Ken Moody considers some of the key practical issues and potential problems for private company owners when considering dividend payments.
The normal reward strategy for director-shareholders of private companies is of course to take a small salary and top up with dividend payments, which saves National Insurance contributions (NICs).
On 11 April 2013, HMRC announced that PA Holdings Ltd (HMRC v PA Holdings Ltd CA [2011] EWCA Civ 1414; [2012] STC 582) had abandoned its appeal to the Supreme Court on the question of whether remuneration paid in the form of dividends (under a complex tax avoidance scheme) was liable to PAYE and NICs. HMRC also announced that there was no change of policy as regards owner-managed businesses as a result of the PA Holdings decision. The status quo in terms of the typical reward strategy holds for now at least. However, it is of course important that dividends are properly declared and paid, as otherwise the tax treatment of the payments may be open to challenge by HMRC.
Distributable reserves:
A dividend may only be paid out of distributable reserves, defined broadly as its accumulated ‘realised profits’ (see ICAEW TR 1/09) by reference to the company’s ‘relevant accounts’, which will usually be the last annual accounts. If those accounts show insufficient reserves (taking into account any dividends already paid in reliance on those accounts), regard must be had to the company’s ‘interim accounts’. For a private company, reliable management accounts will suffice for this purpose. Provided that the last annual accounts show sufficient reserves, taking account of any earlier dividends, there should be no problem. But where dividends are drawn from current profits then unless these are supported by management figures (drawn up by the company’s accountants if necessary), there is a danger that the dividends may be unlawful.
The consequence of the payment of an unlawful dividend is basically that the recipient shareholder(s), or possibly the directors in some circumstances, will be liable to repay it. For tax purposes, if a dividend is unlawful then HMRC will usually regard it as a loan from the company, which will trigger a notional corporation tax liability (under CTA 2010, s 455). An overdrawn directors’ loan account (DLA) will of course also give rise to a benefit-in-kind based upon the ‘official’ rate of interest (4% currently), unless offset by interest payable on the debt.
Interim v final dividends:
The distinction between interim and final dividends is often blurred, but is of some importance. The Articles of most companies provide for a dividend to be declared by the shareholders passing an ordinary resolution. However, the shareholders cannot declare a dividend unilaterally, but only up to the amount recommended by the directors, who must exercise reasonable care, skill and diligence in proposing or making a distribution.
Private companies are no longer required to have an AGM, though a final dividend may also be declared using the ‘written resolution’ procedure. However, most private companies probably do not pay final dividends, in which case all dividend payments will be characterised as interim dividends.
The Articles of most companies authorise the directors to pay (rather than declare) interim dividends by passing a board resolution. A final dividend is legally due on the date it is declared unless a later payment date is specified in the resolution. A directors’ resolution to pay an interim dividend, however, creates no enforceable right for the shareholder. The income tax consequences are that a final dividend is usually taxable by reference to the date the dividend is declared, whereas an interim dividend is taxable when actually paid.
Common practice:
Whilst it is possible for a company to pay monthly dividends if proper procedures are followed, for most private companies this is not practical. It is common practice for director-shareholders of small companies to draw regular amounts on account of dividends, which are then formalised after the company’s year end when the accounts are drawn up.
PAYE regulations apply whenever a payment of PAYE income or on account of PAYE income is made (ITEPA 2003, s 686) and so if amounts are drawn on account of both dividends and remuneration, in the event of a PAYE inspection the question of PAYE/NICs liability may arise. However, HMRC guidance (at EIM42280) recognises that a payment cannot be earnings or on account of earnings if there is an obligation to repay it. It also recognises that:
“Directors very often draw money from the company during the year, which is debited to their loan account and repaid at the end of the year by crediting fees, or a dividend, voted or declared after the end of the year. Until that time, and in the absence of specific evidence to the contrary, the amounts drawn do not actually belong to the director. The in-year drawings are not payments on account of earnings for the purpose of Sections 18(1) and 686(1).”
Usually it will be possible to argue that the drawings are loans or advances, but clearly it would be helpful for the DLA to be written up regularly describing the debits as such. An overdrawn balance on the DLA must of course be cleared within nine months of the year end, or the company will be liable to pay notional corporation tax (under s 455) of 25% of the amount of the balance. The effect of the FA 2013 changes with regard to ‘bed and breakfasting’ loan repayments also require attention and were examined in the May and August 2013 issues of BTI.
When is a dividend ‘paid’?
The question arises as to when a dividend is regarded as having been ‘paid’ for tax purposes. As noted earlier, in the case of a final dividend, the date the dividend is due is certain. As also noted the date an interim dividend is treated as received for income tax purposes is when it is actually ‘paid’. However, private companies will often ‘pay’ dividends by credit to directors’ loan account (DLA). HMRC recognises (at CTM61605) that a loan repayment may be made by credit to a loan account, based upon comments by Vinelott J in Minsham Properties v Price (Ch D 1990, 63 TC 570). However, the reservation is also made that the payment is only regarded as made when the dividend is actually ‘booked’ to the loan account. This poses a problem for many private companies, where the dividend may not be credited to DLA until after the company’s year end, when the annual accounts are prepared.
In Garforth v Newsmith Stainless Ltd ([1979] STC 129), it was held that placing money unreservedly at the disposal of the directors (remuneration in this case) as part of their current accounts with the company was equivalent to payment. Where a dividend is credited to the DLA therefore this may not be regarded as ‘paid’ unless the director is immediately free to draw upon the funds.
Dividend payments – Some ‘do’s and don’ts’
The following are a few general tips for payment of dividends:
- Do not overlook referring to the company’s Articles of Association to find out whether dividends are indeed permitted; who may authorise dividends; and on what basis dividends can be paid.
- Do not overlook ensuring that contemporaneous evidence of payment is available (i.e. minutes of board meeting, dividend resolution and dividend vouchers).
- As far as possible, pay dividends in cash (i.e. by cheque or electronically) rather than credit to DLA to avoid any question of whether or when the dividend was paid. If necessary, the cash may be reintroduced afterwards.
- Dividends may also be paid by a transfer of non-cash assets (i.e. in specie).
- Avoid dividend waivers, as these may fall foul of the income tax ‘settlement’ provisions (and in any event must be signed and delivered before the dividend is due).
Practical Tip:
Do not pay dividends where there are insufficient reserves – as observed earlier, the dividend will in whole or in part be unlawful and therefore legally void. See also the HMRC guidance on ultra vires dividends in its Company Taxation manual at CTM20090 (www.hmrc.gov.uk/manuals/ctmanual/CTM20090.htm) and CTM20095 (www.hmrc.gov.uk/manuals/ctmanual/ctm20095.htm).
