On the face of it, directors are free to vote on their remuneration as the board sees fit. However, directors should be aware that HMRC may challenge excessive salaries and benefits-in-kind on the basis that they are not ‘wholly and exclusively’ paid for the purposes of the trade.
Open to Challenge?
HMRC is less likely to challenge the remuneration of a sole director ‘…where the controlling director is also the person whose work generates the company’s income then the level of the remuneration package is a commercial decision and it is unlikely that there will be a non-trade purpose for the level of the remuneration package’ (see HMRC’s Business Income Manual at BIM47106).
Where a challenge is more likely is where payment is made to other directors (or an employee who is a close relative or friend of the controlling director, including a minor child) under the ‘settlements’ anti-avoidance legislation (ITTOIA 2005, s 619 et seq.), taxing the remuneration as if it were that of the controlling director. Paying wages to a spouse or close relative is acceptable if undertaken correctly with payments being fair, for real work, and being well-documented.
In addition, if a director is remunerated far above what would be considered usual for their role in a similar company (e.g., the work performed does not justify the high level of remuneration) or appears disproportionate to the financial position of the company, this can indicate the existence of a non-trade purpose and may be deemed excessive. HMRC is particularly vigilant if a director’s salary appears disproportionate to the company’s earnings or if there is no corresponding increase in the company’s profitability, especially where the company is loss-making or has very low profits. If a company is not profitable, excessive remuneration could be seen as a method to extract money from the company as part of a scheme to avoid taxes by reducing the company’s taxable profits artificially or avoiding higher rates of tax and NICs.
HMRC can also look at previous years’ declared remuneration and compare year on year, as in Earlspring Properties Ltd v Guest (1995), 67 TC 259. In that case, remuneration paid to the company director’s wife was increased from £1,000 before their marriage to sums varying between £21,359 and £38,777. The company also paid £20,000 or £21,000, respectively as an annual contribution to a pension fund. Paying higher remuneration enabled the large premiums to be paid. The court held that the payments were not ‘wholly and exclusively’ for the company’s trade but represented a diversion of income for fiscal advantage.
Tax Implications
If HMRC consider that excessive remuneration has been paid, they can potentially charge the employee to PAYE tax and NICs and the employer to secondary NICs but refuse corporation tax relief on the payment against business profit. Generally, the ‘excess’ is disallowed, with any justifiable amount being deductible.
Where the payment is deemed excessive and the recipient is also a shareholder, HMRC may treat the payment as a distribution of profits – effectively as a dividend, taxed at dividend rates.
Directors should be aware that payment of excessive remuneration to directors can amount to unfairly prejudicial conduct towards other shareholders. Such a legal challenge by those shareholders is more likely where profits are available for distribution, but are taken by the directors for themselves.
Practical Tip
Proper documentation and justification for director remuneration are essential. If the company can provide evidence that the remuneration is reasonable and in line with its financial position, industry standards, and the director’s duties, it may be more likely to withstand scrutiny from HMRC.