IT Contractors - Profit extraction by dividend payment

Are dividends still a safe method of profit extraction for service companies?

The recent high profile case over whether HMRC can charge PAYE and NI to dividends in the same way as salary, has collapsed after the company involved conceded defeat. What does this mean for you and your company?

The dispute between HMRC and a major firm of consultants, PA Holdings Ltd (PA), recently took a surprise turn when the company threw in the towel. The scheme was devised so that PAYE tax and NI could be avoided on bonuses PA paid to its employees. A special class of share was created which the employees bought for a nominal price. Large dividends were then paid on these. HMRC challenged the scheme leading to speculation that this was a prelude to an attack on directors of owner-managed companies who also take most of their income as dividends.

Split personality payments

The dispute was first considered by the lower tribunal which agreed with HMRC in part. It ruled that the dividends were really a disguised bonus, which of course they were. On the other hand, the tribunal thought it not possible to ignore that legally the payments remained dividends. In this situation the law is clear; to avoid a double charge on income that can be taxed both as dividends and earnings, dividend tax takes preference, but the position for NI is different.

NI on dividends

As a result of this difference, the tribunal ruled that both employers’ and employees’ NI was due on the dividends. Neither HMRC nor PA were happy with the judgment and so the dispute moved to the Upper Tribunal. Since it came to more or less the same conclusion, the argument moved to the Court of Appeal. This was disastrous for PA. The court overturned the tribunal’s decision and ruled that the dividends counted as earnings from employment, i.e. like a salary, and should be subject to both tax and NI accordingly.

Naturally, PA decided to launch another appeal, this time to the Supreme Court, but last month it abandoned this and accepted defeat. This immediately reignited fears of an HMRC assault on director/shareholders who take their income mainly by dividends.

So does this affect you and your company?

No it does not – there’s a world of difference between a scheme contrived to turn employees into special shareholders solely to avoid tax on a bonus and owner-managers extracting profit by way of a dividend. Thankfully HMRC seem to be taking the same approach. It told the Institute of Chartered Accountants’ head tax expert that it won’t be changing its policy as a result of winning its dispute with PA.

A small salary plus large dividend strategy is still a safe tax and NI-saving arrangement for company owner-managers, so there’s no need to change this as a result of the PA case.

Always have the proper paperwork in place for dividend payments. This will ensure HMRC can’t successfully argue that you’ve disguised a payment of salary or a bonus as a dividend merely to avoid tax or NI.
HMRC has confirmed this case makes no difference to its policy on owner-managers of companies who take their income mainly as dividends. No tax or NI is payable on these. You must however keep the proper paperwork to back up a dividend payment to stop HMRC arguing that it’s really disguised salary.