Reclassification Of Dividends As Salary Does Not Work – HMRC Finds Out

The case of Jones v Revenue & Customs [2014] UKFTT 1082 (TC) is a case of HMRC seeking to recover PAYE and NIC from Mr and Mrs Jones after reclassification of dividends as salary.

Another case that has some of the facets of Bass & Ors v Buchanan [2021] EWHC 2740 (Ch) as referred in our post Can You Backdate Your Salary?. It appears to show the potentially hopeless position of seeking to recreate history.

Mr and Mrs Jones were directors of Perfect Change Limited (“the Company”) which went into creditors voluntary liquidation on 20 February 2009.

It appears there was some concern the liquidator would treat some of the dividends as unlawful.

How The Attempt At Reclassification Of Dividends Arose

The Company often paid monies to the directors by way of dividends.

The annual accounts for year ended 31 March 2007 showed directors’ salaries of £10,800 and dividends of £139,000. The first set of draft accounts for year ended 31 March 2008 which had been produced by 9 May 2008 showed directors’ salaries of £10,800 and an interim dividend of £138,100.

In the latter half of 2008, the dividends were reduced by 50%. 

Draft accounts for the year ended 31 March 2008 (undated and unsigned) were presented to creditors at a meeting held on 20 February 2009 which had dividends of £45,000 and directors’s salaries and national insurance of £213,178.

According to the Tax Tribunal, the accountants told the liquidator there was a mis-posting in Sage and should have been allocated to wages. The liquidator it seems was not convinced about that proposition on the basis of the evidence provided.

Mr Jones’ tax return for 2008-09 had no dividends and a salary of £226,010, being consistent with the reclassification. Mrs Jones adopted a similar position with no dividends and a salary of £133,276.

Looking at the evidence (see below the detail) set out by the Tribunal, it might seem surprising HMRC fought this case. However, what it does highlight is if you are going to attempt to vary the substance of transactions after the event, then you could place yourself at some conceivable risk (perhaps not unreasonably) of having that position tested at a tribunal.

The Judgment highlight is as follows:

There was no evidence that the reclassification in January 2009 was reflected in the Company’s accounting records. In our view the reclassification amounted to nothing more than a flawed analysis of the transactions which had taken place.

Judgment That Reclassification Does Not Work

The Tax Tribunal had this to say:

We accept that Mr Jones was advised by Clark Nicklin to include these figures on his tax return. He was certainly ill-advised to do so but we do not consider that he was deliberately seeking to deceive HMRC.

… 

Mr and Mrs Jones were fully aware that PAYE and national insurance had not been operated in relation to the dividend payments. They genuinely believed at the time of the payments that they were dividends and it was not necessary to deduct and pay tax and national insurance at the time the payments were made.

…

The obligation to deduct PAYE and pay national insurance arises at the time the earnings are paid to the employee. In the present appeal HMRC accept that the payments were dividends when originally paid. There was therefore no obligation to deduct PAYE and pay national insurance at the time those payments were made to Mr and Mrs Jones.

…

The hearing bundle included an analysis by Clark Nicklin of the directors’ loan account apparently produced by them in January 2011. It showed an overdrawn balance of £40,599 as per the statutory accounts for the year ended 31 March 2007 and an overdrawn balance carried forward as at 31 December 2008 of £12,105. We did not have all the accompanying explanatory schedules. The basis of the analysis was far from clear and we are not satisfied that it is correct. For example it included entries for the Company’s profit before tax and did not identify why such an entry should have appeared in the loan account. It also included “additional injections” which appear to be payments made by Mr and Mrs Jones in relation to personal guarantees after the Company went into liquidation.

Rather than clearing overdrawn loan accounts, it seems to us that Clark Nicklin were intending to prevent a liquidator from recovering what might be seen as unlawful dividends. The payments however had clearly been made as dividends. It was only if they were unlawful that they might properly have been repayable – either because they were to be treated as loans to the directors or because the directors were liable to account for them to the company. Mr and Mrs Jones did not address their minds in 2009 to whether there was a risk that the dividends might be repayable.

…

It seems to us that the reclassification which occurred in the present case did not truly reflect the nature of the payments at the time they were made. The directors cannot retrospectively alter the nature of the payments simply by deciding to treat them differently. The payments were clearly made as interim dividends and taxable as such rather than as salary. Mr Boyle did not suggest otherwise, at least having regard to the position at the time of payment.

On the basis that the dividends were lawfully paid, tthe so-called reclassification in January 2009 would have no effect. Mr and Mrs Jones would have had no liability to the Company. They could not transform what had previously been received as dividends into salary unless there had been some error or misunderstanding at the time of payment.

…

There was no evidence that the reclassification in January 2009 was reflected in the Company’s accounting records. In our view the reclassification amounted to nothing more than a flawed analysis of the transactions which had taken place. As such the reclassification did not give rise to any employment income or earnings in the hands of Mr and Mrs Jones at the time of the reclassification.

…

On the facts as we have found them we do not consider that there was any obligation on the Company to deduct PAYE or to pay national insurance, either at the time of payment or at the time of reclassification. We therefore allow the appeal, set aside the direction notice and set aside the decision to make Mr and Mrs Jones liable for national insurance contributions.