Discretionary dividends

Allocating dividends unequally across shares in a company

Gerry Jackson of Critchleys made an interesting blog post yesterday reminding us that paying dividends is almost always more tax-efficient for owner-managers than paying bonuses.

I commented about giving the directors a discretion to pay different dividends on separate classes of shares. We corporate lawyers often get asked by tax advisers to change the articles to do that. It allows the company to pay dividends otherwise than in proportion to shareholdings, either to maximise tax-efficiency or to reward contribution to the business – close to being disguised remuneration. But it has legal implications:

• Directors have duties to act in the interests of the company and to treat shareholders fairly, which usually means equally, and the exercise of discretion in any other way could be criticised later or challenged in court.
• It becomes difficult to value any particular block of shares, as the dividends attached to them vary depending on the exercise of the discretion. That difficulty could be exploited by HMRC in some circumstances: see (for instance) example 3 in the HMRC manual on "Securities with Artificially Enhanced Value". The value of the shares may go up and down depending on the history of dividend declarations, and there is no guarantee that the holder will get the same price per share as other shareholders when the company is sold.
• HMRC may attempt to characterise dividends as disguised remuneration, depending on how the discretion is exercised.
• HMRC may seek to attack discretionary dividends under the settlements legislation, especially when the beneficiary is the spouse, civil partner or minor child of the person not receiving the dividend: see the HMRC manual on this. 
• The power to allocate dividends could be abused by directors. Even if the shareholders are directors, decisions could be made by a majority or if a director were absent. Except possibly in husband and wife companies, some protection is usually advisable, and I have some strategies to achieving that protection.

Two further points to add about taking remuneration as dividend. First, it may reduce the amount you can claim on dismissal, including following insolvency, or affect the amount of the pension contributions you can make. Second, remember that dividends have to be covered by distributable profits. My insolvency practitioner friends all have stories of unfortunates who continued to pay themselves by dividend as the company started to make losses, only to have the dividends reclaimed after the company went down.