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Dividends are a reward given to shareholders for taking the risk of investing in the company. Payment is not automatic and in the absence of any provision to the contrary, dividends must be paid in proportion to the shares held by each shareholder of each class of share.
A dividend is paid from retained profits made by the company therefore if no profit has been made over an accounting period or there are no undistributed profits brought forward from previous years, generally no dividend can be paid. Even if the bank account is in credit the company needs to have sufficient retained profits to cover the dividend at the date of payment. Any dividend paid in excess of this profit, or out of capital or when losses are made is ‘ultra vires’ and, in effect, ‘illegal’ (termed ‘unlawful dividends’ in the Companies Act 2006). Therefore, technically, every time a payment is made management accounts should be prepared to confirm that there is enough profit to support the payment.
The consequences of a dividend being designated as being ‘illegal’ will depend upon the status of the company. If the company goes into liquidation the liquidator or administrator reviews the past three years accounts and if it is found that a dividend has been paid ‘illegally’ then directors will be expected to personally repay the dividends payments made. If the liquidation is of a family or owner managed company it could be argued that the directors should have known or at least been aware (or had reasonable grounds to believe) that such a payment breached the conditions laid down by the Companies Act 2006 and Insolvency Act 1980. A director can also face liabilities for the breach of duty associated with authorising the payment of an unlawful dividend.
If the company is not in liquidation rather that HMRC are making enquiries into the validity of the dividend if they find that a dividend has been made ‘illegally’ then they will invariably try to reclassify the dividend as either salary or a loan to the shareholder. If reclassified as salary, then they will demand Income Tax and National Insurance payments on the amount each shareholder received. Conversely HMRC could take the stance that rather than being a dividend, the payment was in effect, a loan under s455 CTA 2007, the consequence being that the company would be charged 32.5% of the gross amount paid unless repaid within nine months and one day of the company’s year-end. After the original loan is repaid the s455 charge can be reclaimed but not interest.
If reclassified as a loan, not only does the amount become repayable but either interest will be paid on it by the shareholder, or they may be liable to income tax on the benefit-in-kind received should all loans received in the tax year total in excess of £10,000. The company will also be liable for employers National Insurance contributions. If all loans are less than £10,000 in the tax year, no benefit in kind charges apply.
If the shareholder is not a director in the company, they may only be required to repay an ‘illegal dividend’ if they know or have reasonable grounds for knowing that it was made illegally when the distribution was made.
Having ‘illegal’ dividends showing in the company accounts can make the company look insolvent having negative balances on the balance sheet which could affect the company’s ability to gain credit from a lender or suppliers and may breach current agreements with lenders or supplier.