This example shows that:
- The reserves and scope for dividends is worked on a cumulative basis, from incorporation;
- Dividends paid out in a year can exceed the profits for that year;
- If Aisha had paid out dividends much greater than £12,000 in 2022, her reserves would have turned negative, and the dividends might have been excessive (but see below for the twist).
What makes dividends illegal?
Family companies will typically pay out interim dividends as the accounting year progresses. They might not actually ascertain the total profits of the company for that year until some time after the year end, when their accountant prepares statutory accounts.
Companies Act 2006, s 836 states that in order to determine if there are sufficient reserves that a proposed dividend distribution may legally be made, one should check the ‘relevant accounts’ – by default these are the last set of annual accounts, as prepared in accordance with the Act.
So, taking Aisha’s company results as above, the dividends paid in some years exceed the reserves available according to the previous year’s accounts. However, Aisha (or her accountant) is allowed to draw up interim accounts on an ad hoc basis, so as to ‘prove’ that the company has since amassed sufficient reserves to make the required dividend payment (for the opening year, such ad hoc accounts are referred to as ‘initial accounts’).
Example 2: Management accounts and dividends
In 2020, Aisha’s last annual accounts (her 2019 results, as above) show distributable reserves of £10,000 but she actually takes £20,000 in dividends. Strictly, it is irrelevant that the 2020 statutory accounts drawn up several months after the year-end show profits of £35,000.
However, Aisha’s accountant drew up management accounts in June 2020, which showed that in-year profits to date provided reserves from which a dividend distribution of £20,000 could then legally be made.
What if dividends are illegal?
Where the recipient shareholder knows or (simply put) should have known that a dividend (or part thereof) is illegal, that shareholder is liable to repay the dividend (or the proportion that exceeds available reserves) back to the company (CA 2006, s 847).
To the extent that a dividend is repayable, HMRC says that it is to be treated as a loan to a participator, rather than dividend income. Under CTA 2010, s 455, if that loan is not repaid within nine months and one day of the end of the accounting period in which the distribution was supposedly made, the company is subject to a ‘section 455 tax charge’ of 32.5% of that repayable amount. The section 455 tax charge will then be repaid by HMRC, nine months and a day after the end of the accounting period in which the ‘loan’ is actually repaid to the company.
Where the shareholder is also a director or employee of the company, this deemed loan will trigger the benefit-in-kind rules for taxable cheap loans to employees; a notional interest rate is charged (currently 2.5% per annum), on which the employee is generally taxable.
While it may at first seem to be good news that an illegal dividend is taxed as if it is merely a loan, it does mean that:
- The excess element will need to be repaid;
- The company will owe section 455 tax until nine months and a day after the accounting period in which the loan is repaid; and
- The director/shareholder may also suffer a corresponding benefit-in-kind income tax charge (and the company will have to pay secondary Class 1A National Insurance contributions thereon, as well).
When does HMRC attack illegal dividends?
HMRC’s Corporation Tax manual at CTM15205 states
‘Officers should not in general seek out cases in which it might be argued that dividends that have been paid are unlawful. An exception to this will be where the dividend is paid as part of some avoidance scheme.’
Despite those wise words, it is not uncommon to see HMRC allege that dividends have been paid illegally when it sees dividends paid out alongside negative reserves (this is relatively easy for HMRC to pick up, now that corporation tax returns include accounts disclosures that are encoded in iXBRL format).
While HMRC accepts that the notional loan consequences of an illegal dividends being repayable apply only when a shareholder knew, or ought to have known, that the dividend was excessive, it also states (at CTM15205) that ‘when dealing with private companies controlled by directors who are shareholders, such a member [shareholder] ought to know the status of the dividend’.
Example 3: Excessive dividend?
Let’s assume that Aisha’s 2022 dividend was £18,000 instead, making her company £4,000 overdrawn. The corporation tax return is filed in November 2023.
HMRC might then argue that the dividend paid out must have been illegal because the company has negative reserves, so the company owes section 455 tax (due 1 October 2023) and Aisha is potentially exposed to a loan benefit (although there is a de minimis of £10,000 across all such loans in aggregate).
But actually, Aisha’s dividend was still less than the £19,000 of reserves in the last available accounts, so prima facie, it was legal. In fact, it is the only dividend in the example that is less than the figure for reserves brought forward from the respective last set of annual accounts; previous dividends will have been made legal only if interim, etc., accounts were drawn up at the time to ‘prove’ that there were, in fact, sufficient reserves to make a distribution.
Note that further restrictions imposed by common law or by the company’s Articles of Association can take precedence over the statutory provisions (CA 2006, ss 851, 852); for example, a company cannot make a distribution out of capital at common law, so the directors are supposed to consider when proposing (and, if later, when paying) a dividend, whether losses made since the last relevant accounts have eroded the profits available for distribution – this is referred to as the ‘capital maintenance rule’.
Directors also have a duty to safeguard the company’s assets and to ensure that the company can settle its debts as they fall due. So, if Aisha might reasonably expect that the company would make substantial losses in (say) October 2022, this should be considered when contemplating a dividend to be paid in June. But losses that were not reasonably foreseeable at the time a dividend was paid cannot retroactively make a dividend illegal, even if the annual results push the reserves into the red.
Whether or not dividends might be considered lawful is a complex issue, which in my experience HMRC officers do not fully understand and will pursue incorrectly, without first gaining an appreciation of how a company’s results have fared over the year, etc. But this may well change if and when ‘making tax digital’ applies to corporation tax.
Shareholders will often be able to argue that the last annual accounts (or interim accounts, where appropriate) justified the dividends paid out. In other cases, they should take advice on whether or not the quasi-dividend treatment of the release of loans under CTA 2010, s 458 might be a better option; but this would have to be done pro-actively, rather than retrospectively.