With the relative tax efficiency of paying dividends when compared to salary now looking increasingly marginal, long established checks and balances protecting shareholder interests are facing renewed pressure. This exposes shareholders to an often overlooked risk which is rarely appreciated until after the event.
Tax on earnings, tax on profits
Historically, many business owner managers have been able to achieve tax efficiencies by taking a relatively small salary which is then supplemented by dividends. The practice is subject to complex rules on what might or might not be acceptable, many of which were implemented following a series of challenges by HMRC. But in recent years successive budgets have chipped away at the dividend advantage, so much so that owner managers in certain income brackets see little significant difference in take home pay between PAYE salary payments and dividend income.
Points of view vary. On the one hand, higher dividend rates discourage the entrepreneurial spirit which drives the SME sector given that the tax eats into the earnings from genuinely risked capital.But on the other, it is not the place of the tax system to encourage differential treatment of two essentially similar ways of channelling corporate income to those driving the business. Such arguments have their place, but not as far as certain shareholder groups are concerned.
So far so good.In fact, in the case of a business which is entirely owned by those running it, you can stop here. But if you happen to be a shareholder in a company where you are not either an employee or director then this situation greatly exposes you to the risk that your dividends might suffer in the future.
Put simply, for as long as dividends attracted a relatively low tax rate, the sensible approach would have been for enhanced dividend payments and lower employee or director wages. Such an approach is financially beneficial to the directors at the same time as ensuring that passive shareholders are well rewarded to. In fact, everyone benefits. But with the pendulum now swinging back towards indifference, a director might take the decision to enhance wages by cutting back on dividend. After all, it would make relatively small difference to him. Conversely, such action would see a non-active shareholder’s dividend income suffer a significant shortfall without any compensating wage increase.
Need more power
Much will depend in practice on the relative balance of power between the shareholders. If those that are not active hold the lion’s share of the voting power, then they could simply exercise their rights to vote a greater profit distribution.
More importantly, the 2006 Companies Act offers shareholders a significant amount of control over a director’s employment or service contract. Not only must copies be available for inspection, but certain variations to terms require member approval, restricting a director’s ability to act unilaterally.
So the dividend risk is greatest therefore where non active shareholders only own a minority of shares. Specialist advice should be taken in such circumstances to ensure that such minority interests are respected by the directors. It could be that a properly drafted shareholder agreement is put in place which clearly establishes the limits of what changes can be introduced. At the same time, such an agreement could equally protect member interests by establishing a transparent dividend policy for the company to follow.
Likewise, a professionally drafted director service agreement could also establish financial parameters to work with to protect the interests of all parties.
Seek advice and take action
If you are a minority shareholder, or if you require advice about your rights as a shareholder you should make contact with the specialist Pinney Talfourd Corporate department. We are frequently called on to advise in these areas, incorporating specific guidance from our employment and dispute resolution teams as required, in order to resolve such issues or, more importantly, prepare the groundwork to prevent such issues occurring in the future.
This article was written by Edward Garston, Partnerin the Company & Commercial Team at Pinney Talfourd LLP Solicitors. The contents of this article are for the purposes of general awareness only. They do not purport to constitute legal or professional advice. Specific legal advice should be taken on each individual matter. This article is based on the law as of March 2021.