Have you taken an 'illegal dividend'?
Newsletter issue - September 2022
Anyone who invests in a company is taking a chance, hoping that the money will not be wasted, and that the directors, as representatives of the company, will use the money in such a way that the company's profit increases. In return for taking this chance, a shareholder receives 'payback' usually in the form of a share in the distribution of profits via a dividend. The payment is not an absolute right and unfortunately some directors/shareholders of family owned companies believe that as long as there is cash in the bank then they can take the balance as a dividend.
However, this is not necessarily the case as a provision in the Companies Act 2006 states that a dividend can only be paid under set conditions. The rules state that "a company may only make a distribution out of profits available for the purpose". 'Profits' in this instance are 'accumulated realised profits less ....accumulated, realised losses'. This figure is the amount of profit made since the company was created, less any dividends already paid out by way of distribution/dividend, (or capitalised in some way), less accumulated losses not written off.
'Illegal dividends' are therefore dividends paid in excess of this resulting amount or made out of capital or where there are losses that exceed the accumulated profits. The best way to confirm that sufficient 'distributable profits' are available to cover any dividend is to prepare a draft set of basic accounts every time the directors intend to make an interim dividend. There is a statutory requirement for full accounts be prepared to back up payment of a final dividend.
HMRC's stance
If the balance sheet shows the figure designated as 'reserves' as a negative figure at the end of a relevant period or where the opening balance next year is in deficit but dividends have been paid then HMRC may raise enquiries. On investigation if it is found that 'illegal dividends' have been paid then HMRC can require the dividend to be repaid. They could go further and argue that rather than being a dividend, the payment was incorrectly designated and was, in effect, a loan or payment of salary. In such a case, unless the 'loan' is repaid within nine months and one day of the company's year end, the company will be charged 33.75% of the gross amount paid. However, should the payment be repaid in full or in part, the tax charge is fully or proportionally repayable nine months and one day after the end of the accounting period in which the repayment is made.
It is not only the company that could be affected in this situation. HMRC could argue that the repayable amount is an interest-free loan and if that loan is more than £10,000 remaining unpaid at the end of the accounting period, then a benefit in kind charge could be levied on the director. Class 1A NIC will also be charged to the employer.
Questions surrounding the legality of a dividend are more likely to arise should a company go into liquidation. As part of the liquidator or administrator's routine it is standard practice to review the conduct of directors over the three years before insolvency. Depending on the situation the liquidator may argue that the director of a family owned company should have known or been aware of or at least had reasonable grounds to believe that such a payment breached the conditions and require the director to repay the amount withdrawn. In a liquidation HMRC is invariably the largest and preferential creditor and will try to pursue repayment if it is financially worthwhile.
Practical point
Whenever it is intended to declare a dividend a draft set of accounts should be prepared, to make sure that the rules are being followed.