What are alphabet shares and how are they used?

What are alphabet shares?

Alphabet shares provide businesses with an alternative way of raising equity finance as their company begins to expand and more shareholders join the company. A company that is limited by shares will have been set up with a nominal number of ordinary shares in issue.

Alphabet shares allow the business to effectively assign their shareholders with shares in different classes, and these separate share classes are identifiable by a specific letter (hence the term ‘Alphabet Shares’). For example, this could mean that the company has categories of shares such as “A” Ordinary shares”, “B” Ordinary Shares” and so on.

The use of alphabet shares could help a business to pay shareholders different amounts of dividends depending on what class of share they own. Alternatively, alphabet shares are used in companies owned by families or in joint ventures so as to give certain shareholders power to make important decisions (for example to appoint a director).

Something important to note here is that if your company’s articles of association do not identify what rights are attached to each different class of share then they will rank pari passu with one another – meaning they all rank equally.

This often leads to director shareholders being unhappy that they have to pay dividends on a pro rata basis to all shareholders, even though one or more shareholders (who are not meant to be passive investors) have not contributed much to the company during the relevant accounting period. Therefore the alphabet share arrangement allows for the board to distribute dividends otherwise than on an equal pro rata basis between shareholders – the board can decide to apportion any dividend in whatever way the board decides between A, B, C, D etc class shareholders on each occasion (even if one or more alphabet class may not receive any of the dividend).

To avoid this, ensure that your company’s articles of association are amended via a special resolution of the shareholders so that the rights attaching to each different class of share is added. Once this has been done, one rate of dividend can be paid to the shareholder(s) owning “A” Ordinary Shares” and a different rate can be paid to the shareholder(s) owning “B” Ordinary Shares”.

Such an amendment to your company’s articles is essential in order to circumvent the ‘model article’ and ‘Table A’ provisions that demand dividends be paid in proportion to the number of shares held. Unless otherwise stated in the articles of association, in relation to all other rights such as voting and rights to capital on a winding up, the different classes of shares will usually rank equally.

How do you set up alphabet shares?

Typically, the process involves:

• The company creating a new class of shares (or classes of shares);
• Setting these new classes of shares out in the company’s Articles of Association;
• Ensuring that these new articles detailing the new share classes are adopted by special resolution (this can be a written resolution);
• The company deciding (once the new share classes have been created) to either allot new shares of the classes concerned or have existing shares converted to the new classes;
• Both directors and shareholders considering and approving the changes to the company’s articles; and
• Sending notices of the statutory forms and resolutions to Companies House.

If allotting new shares, the procedure laid out in the Companies Act 2006 should be followed. This means that a board meeting should be held to approve the decision to allot new shares, and minutes of that meeting must be kept. What then follows are events such as the issuing of share certificates, completing a return of allotment on Companies House Form SH01 and updating the company’s statutory books (i.e. the register of members and register of allotments).

You can download at our shop a set of new articles that includes an alphabet share class arrangement that can easily be adopted, as well as board minutes and shareholder resolutions to adopt the new articles.

A more in-depth procedural analysis is set out below:

Step 1 – Directors hold first board meeting

• Here the directors will decide to create the new share class or reclassify existing shares.

Step 2 – Directors send out notice of General Meeting (‘GM’)

• Directors must pass a resolution at a board meeting to call a GM and must give all shareholders notice of the general meeting. If they do not do this any business conducted at that meeting will be invalid.
• Such notice must be given at least 14 ‘clear’ days before the meeting is to take place (unless the short notice procedure has been complied with).
• Alternatively, instead of calling a GM the shareholder resolutions could be more simply passed by the company distributing written shareholder resolutions (with instructions and a circular) to all shareholders

Step 3 – Obtain shareholder resolution

• An ordinary resolution will be required if there is to be any alteration to the company’s share capital.
• A special resolution will be required where the company has had to amend its articles of association in order to create the new share class(es).
• The Companies Act 2006 requires shareholder resolutions to be filed within 15 days from the date of passing the resolution.

Step 4 – Directors either reconvene first board meeting or hold second board meeting

• This meeting should record the final action taken by the company for example if share capital has been used or if any allotment/transfer of shares has taken place.

Step 5 – Complete and send off Companies House forms

• What forms will be involved will depend on the nature of the transaction that has taken place.
• For example, if new shares have been allotted then Companies House Form SH01 would be used or Form SH02 if shares have been consolidated or sub-divided.
• Forms SH08 and SH10 may be used as well during the process.

The risks involved in implementing an alphabet share scheme 

An alphabet share scheme can involve employees being offered shares in the company that employs them so they are paid a portion of their remuneration by way of a dividend. Such a scheme is tax efficient and can help incentivise a workforce to improve a company’s profitability.

The way that such schemes are normally implemented is by offering the shares to employees and making them redeemable at par / nominal value so as to make sure they can be easily recovered from the employee once their employment with the company ceases.

One of the risks involved with implementing an alphabet share scheme is the way HMRC views such arrangements and how closely they look at such schemes. HMRC are keen to look at the substance of such schemes so as to assess whether they are set up for legitimate reasons or simply set up for the purpose of avoiding tax such as PAYE and National Insurance contributions (‘NIC’). With that being said, HMRC have said that they will not launch attacks on alphabet share structures so long as there is no contrived arrangement to avoid tax or NIC.

The reason why HMRC has such concerns is because of the appealing nature of dividends when compared with other forms of remuneration. When it comes to tax, individuals do not pay NIC on dividends, whereas they do have to pay such tax on their salary income.

Alphabet share schemes came under scrutiny following the PA Holdings case (Revenue and Customs Commissioners v. PA Holdings Ltd) where HMRC ended up winning their case against that company.

The case involved the company paying bonuses to their employees by offering them shares and paying them dividends on those shares. PA Holdings contended that this income received by employees was not employment income and therefore not liable to NIC.

HMRC disagreed and argued that the dividends in actuality were simply bonuses and were therefore liable to NIC. The Civil Division of the Court of Appeal agreed with HMRC which has led to speculation in various forums as to whether this decision could signify the beginning of the end for alphabet share schemes.

It remains to be seen how wide-reaching this decision will be, however, as this case involved a highly contrived scheme that was set up purely for tax avoidance purposes. It is now just a matter of time to see whether HMRC will be looking to extend the outreach of the principle established in the PA Holdings case beyond the facts that were then involved.

Additionally, s.447 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003) states that where an “associated person” (i.e. an employee of a company) receives a benefit (i.e. a dividend) by virtue of the ownership of employment-related securities, then the taxable amount counts as employment income of the employee for the relevant tax year. This provision is therefore always something to consider when thinking of implementing an alphabet share scheme.

Given the risks we often see companies decide to implement an EMI share option scheme first and then once the EMI share options are exercised the company will issue new shares that are alphabet shares (often having full rights to capital, but dividends at the discretion of the board).

Before launching such a scheme, it would therefore be prudent to seek professional advice so as to be sure that the scheme will not be breaching any tax or other regulatory laws.

This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited 2023.