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When are dividends and earnings the same thing?

Posted on February 22, 2013

Please note: PA Holdings has now taken the decision not to appeal to the Supreme Court.

The 2012 Court of Appeal case of HMRC v PA Holdings Ltd concerns the question of whether payments to employees were dividends, or earnings. This is becoming increasingly relevant where employees acquire dividend-bearing shares, potentially, even when shares are acquired under an approved share scheme. In this instance, it was decided that dividends can be taxed as employment earnings for both PAYE and NICs.


PA Holdings Limited paid its staff bonuses annually. In 1999, it set up a discretionary employee bonus scheme designed to give a corporation tax deduction whilst making payments to employees via dividends, in order to avoid NICs and attract a lower rate of tax.

Having transferred funds into an Employee Benefit Trust (EBT), the trust purchased shares in another company. By a series of steps, shares from another offshore company were awarded to employees. The employees then received their bonuses as dividends and redeemable shares.

Were the payments earnings?

  • HMRC claimed that the dividends were earnings.
  • In order to succeed in this claim, HMRC had to prove the cash receipts were “from” employment.
  • On these facts, in the earlier Tribunal hearing, it was agreed this was indeed the case applying the test of Upjohn J. in Hochstrasser v Mayes: “to be a profit arising from the employment payment must be made in reference to the services the employee renders by virtue of his office, and it must be something in the nature to reward for services past, present or future.”

The fact that the purchase of the shares by employees was “funded in full by PA (and not to all employees)” and the reason for the company making the payment into the EBT was “to motivate and encourage employees in the performance of their duties” were important factors in reaching the decision that the link to employment had not been entirely displaced.

What if they were also dividends?

The Tribunal at the first hearing went on to decide that the fact that the payments were provided as dividends meant that, even though they were also earnings, they could only be taxed once.

It held that:

  • The payments were to be treated as employment income.
  • The payments constituted dividends.
  • The payments were therefore taxable as dividends, accordingly they could not also be charged to PAYE.
  • The payments were earnings that were subject to liability for Class 1 National Insurance.

HMRC appealed, seeking to also apply the Ramsay principle in order to unpick the scheme and apply PAYE. The taxpayer appealed on the grounds that the payments were not earnings and therefore not subject to NICs.

HMRC challenged PA Holdings on the tax and NICs treatment of this income paid to its employees. It also observed that the shares awarded were “thin” – they carried rights to a single dividend and no voting rights.

The Upper Tribunal threw out both arguments. HMRC went to the Court of Appeal.

The Court of Appeal looked at the character of the payments:

  • PA Holdings had decided to award its employees bonuses.
  • The employees received bonuses, albeit in dividend form.
  • The fact the bonuses were paid as dividends did not change income accessible as earnings into dividend form.
  • In any event the scheme could be unpicked under the Ramsay (general anti-avoidance) principle.

The Court of Appeal therefore concluded that dividends can be taxed as employment earnings for both PAYE and NICs.

Future Relevance

Where an individual owns shares in a company, when deciding how to extract profits it is generally more tax efficient to take a dividend rather than pay salary.

The principle in the PA case no longer applies as the legislation has subsequently changed, meaning a corporation tax deduction in such circumstances is no longer effective. When income can constitute both employment and dividend income, ITTOIA 2005 now dictates that dividend analysis prevails: see ITEPA 2003 a716A and ITTOIA 2005 s366(3). However, if you look at an arrangement like PA’s and then apply the general anti-avoidance principles and unpick the steps, you may find that you have earnings after all.  

It has also been announced that a new General Anti-Avoidance Rule (‘GAAR’) is to be enacted and we must be mindful of that also. It is therefore important to understand that a desire to provide employee shareholders with dividend yield income requires careful navigation and a consideration of a number of factors.

Any attempt to disguise bonus payments as dividends to avoid NICs and reduce a tax charge is likely to be inflammatory to HMRC. It is therefore necessary to have and record a defensible position to evidence that payments as dividends are made to shareholders as a return on investment and not as disguised earnings.

For various reasons shareholders may want to take different dividends and where there is only one class of shares this can only be achieved by the use of dividend waivers. Such arrangements can be cumbersome and are dependent on there being sufficient reserves to cover the full dividend including the waived amount. In such circumstances, the use of A and B shares, to allow for different dividends to be paid, should be considered.

HMRC may review the arrangements to ensure the planning and implementation is effective and that the employment related securities provisions do not come into play. The arrangements are likely to be effective where the following can put in place:

  • Both A and B shares have the same rights including rights to vote and a share in net assets following a winding up of the company.
  • Reasonable salaries are paid to employees at least, in line with the national minimum wage and commensurate with their duties.
  • In husband and wife cases, the dividend should be paid to the spouse without any reciprocal obligation for it to be returned to the main shareholder.
  • There is more than 1 person in each share class.
  • All classes receive a base-level dividend but perhaps classes with additional rights receive a further dividend payment.
  • Crucially, the substance and not just the form, of the payment support treatment as a dividend.

Many share plans, Unapproved Share Option Plans (USOPs) and Enterprise Management Incentives (EMIs), for example, can operate with different classes of shares and proposed legislative amendments mean Company Share Option Plan (CSOP) and Share Incentive Plan (SIP) participants might also have restricted share classes offered in future. As always, RM2 can advise and steer a safe course of passage for you and your business. If a plan is exit-only, the aforementioned is not a concern, but if employees may exercise options in advance of an exit and acquire dividend-bearing shares then the above matters need to be considered.


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