Whilst Alphabet shares have been seen as better than dividend waivers, which are purely a gift of income and will generally be caught as unallowable “income shifting”, there can be more to it than meets the eye.

What are Alphabet shares?

‘Alphabet shares’ is a term used where a company has multiple classes of share in issue, often distinguished by the use of different letters of the alphabet, for example:

• Ordinary ‘A’ shares
  
• Ordinary 'B' shares
  
• Ordinary 'C’ shares (and so on…)

Alphabet shares allow varying rights to dividends and voting to be included amongst the different classes of share. This flexibility may be useful where there are passive shareholders or where the company wishes to distribute dividends amongst shareholders in different proportions.

Structuring the share capital in this way can be beneficial as it allows flexibility, whilst maintaining a fair transparent dividend policy.

Potential issues

Whilst Alphabet shares do provide flexibility, there are potential tax issues that can arise where the highest dividend rate voted on any share class couldn’t have been voted on all classes due to a lack of reserves.

Where this is the case, there is potentially a gratuitous arrangement between the shareholders.

This means that a deemed gift of income can be caught by the settlements legislation which re-assigns the income back to its deemed donor (aka settlor) for tax purposes, albeit, this technically only applies where the recipient of the gifted income is the settlor’s spouse or minor child.

Below we have explored three scenarios to illustrate which scenarios may be caught.

The “good”

There will be instances where there are true commercial reasons for a shareholder to be issued a higher dividend, where this is the case there shouldn’t be any consequences of doing so.

This does, however, rely on the shareholders being unconnected individuals.

Example scenario

Unconnected individuals own 50 shares each in a company, with individual 1 owning 50 Ordinary ‘A’ shares and individual 2 owning 50 Ordinary ‘B’ shares.

Profits of £100,000 have been generated in a particular year, three quarters of which is distributed on the A shares because the division which individual 1 oversees has achieved better results than the division the second individual oversees.

It would be entirely reasonable for individual 1 to be declared dividends at a higher rate to reflect this difference.

There should be no adverse tax consequences arising from this scenario.

The “bad”

Where shareholders are connected, e.g. spouses / children under the age of 18, HMRC deem that there may be motivation for dividends to be declared with the intentions of achieving a tax advantage.

Where there are not sufficient reserves to pay the highest dividend rate across all share classes, the income can be caught by the settlements legislation.

Effectively this means that income can be ‘reassigned’ to be taxable in accordance to percentage ownership of capital, as opposed to being based on the voted dividends.

Example scenario

Husband and wife are both shareholders in a company - husband owns 80 Ordinary ‘A’ shares and wife owns 20 Ordinary ‘B’ shares.

Profits of £100,000 have been generated in a particular year and a dividend of £50,000 has been voted on the Ordinary ‘A’ shares and a dividend of £50,000 has been voted on Ordinary ‘B’ shares. In other words, at a rate of £625 per A share and £2,500 per B share.

Should the company not have had distributable reserves to vote £2,500 per share across both classes (being £250,000), this could be caught by the settlements legislation. This would mean £30,000 of dividends would be deemed to have been made from husband to wife and that income should be assessed on him.

The “grey”

Where this can become complicated is when shares are transferred to adult children with discretionary dividends rights.

Where a child is under 18, the settlements legislation would likely apply making the income taxable in the hands of the parents. However, young adults wouldn’t automatically trigger this legislation, instead the settlements legislation may apply where there is a clear settlor-interest e.g. an arrangement for the shares to be potentially transferred back to the parents in the future.

Example scenario

Husband and wife own Ordinary ‘A’ shares in a company and decide to convert some into Ordinary ‘B’ shares and gift to their adult children. The parents own 98 Ordinary ‘A’ shares, and their children own 2 Ordinary ‘B’ shares (1 share each).

Dividends of £10,000 per annum are voted on each B share whilst the children are at university, but the profits of the company are far lower than £1million (the reserves that would be required should the same rate of dividend to be paid on all Ordinary shares).

Technically this would not be caught by the settlements legislation, however, it would be caught were there to be a plan for the shares to be transferred back to the parents at any point in the future.

Other issues

There are other issues to consider, for example, whether certain alphabet shares are actually “thin shares”, i.e. they have limited or no capital rights.  In the case of PA Holdings v HMRC, employees were awarded with shares which appeared ‘thin’ with the main entitlement being to a single dividend. Those dividends were caught under the disguised remuneration rules and were subject to PAYE and NIC.

In our ‘grey’ scenario above, even if the dividends weren’t caught under the settlements legislation, there is a risk that those B shares could be considered ‘thin’ instead.

The team at Rickard Luckin can help implement an Alphabet share structure and advise on tax efficient dividend planning.