Corporate Law Update
- Payments to a company’s shareholders made through employee benefit trusts and an interest in possession trust were distributions of profits
- A person who witnesses a party’s signature does not need to sign in that party’s presence
- A few other items
Employee benefit trust payments were actually (unlawful) dividends
The High Court has held that payments made into two employee benefit trusts and an interest in possession trust for the benefit of shareholders were in fact dividends.
In Toone v Ross, a company wished to make remuneration payments to its two directors and a third senior manager in a tax-efficient way. Between them, the two directors held 80% of the company’s shares, and the senior manager held the remaining 20%.
The directors attempted to achieve this by setting up two separate schemes.
The first scheme used employee benefit trusts (EBTs). An EBT is a discretionary trust set up for the benefit of a company’s current and former employees and their relatives and dependants. The trustee of an EBT is required to act independently of the company, although the company will often recommend that the trustee take particular actions in relation to the EBT’s assets.
The company set up an EBT in 2009 and transferred £609,000 into it. It set up a second EBT in 2010 and transferred £1,015,000 into it. Although the trusts were established for the benefit of employees generally, the EBTs’ assets were essentially reserved for the three individuals.
The purpose of the EBTs was to defer indefinitely any liability to pay PAYE or National Insurance Contributions. There was no dispute that the payments to the EBTs were intended to be remuneration. Indeed, this was part and parcel of the scheme.
The second scheme used an interest in possession trust (IIPT), a type of trust under which the beneficiaries have an immediate right to enjoy the trust assets. In this case, the IIPT was used as part of a tax avoidance scheme known popularly as “Aikido” or “dividend replacement strategy”. The ultimate goal was to allow the company to pay dividends tax-free.
Under the scheme, the company created a subsidiary with A shares and B shares (all held by the company). Only B shares carried a right to receive dividends. The company placed the B shares into an IIPT, with the three individuals as beneficiaries. Finally, it contributed capital to the subsidiary.
The subsidiary carried out a capital reduction to convert that capital into profits. It then paid the money back out as a dividend to the company (as the trustee of the IIPT). The company then paid the money to the IIPT’s beneficiaries, namely the three individuals.
In simple terms, the structure of the three schemes was as follows:
The company was placed into insolvent liquidation in 2016. The liquidators argued that the payments through the trusts were actually a mechanism for getting profits or capital from the company back to its shareholders. As such, they said, the payments were distributions by the company.
Under English law, to pay a distribution (such as a dividend) to its shareholders, a company must have “distributable profits” to cover the distribution and follow a strict procedure in the Companies Act 2006. This includes producing accounts that show there are sufficient profits. If the company does not follow this procedure, the dividend will be unlawful and the recipient will usually be required to pay it back.
The liquidators said the company had not followed this procedure and so claimed the payments back.
What did the court say?
The payments were in fact all dividends. They had come from the company’s reserves and were never destined for anyone other than its shareholders. Despite being paid into trusts for employees generally, the money was earmarked for a “specific list of beneficiaries that matched the identity of the shareholders” and paid to those individuals in the proportions in which they held their shares.
The judge also noted that the company’s adviser had warned the directors that the schemes might be seen by Her Majesty’s Revenue & Customs (HMRC) as “effectively a disguised dividend”.
Because the company had not justified the payments by reference to accounts, they were unlawful.
What does this mean for me?
It is worth noting that the court did not rule on the tax treatment of the schemes. The judgment relates purely to whether the payments were dividends as a matter of company law.
But it shows how readily the courts will look at the substance of a scheme to understand what is really going on. In this case, all the facts showed that the schemes were merely an attempt by the shareholders to extract company funds in a way that minimised tax.
The court had some sympathy for the directors. Case law has shown that, when making a payment, the directors’ state of mind can be relevant in deciding whether it is a dividend. Indeed, the court said the two directors here had been honest. However, they had failed to take independent accounting advice, and the only legal “advice” they received was an informal chat from a friendly lawyer. This was not a reasonable basis on which to commit the company to large financial decisions.
