Essential Guide to Alphabet Shares

Alphabet shares are the different classes of shares issued by a company using different letters to differentiate between them, for example ‘A’, ‘B’ and ‘C’ shares. Allocating these varying share classes allows a company to attach different rights to each class, allowing them to be used for different purposes.

This guide to alphabet shares helps businesses understand what alphabet shares are and how they can be used to enable a company to be run more efficiently.

 

What are alphabet shares?

 

Alphabet shares are different classes of ordinary shares denominated by a letter of the alphabet, such as ‘A’, ‘B’ and ‘C’ shares. Issuing these different share classes allows a company to attach different rights to each class and to use them for differing purposes. They allow a company to separate and distinguish between the class types, which can be very beneficial where particular rights are to be given to certain shareholders and where dividends are to be paid to shareholders at different rates, usually for tax purposes. These share classes should be specified in the company’s Articles of Association, along with the rights attached to each. The Terms of Issue may set out the apportioning of rights and value in the shares.

 

How can alphabet shares be used?

 

The use of alphabet shares is particularly beneficial for a small family company, for employees or in a joint venture as well as any other situation where certain rights are allocated to specific shareholders or differing dividend payments are to be made.

 

Payment of different rates of dividend

Many companies prefer to pay income out to directors and shareholders as dividend payments rather than as a salary because of the tax benefits of doing so. As a result, using alphabet shares allows a company the flexibility to pay dividends to shareholders in the proportions they see fit instead of dividends being paid to all shareholders in proportion to the number of shares they hold, as is the case with ordinary shares. To enable this flexibility, the company’s Articles of Association must be amended, or a clause inserted on incorporation, to allow for the creation and allocation of alphabet shares and to vary the dividend payments between the classes. Therefore, the owner of ‘A’ shares receives dividends at one rate and the owner of ‘B’ shares receives dividends at another rate, and so on. Unless specified, in all other respects, the different classes of alphabet shares are ranked equally.

 

Family companies

In family companies, it is often the case that some members of the family are more involved in the business than others and shares in that company will be issued to the family members accordingly. Flexibility will often be required both in terms of paying income out to family members as well as in terms of the rights in the company those members will have. Issuing alphabet shares again allows flexibility when paying income out as dividend payments rather than salaries and allows the company income to be spread amongst the family in the proportions it wishes, provided that the Articles provide for this. Doing this also improves tax efficiency within the family, by enabling full use of family members’ income tax personal allowances. These shares can also attach other rights to them, such as voting rights, or carry certain restrictions in relation to key company decisions for family members who are not involved in the company on a regular basis. This encourages fairness by acknowledging the participation of those more involved in the running of the company.

 

Joint ventures

Alphabet shares are often used in joint ventures to enable each of the joint owners to keep their rights and representation on the board in the joint venture separate. Company A might be issued A shares in the joint venture, company C, and company B might be issued B shares. Company C’s Articles of Association might make provision allowing for a certain number of directors to be appointed and removed by the owner of the A shares and similarly by the owner of the B shares. They might also make provision for certain company decisions to be made by both parties.

 

Employees

Often companies will offer their employees shares in the company to incentivise them to maximise company profits and remain loyal to the business as well as to offer the employee the chance to receive some of their salary as dividend payments for the tax benefits in doing so. These schemes are a tax efficient way of paying employees. Alphabet shares can again be used in smaller companies to differentiate between the payments made to specific employees and employees of differing levels. Usually, they will be non-voting shares which will be redeemable at par value when the employee leaves the company. These schemes need to be set up with careful consideration and appropriate professional advice to ensure they do not fall foul of HMRC tax payment rules.

 

How to set up alphabet shares

 

A new class of share must be created; this should be set out in the Articles of Association, with any amendments being adopted by special resolution. Once created, the new class of share must be allotted, or existing shares converted to the new class.

Any changes must be approved by the directors and then the shareholders.

