The ‘Right’ And ‘Wrong’ Way To Pay Dividends

Jennifer Adams looks at procedures for the payment of dividends in private companies. 

“Just remember, there's a right way and a wrong way to do everything and the wrong way is to keep trying to make everybody else do it the right way.” So said Colonel Potter in the American hit TV show M.A.S.H. This article considers whether Colonel Potter is right with reference to the paying of dividends – is there a ‘right’ or a ‘wrong’ way?

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. 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.

In the search for a ‘right’ or ‘wrong’ way of paying dividends, the starting point is the Companies Act 2006, which states: “a company may only make a distribution out of profits available for the purpose” (s 830). ‘Profits’ in this instance are ”accumulated realised profits less...accumulated”, realised losses’ (CA 2006, s 830(2)). 

Therefore, for a dividend payment to be ‘right’ a company needs to have sufficient ‘distributable profits’ to cover the dividend at the date of payment. This figure is the amount left over after the company has paid its corporation tax. 

Should there be such profits, the total amount of dividend can be varied payment by payment, unlike a salary which must be paid of the same amount on a regular basis. 

‘Wrong’ (termed ‘unlawful’ in the Companies Act 2006 s 847) dividends are broadly payments made in excess of the ‘distributable profit’ or out of capital. 

Profit not returned as dividends is carried forward to the next year, any losses made in following year(s) reducing the ‘distributable profit’ available for payment of subsequent dividends.

 

Tax consequences

Should the dividend subsequently be found to have been issued ‘unlawfully’ then the receiving shareholder will be treated as not having received the dividend. He will be required to repay the dividend if it can be proved that he had reasonable grounds to believe that the payment was ‘unlawful’ (CA 2006, s 847 (3)). The time limit for recovery of dividends from the shareholder is generally six years from the date of declaration or its declared payment date, whichever is later (Limitation Act 1980, s 5).

The dividend will be treated as a distribution and the shareholder will not be required to repay if the shareholder was unaware of the payment’s ‘unlawful’ standing and had no reasonable grounds to believe that the dividend was ‘unlawful’. This stance may be difficult to prove with director/shareholder dividend payments in owner-managed companies. 

HMRC considers that director/shareholders of private companies ought to have been aware (or have reasonable grounds to believe) that the dividend should not have been paid. HMRC will automatically assume that the director/shareholder would normally be treated as holding such funds as ‘constructive trustee’ for the company (see HMRC’s Company Taxation Manual at CTM15205).

HMRC can go further and argue that rather than being a dividend, the payment was incorrectly designated and was, in effect, a loan. They will then charge the company 25% of the gross amount paid. The ‘loan’ must be repaid within nine months of the company’s year end (CTA 2010, s 455), otherwise the full charge stands. Should the payment be repaid in full or in part, the 25% 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. 

Liquidation problem

A significant consequence of an ‘unlawful’ dividend may arise should the company go into liquidation. The liquidator or administrator reviews the conduct of the directors over the three years prior to insolvency as a matter of routine. If it is found that a dividend has been paid ‘unlawfully’ then the directors will be expected to repay the amount withdrawn (CA 2006, s 847). 

HMRC will actively pursue this route, as they are often the largest unsecured creditor of any liquidated company. 

Why the ‘right’ paperwork is needed

Although a dividend may have been correctly paid as per the ‘distributable profits’ rules, there is still the hurdle of ensuring that the dividends are recorded correctly in the company’s books for there to be an enforceable right. 

Directors can authorise payment of interim dividends (CA 2006, Model Article No 30), but final dividends need to be approved by ordinary resolution confirmed by a simple majority of shareholders; this can now be done in writing – no meetings being required.

As no resolution is required for the payment of an interim dividend, the relevant date for such dividends is the actual date of payment. As proof, HMRC consider the date of payment of interim dividends to be the date of entry in the company’s books (CTM 20095 (8)).

A final dividend is treated as being paid on the date that the enforceable debt is created, unless a later date is specified (see Potel v CIR (1970) 46 TC 658, and HMRC’s Savings and Investment manual at SAIM5040).

What is the ‘right’ way to proceed?

Company directors need to be confident that the company has sufficient ‘distributable profits’ to cover any dividend they intend to pay. If the accounts show a trading loss or confirms that the profit was insufficient to support payment, then HMRC will try to argue ‘in the majority of such cases’ that the director/shareholder of a private company will have been aware (or had reasonable grounds to believe) that such a payment designated as dividend was ‘unlawful’ CTM20095 (27 and 29)). 

For owner-managed companies, the issue of whether a dividend has been paid ‘rightly’ or ‘wrongly’ might only come to light when the final accounts are prepared for that period. Only then can it be confirmed whether there had been sufficient ’distributable profits’ available at the time the dividend was paid. 

There is a statutory requirement for full accounts to back up payment of a final dividend (CA 2006, s 836), but there is no such requirement for the preparation of any accounts covering the calculation of an interim dividend by a private company. HMRC’s Company Taxation manual states that for non-final dividends accounts should enable ‘a reasonable judgement to be made as to the amount of the distributable profits. The format of those accounts may necessarily differ from the annual audited accounts submitted as part of the company's return (CTM20095(17)).

Practical Tip :

A draft set of basic accounts (preferably prepared by or checked with the accountant who prepares the final accounts) should be prepared every time the directors intend to pay an interim dividend. This will confirm the financial status of the company, thus proving that there are sufficient ‘distributable’ profits to cover the interim dividend payment. 

Colonel Potter was partly ‘right’ and partly ‘wrong’ – there is a ‘right’ way to pay dividends but he is ‘wrong’ in the second part of his quote as the law requires that ‘everybody...do it the right way’.