For several years until 2005, some companies used an arrangement for paying bonuses which involved employees receiving a particular type of share in a UK tax resident company (often specially created for this purpose). Those shares then paid out a dividend shortly after employees received them. Following payment of the dividend, the shares then effectively ceased to have any value at all: i.e. they were just created to pay the dividend.

The supposed tax efficiency of this scheme sprung from the intricacies of the tax system. It was believed that particular provisions in the tax code meant that employees were not taxable on receiving this particular form of share; dividends could not be recharacterised as bonuses and so would suffer tax at a more favourable rate than employment income; and finally that dividends would also escape National Insurance contributions (NICs).

In recent years, much of the optimism in that tax planning has been shown to be ill-founded. The Courts have in several cases supported the Revenue and have eroded these supposed tax advantages. In 2005 the Government changed the legislation so that these schemes are expressly not effective.

The most recent judgement is in a case which had already at a lower tier of the judicial process been authority for the dividends being subject to NICs. The Court of Appeal has held that the fact that tax legislation included a specific provision saying that dividends could only be taxed as dividends still did not prevent these types of dividends being taxable as bonuses. This means that they did not have the benefit of a tax credit and were subject to deduction of tax under PAYE at the employee's full marginal rate. In any event, even if this particular piece of legislation had been relevant, the Court of Appeal said that it would under the Ramsay doctrine (which looks through form and taxes on the basis of substance) have held that these dividends should be taxable as bonuses.

Companies still defending these schemes will be discouraged by this result. It is not clear whether there will be a further appeal. Some of the reasons given by the Court of Appeal are surprising both in the context of these schemes and more generally. While many companies at the time of implementation were advised to put in place retention and/or indemnity arrangements with their employees in case of this eventuality, with the passage of time, recovering these amounts could now be difficult.

To read the Court of Appeal decision, please click here.

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The original publication date for this article was 05/12/11.