Illegal Dividends: Company Owners Beware!

Lee Sharpe looks at illegal dividends and their tax implications.

In this article, we shall look at ‘illegal dividends’:

It is important to note that, merely because a dividend is ‘illegal’ – unlawful – it does not mean that the directors or shareholders have done anything criminal. It is merely that a dividend has been paid that the company should not have made. The following guidance relates to ‘close’ companies – those with five or fewer shareholders, or where all the shareholders are also directors of the company. 

The easiest way to define an illegal dividend is simply to say that it is a dividend that is not legal. So what is legal?

Companies Act 2006, s 830 states that ‘a company may only make a distribution out of profits available for the purpose’. The implication is that a distribution – basically, a dividend – that is not so made is illegal. In this context, we refer to ‘distributable profits’ or ‘distributable reserves’. 

As a basic definition, a company’s ‘distributable profits’ are its accumulated profits that have not already been either paid out by way of distribution/dividend, (or capitalised in some way), less its accumulated realised losses that have not already been written off.

Essentially, therefore, distributable profits are based on a running balance of profits (less losses) made since the company was created, and less any dividends already paid. The definition is more technical than this and there are other things that can affect distributable profits, but this basic equation will generally apply to standard family companies. The company’s Articles of Association may also be relevant.

Dividends paid out over and above those distributable profits are potentially illegal; the implication is that they may have to be repaid to the company. 

Bill’s Bubblegum Limited commences in July 2010, with the following profits, losses and dividend distributions:

 

Initially, Bill – the company’s sole shareholder in this example – takes out a smaller dividend than the company made in profits during its accounting year. This means that the distributable reserves start to grow. 

In 2013, Bill’s dividend exceeds the profits made in that year but there are still sufficient accumulated reserves brought forwards to cover the larger dividend: even though slightly depleted, the reserves are still ‘in the black’. Reserves start to accumulate again in 2014; 2015 is balanced but in 2016 disaster strikes: Bill takes relatively modest dividends but his year-end accounts show a loss: the combination of losses and dividends takes the company’s reserves into negative territory, and the company has made excessive distributions. 

Note that we have not said (yet!) that the company has made an illegal dividend payment – because we don’t actually know, at this stage, whether or not the dividends have been illegally paid.

According to CA 2006, s 847 if, at the time that the dividend is paid out, the shareholder knows, or has reasonable grounds to believe, that a distribution is unlawful, (i.e., excessive), then he or she is liable to repay the dividend (or, if less, the part that causes the distribution to exceed available reserves). Whether or not the shareholder should have known will be based on what ‘the relevant accounts’ say (CA 2006, s 836) as to the extent of available distributable profits. 

Generally, these are the last set of annual accounts prepared by the company and available to the shareholders in a general meeting, although the company can use interim accounts if the last annual accounts do not show sufficient reserves for the proposed dividend, or if there are no previous annual accounts because it is the company’s first period. 

HMRC states in its Corporation Tax manual (at CTM15205, and at CTM20095) that, where company law requires the distribution to be repaid in full or in part, then they will consider the company to have made a loan to the shareholder. This will then fall under the rules governing ‘loans to participators’ under CTA 2010, s 455. 

These rules require the company to pay a ‘deposit’ tax to HMRC, if the loan is not repaid within nine months and a day of the end of the accounting period in which the loan (illegal dividend) was paid. This gives the person in receipt of the funds a long time to repay the loan, before the tax charge is triggered; the ‘flip side’ is that HMRC gets to keep the funds for quite some time after the loan is repaid. Note that if the loan were formally released by the company, then this would be as if the loan had been repaid – but if the company’s reserves are overdrawn, then the directors are obliged to try to recover the funds from the shareholders.

The company’s excessive dividend to Bill was made on 30 September 2015, in the accounting period ended 30 June 2016. Assuming for now that the shortfall must be repaid, then if it hasn’t been returned to the company by 1 April 2017, the company will have to pay 25% x £20,000 = £5,000 to HMRC; assuming Bill repays the funds on 10 August 2017 – in the Accounting Period Ended 30 June 2018 – HMRC gets to hold on to the money until 1 April 2019 (i.e., nine months and a day after the Accounting Period of the repayment). 

Note that the 2016 Budget contains provisions to increase the s 455 tax charge from 25% to 32.5%, for any loans (or deemed loans) made on or after 6 April 2016.

Where the recipient of the illegal dividend is also a director/employee, then there may also be a taxable ‘benefit-in-kind’ on the provision of an interest-free loan to that person as well. This will result in an income tax charge on the deemed interest that the employee did not have to pay – currently 3% per annum. 

Bill’s excessive dividend was made on 30 September 2015. For the tax year 2015/16, HMRC would like to charge him to a benefit-in-kind on the ‘interest-free loan’ of £20,000 x 3% x 9/12 = £450.

Income tax would be chargeable on the benefit, each tax year until there is no longer a loan – i.e. it is repaid or written off. 

Critically, if the dividend is paid at a time (e.g. early in the year) when there was no reason to believe that the reserves in the last set of accounts would prove insufficient, then it is not an illegal dividend. Loss-making events can occur after dividends are paid out. Furthermore, a shareholder would only be required to repay the dividend (so that HMRC can treat it as a loan) if the shareholder knew, or should have known at the time it was paid, that the dividend would prove unlawful. 

Let’s say that Bill paid himself a dividend on 30 September 2015, three months into the accounting period. The accounts to 30 June 2015 would certainly support a dividend of £40,000 paid three months later – there are sufficient reserves. But let’s suppose that, in December, parents find that a new additive in Bill’s Bubblegum turns children’s teeth green and sales fall to nil, with huge losses arising a few months after the dividend. Neither Bill nor the company may have seen this coming: the dividend was not an illegal dividend at the time it was paid, and Bill would not be obliged to repay the deficit on the distributable reserves. This would mean that the dividend is not a loan, and there can be no charge on the company under the ‘loans to participators’ regime, nor on Bill as an ‘interest-free loan benefit’. 

I have seen HMRC pursue apparently illegal dividends quite aggressively in the past. It is important to note that a deficit on reserves does not always mean the dividend must have been illegal at the time it was made, nor that the shareholder(s) should have known it was illegal – both being required in order to cast the dividend as a loan. HMRC’s grasp of accounting is often not what it should be.

It is unfortunate that HM Inspectors do not always heed the following (in CTM15205): ‘…officers should not in general seek out cases in which it might be argued that dividends that have been paid are unlawful’; I have even seen one Inspector try to instigate a s 455 charge on an ‘excessive’ dividend between group companies; in other words the recipient of the dividend was a sister company, and not a participator (an individual in almost all cases) by reference to whom a s 455 charge could actually be levied!