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Earnings Are A Reward In Return For A Person’s Services

Overview Of The Difference Between Earnings And Dividends

What Is The Difference Between Earnings And Dividends? A troubling question and sometimes even the finest whisker might struggle to separate the two concepts.

The case of Marlborough DP Ltd v Revenue & Customs (INCOME TAX – whether under the Income Tax (Pensions and Earnings) Act 2003 amounts are taxable) [2021] UKFTT 304 (TC) (“Marlborough”) has recently sprouted and there are some 59 pages devoted to matters surrounding this point.

This was a case whereby payments were made by being routed through a trust tax avoidance scheme (“remuneration trust”) and then onwards onto the company Director through loans.

Notably, the Director appears to have accepted that the whole HMRC tax avoidance scheme was a mechanism to enable monies to be routed to him under documents that he did not understand and which were not consistent with factual realities.

What are earnings for tax?

What Are Earnings?

In Marlborough, the Tribunal referred to earnings as follows:

In summary, sums are taxable as employment income (under s 6 ITEPA) if they are “earnings from an employment in a tax year” (s 10(2) ITEPA) where:

(1) “earnings” are defined as: “(a) any salary, wages or fee”, “(b) any gratuity or other profit or incidental benefit of any kind obtained by the employee if it is 20 money or money’s worth” (meaning something that is (i) of direct monetary value to the employee, or (ii) capable of being converted into money or something of direct monetary value to the employee (under s 62(3) ITEPA), or “(c) anything else that constitutes an emolument of the employment” (under s 62(2) ITEPA);

(2) an “employment” includes any employment under a contract of service (under s 4 ITEPA); and

(3) the provisions in ITEPA that are expressed to apply to “employments” apply equally to “offices” (such as the office of director), unless otherwise indicated and in those provisions, as they apply to an “office”, references to being “employed” are to being “the holder of the office”, “employee” means the “office holder”, and “employer” means “the person under whom the office-holder holds office” (s 5 ITEPA).

Section 6(1) Of The Income Tax (Earnings and Pensions) Act 2003

The charge to tax on employment income under this Part is a charge to tax on—

(a)general earnings, and

(b)specific employment income.

The meaning of “employment income”, “general earnings” and “specific employment income” is given in section 7.

Section 10(2) Of The Income Tax (Earnings and Pensions) Act 2003

“Taxable earnings from an employment in a tax year are to be determined in accordance with Chapters 4 and 5 of this Part.

What Are Dividends?

For tax purposes the Tax Tribunal said dividends were:

Sections 383 and 384 of the Income Tax (Trading and Other Income) Act 2005 (“ITTOIA”) impose a charge to income tax on “dividends and other distributions of a UK resident company” by reference to amount or value of the dividends paid and other distributions made in the tax year. The term “distribution” has the meaning given by Chapters 2 to 5 of Part 23 of the Corporation Tax Act 2010 (“CTA 2010”) (excluding s 1027A). The relevant provisions for present purposes are in s 1000 CTA 2010 which provides as follows:
“1000 Meaning of “distribution”
(1) In the Corporation Tax Acts “distribution”, in relation to any company, means anything falling within any of the following paragraphs. Any dividend paid by the company, including a capital dividend. Any other distribution out of assets of the company in respect of shares in the company, except however much (if any) of the distribution—
(a) represents repayment of capital on the shares, or
(b) is (when it is made) equal in amount or value to any new consideration
received by the company for the distribution.
For the purposes of this paragraph it does not matter whether the distribution
is in cash or not……… (Emphasis added.)

Section 1000 of the Corporation Tax Act 2010

(1) In the Corporation Tax Acts “distribution”, in relation to any company, means anything falling within any of the following paragraphs.

Any dividend paid by the company, including a capital dividend.

Any other distribution out of assets of the company in respect of shares in the company, except however much (if any) of the distribution—

(a) represents repayment of capital on the shares, or

(b) is (when it is made) equal in amount or value to any new consideration received by the company for the distribution.

For the purposes of this paragraph it does not matter whether the distribution is in cash or not.

Any redeemable share capital issued by the company—

(a) in respect of shares in, or securities of, the company, and

(b) otherwise than for new consideration (see sections 1003 and 1115).

Any security issued by the company—

(a) in respect of shares in, or securities of, the company, and

(b) otherwise than for new consideration (see sections 1004 and 1115).

Any interest or other distribution out of assets of the company in respect of securities of the company which are non-commercial securities (as defined in section 1005), except—

(a) however much (if any) of the distribution represents the principal secured by the securities, and

(b) however much (if any) of the distribution represents a reasonable commercial return for the use of the principal.

