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This article will look at ‘illegal dividends’ (perhaps more clinically, ‘unlawful distributions’) and the tax implications that flow therefrom. The focus is on owner-managed businesses and family companies – normally ‘close’ companies within CTA 2010, Pt 10 (s 438 et seq.).
It is important to note that HMRC in general is by no means the arbiter or authority on what constitutes an illegal dividend. It is a matter of company law, and more the preserve of lawyers and insolvency experts. Having said that, a company should (in theory at least) never pay an illegal dividend and, by implication, it is something with which all directors should be familiar.
Why are illegal dividends relevant?
The two main reasons why unlawful distributions are at risk of becoming more commonplace (or at least more commonly identified) will be down to the acute financial shock attributable to Covid-19 and changing consumption patterns as a result.
We do not yet know what the long-term trends will be, but: there will be large losses, and there will be insolvencies.
Where an insolvency practitioner is appointed to deal with a company in distress, its recent dividend history will often be scrutinised to see if there are any irregularities that may have put creditors’ interests at risk.
To determine if a distribution has been made unlawfully, the first place to start is Companies Act 2006, which sets out how distributions might be made lawfully.
What makes a ‘legal’ dividend?
A distribution can be made only out of profits available for the purpose, the basic definition being 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 (CA 2006, s 830). There are further restrictions imposed on public and investment companies.
To determine the quantum of distributable profits available at the point of making a dividend, one must refer to the ‘relevant accounts’, being:
- The last statutory accounts or, where they indicate that accumulated profits are insufficient
Suitable interim accounts may be prepared (there are similar provisions to cover where a company is too ‘young’ to have prepared statutory annual accounts, etc.) (CA 2006, ss 836–840).
These are the basic provisions. However, the Companies Act also states that regard must be had both to common law and the company’s own Articles of Association, to include the so-called ‘capital maintenance rule’, which requires a director to ensure that a dividend will not erode the company’s capital at the point of proposal and, if later, on payment. Where a dividend has not been made in line with the foregoing, it will be unlawful.
Consequences of an ‘illegal’ distribution
Where a shareholder knows or has reasonable grounds for believing that the distribution (or part of it) has been made unlawfully, the shareholder is liable to repay it (or the ‘unlawful part’). This extends to having to pay an amount of cash equivalent to a distribution made in specie. (CA 2006, s 847).
Furthermore, a director can be held personally liable for any breach of his or her fiduciary duty to the company and can be required to restore the funds to the company (IA 1986, s 212 et seq.).
These are the reasons why insolvency practitioners will review a company’s dividend history (amongst other things) to determine if a claim should be made against shareholders and/or directors. Such claims would not be limited only to unlawful distributions, but that is what this article and HMRC will focus on. In particular, HMRC’s course of action will be decided independently of any claims by an insolvency practitioner.
Tax treatment of ‘illegal’ dividends
HMRC treats a dividend it perceives to be illegal as being repayable to the company, in line with company law. While case law treats the liability to repay as the shareholder’s holding the funds ‘on constructive trust for the company’, HMRC considers this equivalent to a loan and, for a ‘close’ company, a loan to a participator (within CTA 2010, s 455).
As noted above, company law requires repayment only where the shareholder knows, or should have known, that the dividend exceeded available distributable reserves at the time it was made. However, HMRC argues that ‘when dealing with private companies controlled by directors who are shareholders, such a [shareholder] ought to know the status of the dividend and it is expected that section CA 2006, s 847 will apply in the majority of such cases’ (see HMRC’s Company Taxation manual at CTM15205).
Note that the legislation applies where the company makes a loan or advances money to a participator (shareholder) in the company. When it comes to illegal dividends, HMRC will look at such ‘loans’ separately, ignoring any credit balance the company might otherwise owe to the shareholder (see CTM61565). But this might be a difficult line to take where dividends are traditionally credited to the director/shareholder’s loan account and it would remain in credit regardless of any ‘illegal’ distribution.
Practical considerations of an illegal dividend
Assuming HMRC’s treatment is correct, a company will be obliged to file a supplementary form CT600A with its usual tax return. The statutory accounts submitted alongside should also include relevant disclosures.
The section 455 tax will have been payable alongside the main corporation tax liability – assuming there was one – at nine months and one day after the end of the chargeable period in which the distribution was made. The company may seek relief under CTA 2010, s 458 for any amounts repaid prior to that date, but HMRC may not accept that general directors’ loan repayments were made specifically against that debt to the company, and in any event this may simply ‘move’ the section 455 liability to a different debt.
HMRC may also argue that the repayable amount is by implication also an interest-free loan made to an employee of the company, resulting in a taxable benefit-in-kind (or increasing one that already arose).
On a more positive note, HMRC does say that a distribution paid unlawfully is not a dividend:
‘The company has not made a distribution as a matter of company law, and so the dividend does not form part of the recipient’s income for tax purposes’ (see CTM15205)
So the director/shareholder’s personal tax liability should fall.
Implications if HMRC spots it first
If we assume that the directors and their advisers are unaware that a distribution has been made unlawfully, there will be no entries in the company’s tax return.
However, the financial statements filed online as part of the company’s return may well show that the company’s reserves are still in deficit at the end of the relevant period, even if no other disclosures are made. This should be picked up automatically by HMRC’s systems and flagged accordingly. Likewise where the opening balance next year is in deficit (representing the ‘relevant accounts’ for the following year) and dividends are then paid notwithstanding. HMRC has been known to open enquiries on precisely these grounds.
The problem then arises that the company has filed an incorrect return, risking a penalty (under FA 2007, Sch 24). The calculation of the penalty arising will include the extra section 455 tax claimed to be due by HMRC, but notably without any relief for sums repaid or to be repaid under CTA 2010 s 458, after the usual nine month post-year-end window has expired (FA 2007, Sch 24, Para 5 (4)(b)).
There seem likely to be many more cases of ‘illegal’ dividends over the months and years to come, due to the impact of the Covid-19 pandemic, and its effects on trading profits and potentially on asset values going forward (although the latter may not always affect distributable reserves).
Ironically, while there may be many more such instances than directors or HMRC realise, HMRC will often be wrong if it simply assumes based on deficits reported in year-end returns. In the second part of the article, I’ll examine why, and what companies can do if enquiries are raised.