Contractors' guide to dividend waivers
Before even the most skilled of contractors should try to mentally take on, let alone make a dividend waiver, let’s first establish that dividends are one of two ways a contractor rewards themselves when they work through their own limited company, writes chartered accountant Helen Christopher, operations director of Orange Genie.
Dividends: quick recap
The other way is via PAYE payroll, but typically a contractor will draw only a small salary, typically set at a level below or close to the tax and National Insurance thresholds to minimise liabilities, and then withdraw additional funds as a dividend.
Remember, dividends are a distribution to the company’s shareholders, of the company’s profits after tax. Dividends do not attract National Insurance contributions so are seen as a tax-efficient method of reward. By introducing the subject of shareholders, we are getting closer to dividend waivers, but outlining how dividends are drawn needs to come first.
How are dividends taken?
When taking dividends, a contractor’s company needs to issue a dividend voucher. This is an official record of a dividend payment. Your accountant can help with this, or you can use a template. A dividend voucher needs to include:
- Your company’s name
- The shareholder’s name
- The amount paid
- The date
- The signature of the company director
Potential tax inefficiency
Dividends are paid at the same rate for each category of share according to the number of shares held.
For instance, if Mr & Mrs Jones respectively hold 70% and 30% of the 100 shares in their family company and a dividend of £20,000 is declared, Mr Jones will receive £14,000 and Mrs Jones will receive £6,000.
This approach to dividend payments can mean the distribution of profits is not being made in the most tax-efficient manner for all shareholders. It may result in additional tax bills where the shareholder does not want or need the dividend payment. Examples of such inefficiencies may be;
- One shareholder is a higher rate tax payer or non-tax payer.
- By taking the dividend the taxpayer is affected by the additional income tax rate.
- By taking the dividend the taxpayer may be affected by the higher income charge on child benefit.
So, a so-called ‘dividend waiver’ may offer the solution!
What is a Dividend Waiver?
In a dividend waiver, a shareholder voluntarily waives their right to their share of the dividend, which then allows the distributable profits to be divided between the remaining shareholders in the proportion of their shareholdings while they themself receives nothing.
In our example above of Mr & Mrs Jones’ family company, Mr Jones is a higher rate tax payer thanks to other sources of income, and he has decided he does not want to take his dividend as it will affect his entitlement to his personal allowance.
Mr Jones therefore decides to waive his entitlement to the next dividend declared by the company by making a dividend waiver. In this instance, when a £20,000 dividend is declared, Mrs Jones receives £6,000 and Mr Jones receives nothing.
A dividend waiver can refer to a single dividend or a series of dividends declared during a specified period.
How do you make a Dividend Waiver?
In any limited company, if a shareholder decides not to take a dividend in favour of waiving their entitlement, they need to make a formal ‘deed of waiver’ election. A record of the discussion when the dividend waiver was agreed – minutes from a board meeting - should be composed and made available.
The dividend waiver should be signed and witnessed as an official record held by the company. Otherwise, HMRC could potentially challenge it in the future and argue the dividend stands!
Where interim dividends are paid during the course of the company’s year, any dividend that is to be foregone must be waived before being paid. Where a final dividend is to be paid at the company’s year end, the waiver needs to be signed before the right to the dividend arises to avoid a situation whereby it is deemed to be a false arrangement, or construed to be a “settlement” on another shareholder for tax purposes.
To alleviate the possibility of HMRC looking into a dividend waiver, the waiver deed should state a business reason for the waiver. For instance, that the waiver has been made to allow the company to retain funds for a specific purpose.
The amount of dividend being waived needs to actually be available to take – i.e. the company must have enough distributable reserves available to pay all dividends, irrespective of the fact that some may be waived. So, in our example (above), the company must have had profits available to distribute of £20,000, even though only £6,000 was paid by way of dividend.
What is the problem with a ‘Settlement’?
Not all dividend waivers are subject to challenge by HMRC but where a company with few shareholders declares a dividend when one or more of the shareholders has waived their right to a dividend in circumstances where another shareholder may benefit, it is possible the Settlements legislation may apply.
HMRC will look to see if the legislation applies where they believe a waiver has created a tax advantage. HMRC’s interest is more likely to be aroused where the following scenarios exist.
- The level of retained profits is insufficient to allow the same rate of dividend to be paid on all issued share capital.
- Although there are sufficient retained profits to pay the same rate of dividend per share for the year in question, there has been a succession of waivers over several years where the total dividends payable in the absence of the waivers exceed accumulated realised profits.
- There is any other evidence, which suggests that the same rate would not have been paid on all the issued shares in the absence of the waiver.
- The non-waiving shareholders are persons whom the waiving shareholder can reasonably be regarded as wishing to benefit by the waiver.
- The non-waiving shareholder would pay less tax on the dividend than the waiving shareholder.
Dividend waivers should be used sparingly. It is not advisable to waive every year, as HMRC tends to look more closely at habitual arrangements that result in a reduced tax take to them. For this reason, if a dividend waiver is agreed, it should not last for more than a 12-month period. In any event, a long-term waiver attached to a shareholding can de-value the asset and potentially increase the value of the shareholdings that are enjoying higher dividend returns.
If it is the case that you wish to permanently differentiate between the dividends paid to different shareholders, then it is worth considering ‘Alphabet shares.’ Different share classes can be set up that attract different rights to dividend payments. If contracts want to set this type of arrangement up, they should seek professional advice from their accountant or tax adviser.
Editor's Note: For more information take a look at our dividend waiver template here.