All relevant resolutions and statutory forms should be sent to Companies House according to the updated procedures under the Companies Act 2006. The default Articles of Association, the Model Articles or Table A, provide that dividends should be paid in proportion to the number of shares a shareholder owns. Therefore, it is important to ensure these Articles are amended to allow for the use of alphabet shares and the payment of differing rates of dividend.

 

Tax rules on using alphabet shares and the pitfalls to avoid

 

One of the main reasons for using alphabet shares is to take advantage of the tax benefits they provide. Their use allows for differing dividend payments to be made to different shareholders, enabling full use of shareholders’ income tax allowances and to benefit from the varying rates at which they pay tax. For instance, it may be more beneficial to pay a higher dividend to a shareholder who pays no tax or basic rate tax than to a higher rate taxpayer.

As dividends are in effect a return on investment, HMRC often tries to argue that a payment to a shareholder, particularly one who is also a director and runs the company, should in fact be made as a salary payment rather than a dividend, and therefore taxed under PAYE and subject to National Insurance contributions (NICs) which would give rise to a higher payment of tax than dividends which are taxed at 20% with no requirement for NICs. Employee schemes using alphabet shares must be set up carefully to ensure that dividend payments made are not in fact classed as being part of an employee’s salary payment.

It is also important that any payments made are not in breach of the HMRC’s ‘settlements legislation’. The anti-avoidance provisions contained in the Income Tax (Trading and Other Income) Act 2005, cover income from a settlement which is defined widely as including “any disposition, trust, covenant, agreement, arrangement, or transfer of assets”. A settlement situation could arise where a company makes an arrangement to divert income from one shareholder to another for tax efficiency, whether through the use of alphabet shares or by dividend waiver. A settlement situation might also arise where a bounteous arrangement has been made to the detriment of the other shareholders. In this situation, it is preferable to have enough profits available so that dividends could be paid on all share classes to prevent any challenge being brought.

The provisions of the legislation are designed to prevent the diversion of income for tax avoidance purposes and there has been a number of cases brought by the HMRC under this legislation. The provisions apply to married couples as well as where assets and income are split with a minor. They do not apply to unmarried couples or transactions between parents and their adult children. If the rules are applied, any dividend income will be taxed as if it belongs to the original owner, the parent or spouse who gifted the shares. However, provided that alphabet shares are set up correctly, they should not fall foul of the ‘settlements legislation’.

The provisions will not apply in the following circumstances:

 

• Where shares are an outright gift and the following apply:
• When the gift of shares is executed by a deed of gift
• If the shares are sold, the sale proceeds are paid into the recipient spouse’s bank account
• The shares gifted are ordinary shares with voting rights
• All dividends paid on the shares are paid into the spouse’s personal bank account rather than to any joint account
• Where the gift of shares is not wholly a right to income: the shares should not be restricted and should have other benefits, such as voting rights, in addition to a right to income.

 

For Capital Gains Tax purposes, alphabet shares can be transferred between spouses who are living together without incurring a CGT liability under the Taxation of Chargeable Gains Act 1992. The transferee spouse acquires the shares at the original cost to the transferor, at a ‘no gain/no loss’ value. To claim entrepreneurs’ relief on a sale of the business, at least a 5% share in the company is needed.

 

Best practice advice

 

Alphabet shares allow for the fair treatment of all shareholders by differentiating between the value and rights attached to each class of alphabet share. This enables recognition of a shareholder’s dedication to, and participation in, the business. They also allow for better control over a company by attaching full, limited or no voting rights to each share class. Using alphabet shares also allows a company to take advantage of the tax benefits gained by paying shareholders by way of dividends rather than salary.

If alphabet shares are set up correctly and for legitimate reasons rather than for tax evasion purposes, they provide a useful method of structuring a business. To avoid any dispute between shareholders, the Articles of Association and any Terms of Issue and shareholders’ agreement should clearly record the value and rights of each share class and how differential dividends are to be calculated. If no agreement is in place, and a challenge arises, it may be difficult to justify why certain shareholders are being paid more than others. Professional advice should be sought to ensure any alphabet share scheme does not fall foul of HMRC rules and regulations.