The technical definitions of this can be found at Section 830 of the Companies Act 2006 and reads:
“A company’s profits available for distribution are its accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made.”
Dividends vs Salary
A director of an owner managed business, where they are the sole director and shareholder, may ask why not just keep things simply and just receive a salary?
The popularity of the split between dividends and salary is due to the tax benefits this arrangement achieves:-
- Dividends have their own separate tax free allowance of £5,000
- Tax rates for dividends are lower than tax rates on PAYE income
- Dividends do not attract National Insurance Contributions
As a result, to become more tax efficient, owner managers will often seek to take the tax free threshold as salary and the remainder of their income as dividends.
When can a dividend be paid?
The basic definition of when a dividend can be paid is:
- When the level of profits your company has made exceeds the amounts in the period you have made losses and;
- You have not already paid a dividend from these reserves.
It’s then mandatory to see the proper process is followed to ensure they are not classified as illegal dividends:-
- Prepare annual or interim accounts to justify the dividend
- Hold a board meeting to declare the dividend and complete minutes of the same
- Prepare a dividend voucher for issue to each shareholder
It doesn’t matter whether the company is owner managed or a large plc, only once all of these steps have been taken can a dividend be declared lawfully.
What can make a dividend unlawful?
This is a problem we come across far too often and these are some of the common pitfalls we see directors fall into resulting in illegal dividends. They include:-
- Failure to ensure there are adequate reserves to support their dividend payments
- Failing to take into account future and contingent liabilities in assessing the company’s solvency
- Not preparing interim accounts or attaching management accounts to support interim dividends
- Deficiencies in the paperwork to declare the dividend
- Not paying all shareholders of the same class the same amount
If you’re uncertain before declaring a dividend you should speak to your accountant.
They’ll be able to assess whether a dividend can be paid and assist you with preparing the necessary paperwork. A lack of knowledge into the proper dividend process is not a valid defence if illegal dividends are pursued.
What if the company enters liquidation or administration?
Where the company enters an insolvency procedure, the liquidator or administrator has a duty to investigate the conduct of the directors. It will fall on the office holder to take action where any illegal dividends have been paid.
What are the implications for directors?
The potential implications for directors of allowing unlawful dividends to be paid include:
- HM Revenue and Customs reclassifying the payments as salary
- Breach of fiduciary duty as a director
If HMRC reclassifies the dividend this will increase the PAYE/NIC liability of the company.
In certain circumstances, if HMRC feels they’re unable to recover the tax from the company, they may also pursue the beneficiary of the dividend directly for the tax due.
If the company has entered liquidation or administration, the liquidator or administrator will pursue the directors for the repayment of any illegal dividends.
This is not limited to any unlawful dividends they’ve received as shareholders, but stretches to all distributions they have authorised. As illegal dividends and a breach of fiduciary duty they will be classed as misfeasance, for which the penalty is to reimburse the company for the improper use of funds.
Actions such as unlawful distributions may also result in disqualification proceedings being taken by the Insolvency Service, particularly if this led to the insolvency of the company. This can result in them being prohibited for acting as a director for 2 to 15 years along with a financial penalty.
What are the implications for shareholders?
For an insolvency practitioner to recover illegal distributions they must prove that the recipient was aware that the company did not have sufficient reserves to make the payment.
Where this is assumed for board members, shareholders will not generally have this knowledge ahead of receiving the payment.
For a shareholder to be at risk of having to repay illegal dividends, where they are not a director, the insolvency practitioner would likely need to demonstrate they were a de-facto or shadow director, or at least regularly attended board meetings as an observer.
HMRC however may choose to pursue shareholders directly for the PAYE/NIC that would be due on these payments if they exhaust all other avenues to recover the balance.
The proper declaration of dividends has a rigid process and failing this can cause the insolvency of the company, assuming it is not already insolvent. It can also cause liabilities for directors which will need to be dealt with.
The team at Robson Scott Associates can assist with this, whether you believe someone who owes you money has been paying themselves unlawful dividends or whether you have some of these issues in your own business, no matter what your issues – don’t hesitate to contact us for some free, impartial advice.