusion then it is not so much a case of rickety houses, but one of houses built on sand. If dividends were reclassified as remuneration as part of a PAYE enquiry then, depending upon the number of years involved, the final bill for PAYE, NICs and interest could be substantial, even leaving aside any question of negligence.

An additional tariff?

I would be surprised if the Revenue were not enquiring into situations similar to Forthright as and when it becomes aware of them. However, the wider policy issues will no doubt be addressed in the forthcoming Government discussion paper on the taxation of small owner-managed businesses, to be published at the time of the 2004 Pre-Budget Report on 2 December (with the aim of ensuring that 'the right amount of tax is paid'). What is the right amount is almost impossible to define objectively since, as I ask above, who is to say what would be a proper balance between remuneration and dividends for an owner-managed company?

Rather than attempt to answer the unanswerable and also in order to compromise arrangements for paying dividends to employees or relatives, whilst rendering the cumbersome and not wholly successful IR35 régime otiose, it seems likely that the Revenue will visit 'a plague on all their houses' in the form of an additional tariff on private company dividends.

Ken Moody is Tax Development Manager with Macintyre Hudson. The views expressed in this article are those of the author and not necessarily those of the firm.

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