Before embarking on any arrangement, but particularly when structuring executive remuneration, the directors of a company should ask themselves the following.
- What is the purpose of the arrangement? Is the main objective to return profits or capital from the company to shareholders? If so, it is more likely to be a disguised distribution.
- Are the payments to be made solely to shareholders? Payments are less likely to amount to dividends if persons other than shareholders (e.g. employees) are receiving them too.
- Do payments under the scheme mimic equity arrangements in the company? If the recipients are to receive payments in the same proportions as their dividend entitlements, the scheme may well have the hallmarks of a disguised distribution.
- Have the directors taken legal advice? Doing so won’t prevent an arrangement from being a distribution, but it may help directors to establish that they acted reasonably and honestly.
- Have the directors taken accounting advice? If the arrangement is treated as a distribution and the procedure followed, the company will need sufficient distributable profits to make the payment.
A witness does not need to sign in the presence of a signatory
The High Court has held that, where a document needs to be countersigned by a witness, the signatory does not need to be physically present when the witness signs.
Wood v Commercial First Business Ltd concerned a mortgage deed. Mrs Wood, a buffalo farmer, applied to borrow money from Commercial First to acquire a second farm. The loan was to be secured by a mortgage on Mrs Wood’s existing farm.
A mortgage over land in England must be executed as a deed. As an individual, under section 1(3) of the Law of Property (Miscellaneous Provisions) Act 1989, Mrs Wood needed to sign it in the presence of a witness, who would then attest the signature by countersigning it.
Mrs Wood signed the deed in the presence of her insurance broker. The broker then signed the deed as a witness, but he did not do so in Mrs Wood’s presence. In other words, in this case, the signatory signed in the presence of her witness, but the witness did not sign in the presence of the signatory.
Mrs Wood claimed this rendered the mortgage deed invalid.
What did the court say?
The court disagreed.
The judge dealt with the point simply and quickly. He said that, although section 1(3) clearly states that the witness must be present when a signatory signs a deed, it does not say anything about the signatory needing to be present when the witness countersigns.
It was therefore perfectly legitimate for the broker to countersign the deed after the event.
What does this mean for me?
This is an interesting decision, but it must be seen in context. Here, the court was not prepared to allow Mrs Wood to avoid the mortgage merely due to what might be described as a technicality.
Previous (now quite old) case law has suggested that a person cannot attest a signature some time after the event merely on the basis that they were present when the signatory signed. Rather, the parties must have intended for that person to act as a witness when they were there. As a result, to avoid questions about whether a person was intended to be a witness, the best approach has been to ensure that a witness countersigns immediately after the signatory signs.
This case helpfully clarifies that, provided the person signing as witness was intended to fulfil that role, they can in theory countersign any time after the event. Although this case related to an individual, the same principle should apply where a company director or LLP member signs before a witness.
Unfortunately the judgment does not elaborate on what it means to be “present”. With the increasing use of electronic signing technology, people are now asking whether a person can witness someone signing a document via a video link, or whether they need to be physically present with the signatory.
The Law Commission’s view (in its recent report on electronic execution) is that a witness must be physically present with a signatory. Until the uncertainty around this is resolved, it is clearly appropriate to ensure that any witness is physically present with the signatory and to avoid “remote witnessing”.
- PSC regime. The Law Society and the City of London Law Society (the CLLS) have published a joint Q&A paper on the UK’s regime for registering an entity’s beneficial owners (the PSC regime). The purpose of the paper is to highlight certain areas of complexity within the regime that are not specifically covered by the legislation or the related Government guidance. Although intended principally for practitioners, it may be of use to organisations carrying out a PSC analysis.
- Capital markets. Institutional Shareholder Services (ISS) has published its updates to its UK proxy voting guidelines for 2020. The key changes relate to board diversity, board composition and director independence, and directors’ pension contributions, bonuses and exit payments. The updates will apply to meetings taking place on or after 1 February 2020. ISS is planning to publish its full amended policy later this month.