Over the years creative tax advisers have come up with schemes that aim to “convert” employment income into dividend income to avoid higher rates of tax and employer’s NICs.  The case of James H Donald (Darvel) Limited (“Darvel”) and others v HMRC reported on 5 October 2015 has seen another win for HMRC.

 In this case a services company was set up with shares issued to both Darvel and a number of employees.  Those employees who participated in the plan agreed to reduce their pay to the minimum wage.  The reduction in pay was then routed through the service company and paid to them as dividends.

 In finding for HMRC on appeal, Lord Jones in the Upper Tribunal was presented with the argument that the tax legislation that charges dividends to income tax took precedence over those that charge employment income to income tax.  The Judge disagreed and emphasised that the clear finding of fact by the First Tier Tribunal was that the payments were made because of the employment services provided.  The fact that the income came from that employment relationship was key and trumped the form of the payment.

 Reference was made by Lord Jones to the 1999 case of PA Holdings Ltd versus HMRC.  In that case bonuses were routed through a Jersey company in which participating employees held preference shares.  Again the court had no difficulty in characterising the payments as employment income that derived from the services of the participants as employees.

Increases in rates of tax on dividends to be introduced from April 2016 make it less beneficial to pay dividends rather than salaries under PAYE. But for those still keen to reduce tax this case highlights the dangers of any elaborate schemes that private companies may utilise.

A common device in this context has been the use of alphabet shares with a separate class of share held by each employee.   Often such shares have been issued without proper consideration of whether the shares had any day one value.  An expectation of an income equal to the salary being sacrificed could lead to HMRC attacking the arrangement s a benefit in kind. The net present value of shares with an expectation of a high dividend could be a scary number.   Companies will sometimes forget to file a Form 42 to notify HMRC of the acquisition of the shares or provide guidance to the employee on how to fill in their self-assessment tax form.

 So all in all lots of traps for the unwary…