Any interest or other distribution out of assets of the company in respect of securities of the company which are special securities (as defined in section 1015), except—

(a) however much (if any) of the distribution represents the principal secured by the securities, and

(b) however much (if any) of the distribution falls within paragraph E.

Any amount treated as a distribution by section 1020 (transfers of assets or liabilities).

Any amount treated as a distribution by section 1022 (bonus issues following repayment of share capital).

(2) In the Corporation Tax Acts “distribution”, in relation to a close company, also includes anything treated as a distribution by section 1064 (certain expenses of close companies treated as distributions).

(3) See also section 1072 (which extends the meaning of “distribution” in relation to members of a 90% group).

Why Are Earnings And Dividends A Difficult Issue?

The reason that earnings and dividends are so much trouble is that there are tax consequences that affect them.

If funds paid to a Director are categorised as earnings then they will be deductible for corporation tax purposes and such payments will be subject to National Insurance Contributions (“NIC”) payable by not only the employee but also the employer. However, if such payments are classed as dividends then there will be no NIC but corporation tax will be payable before a dividend can be declared without any deduction.

Were They Earnings Or Dividends In Marlborough?

The Tax Tribunal decided in Marlborough that the payments in question were not earnings.

The Tribunal set out the broad purpose principle to assess if payments would be considered to be earnings as follows:

… it is plain from the caselaw that sums constitute earnings if they are paid as remuneration or a reward in return for a person’s services as an employee. The courts have consistently recognised that, given the test is centred on why or in return for what a payment is made, establishing the purpose of an employer in making a payment is key to assessing, as it was put in PA Holdings, its character in the hands of the recipient “looking at its substance and not its form”. As summarised in Kuehne the courts have also recognised that this may be a difficult finely balanced exercise where there is more than one reason for a payment. As it was put at [52] of that case, a tribunal or court needs to be satisfied that the payment is from employment rather than from a nonemployment source. That involves evaluating the reasons and background to the payment and applying a judgment as to whether the payment was from the employment rather than from something else. Whilst employment “does not have to be the sole cause” of the payment “it does have to be sufficiently substantial as to characterise the payment as one from employment” (see [56] of Kuehne).

The Tribunal then gave four reasons why in Marlborough it considered the relevant payments were not in the nature of earnings:

(1) There was no contractual obligation on MDPL to pay the sums as a reward for Dr Thomas’ services as director/dentist and there is nothing in any of the documents or evidence to suggest that that was the reason for the extraction of MDPL’s funds into Dr Thomas’ hands.

(2) The sums paid to Dr Thomas comprised the totality of the overall profits of MDPL’s business, as computed after the deduction of expenses, such as salaries paid to those employed by MDPL including the relatively small salary paid to Dr Thomas and, accordingly they were paid out sporadically.

(3) Dr Thomas’ evidence was that, had those profits not been routed through the RT arrangements, they would have been paid to him by way of dividend and not as salary. It lends support to the credibility of Dr Thomas’s evidence in this respect that:

(a) As Mr Firth noted, it is a well-known common practice for a sole owner and director of a company to organise matters such that the relevant company pays him or her a low salary and much more substantial dividend payments (and see the comment in [130] below).

(b) That is how Dr Thomas extracts profits from the company he now operates through now he no longer uses the RT arrangements and, as noted, MDPL paid him a small salary during the periods in question.

(4) For the reasons set out in full below, we do not accept HMRC’s view that Dr Thomas’ evidence is not relevant. In short, (a) his evidence, as the controlling mind of MDPL, indicates that its purpose, in putting in place steps to extract the funds into the hands of Dr Thomas, was to provide him with a return on his investment in it as shareholder in the same way as if it had formally declared and paid a dividend, and (b) it does not detract from this that Dr Thomas and MDPL did not consider that MDPL was making a dividend or check that in making the relevant contributions MDPL was not making an unlawful distribution for company law purposes.

The Tribunal whilst noting that the remuneration trust position appeared irregular, suggested that such a position in itself did not render the payments were emoluments or dividends.

The Tribunal was unpersuaded by HMRC’s argument, that the strict and mandatory character of dividend procedures means that the relevant payments could not have been a distribution. The Tribunal said that substance wins over form and the caselaw supports such an approach.

Observation On Tribunal Reasoning

It was interesting the Tax Tribunal took into account not only the position when the Director said that had a remuneration trust arrangement not existed he would have extracted the relevant funds as dividends, not as salary. Further, it also took account in its reasoning how the Director currently operated since no longer using remuneration trust arrangements.

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Elliot Green

Licensed Insolvency Practitioner & Chartered Accountant. We Know Insolvency Inside Out.