Many family companies extract the majority of profits by way of dividends as this strategy often saves both income tax and National Insurance contributions. However, this has its limitations...
Company dividends must be paid in accordance with the shareholdings. Let us suppose that shareholdings in a family company are as follows:
Consequently, whenever a dividend is declared, 40% must be allocated to shareholder A, 35% to shareholder B and 25% to shareholder C. This denies the flexibility to pay more to one particular shareholder by way of a dividend as it is not possible to tailor dividend payments in the same way as it would be if bonuses were paid. Also, dividends may be paid to a shareholder who may not want or need them.
Where total taxable income is below the basic rate limit (£37,400 for 2010/11), no additional income tax is payable in respect of dividends. However, additional tax is payable on dividends received by higher rate taxpayers.
In a family company scenario, if one spouse is a basic rate taxpayer and the other a higher rate taxpayer, it may therefore be beneficial for one spouse to receive all the distributable profits. The requirement for dividends to be paid in accordance with shareholdings may mean that it is not possible to distribute profits in the most tax-efficient manner without changing the underlying shareholdings.
However, dividend waivers offer a possible solution. One or more shareholders can decide to waive their entitlement to the dividend, leaving the distributable profits to be allocated between the remaining shareholders in proportion to their holdings.
Mr and Mrs H each own 50% of the shares in their family company H Ltd. The company has made a profit and wishes to declare a dividend of £10,000. Under normal circumstances, each spouse would receive a net dividend of £5,000.
However, As Mr H is a higher rate taxpayer and Mrs H is a basic rate taxpayer, they decide that it would be beneficial for Mrs H to receive the full amount of the dividend. Mr H waives his entitlement to the dividend and the full £10,000 is paid to Mrs H. This saves higher rate tax on the net dividend of £5,000, a saving of £1,250.
A dividend must be waived before the right to receive it arises. It is not possible to waive entitlement retrospectively to create a different allocation of distributable profits.
A dividend waiver is a formal document. It must be executed in writing by the person entitled to receive the dividend and must be signed, dated and witnessed. The waiver can apply in relation to a particular dividend, in relation to particular accounts or to dividends declared in a specified period of time.
To escape the eyes of the taxman, it is always better if there is a genuine commercial reason for the waiver other than just a desire to save tax. Additionally, they should not be used too frequently.
In a husband and wife scenario where one spouse is a higher rate taxpayer and the other isn’t, HMRC may challenge the waiver under the settlement legislation provisions in some cases, claiming that by giving up his or her right to the dividend the taxpayer has created a settlement in favour of his or her spouse or civil partner. They would then seek to tax the dividend as if entitlement had not been waived. A ‘health check’ from a professional adviser is therefore recommended, particularly before waiving dividends for the first time.
Therefore, while dividend waivers can create flexibility, care must be taken in their use.