Alan Pink looks at the consequences of paying illegal dividends: and questions HMRC’s approach to taxing them.
This is just one area of business taxation covered in our popular tax report 'Tax Efficient Ways To Extract Cash From Your Company' 2022/23 edition. Save 30% Today.
------------------
In one of the P.G. Wodehouse novels, a sympathetic friend is siding with the victim of high-handed behaviour:
“But they can’t do that!”
The friend replies, “I know they can’t. But they have.”
This little passage is called to mind by the way company law and HMRC deal with dividends paid by a company which, according to the Companies Act, should not have been paid.
The legal rules
In order to understand what an illegal dividend is, it’s necessary to go into some detail on what the law says about when you may pay dividends, and when you may not. The Companies Act 2006 is one of those monster acts of Parliament that was the result of a number of previous Acts being consolidated into one desk–straining volume. The rules about paying dividends are in Section 830 and onwards, and what this basically says is that dividends can only be paid out of “profits available for the purpose”. But for one technical exception, this figure can be broadly taken to equate to the balance on the profit and loss account reserves in the balance sheet of the company because this figure is intended to represent realised rather than unrealised profits, and it is key to the company law rules that you’re not allowed to pay dividends either out of the company’s capital or out of unrealised profits (such as an increase in value of investments). Whilst you could quibble about the precise relationship between the company law rules and the accounting rules, if you want a possible scrap with HMRC, for planning purposes it’s best to assume that you must not pay a dividend which would result in the P & L account going negative.
The relevant accounts
That’s all very well, you might say, but the company’s profit and loss account reserves, at least in principle, change from day to day. Is it necessary to determine what the balance is at the exact point at which the dividend is paid?
Fortunately, the Companies Act recognises that this would be an unrealistic aspiration. The accounts you have to look at are the most recent finalised statutory accounts for the company. That is, the accounts which are prepared to their official filing date and form the basis for the abbreviated information that has to be sent to Companies House.
If these accounts do not show sufficient profits to pay the dividend you have in mind, there’s a potential escape route. You can use subsequently prepared interim accounts if these show more distributable profits. Or if you’re in the first accounting period of the company, you can use so-called ‘initial’ accounts, prepared for the purpose in advance of the statutory balance sheet date for the company. For public companies, these interim or initial accounts have to be ‘the full Monty’. That is, they must be prepared in accordance with the highly prescriptive accounting and disclosure requirements that apply to final accounts, including the need to show a “true and fair view”. Private companies, on the other hand, can dispense with all this – potentially very expensive – red tape. Any format is acceptable (although the accounts should obviously be correct) so long as it gives a reliable figure for what the distributable profit and loss account reserves are at the date to which the figures are made up.
Illegal dividends: The company law consequences
Since the tax treatment of illegal dividends by HMRC depends on how the law itself treats them, we need to have a look at the rules set out in the Companies Act 2006 first of all. And here the consequences depend on a highly contentious criterion. The question is whether the shareholder knew or had reasonable grounds for believing that the dividend contravened the rules. If the shareholder can get away with claiming that they had no idea that there weren’t sufficient distributable profits to pay the dividend that they’ve received, they’re basically allowed to keep it. If, on the other hand, they knew or should have known about the illegality, they have a legal obligation to repay the amount to the company. And the law here, in the Companies Act and decided cases, is quite uncompromising about the status of the money that has been paid over wrongly. This is that the dividend is void in law, and the company has never given up the legal title to ownership of the money. The person who received the funds is holding them as a kind of trustee, known as a constructive trustee, for the company. In short, legally, it’s still the company’s money.
HMRC’s view
So much for the law: what is HMRC’s view? If you’ve paid an illegal dividend, particularly in the situation where the company has then become insolvent, it’s understood that HMRC can argue that the amount paid should instead be treated as remuneration, with Pay As You Earn and National Insurance liabilities for the company. This is an entirely separate issue from the company law rules. Basically, HMRC is attempting to re-characterise a dividend as remuneration as a question of fact. The counterargument to that is, of course, that it really was a dividend and was not payment for any individual’s services and, clearly, this argument should be successful in cases where the recipient is just a shareholder and does not work for the company, or does not do any substantial work for it.
However, the other possible consequence which seems more likely, to judge from HMRC’s published practice, is that a shareholder who is in the ‘knew or ought to have known’ category, being liable to repay the amount to the company, is a debtor of the company. Therefore, the so-called ‘loans to participators’ rules come into play. Where a close company lends money to its shareholders (or certain other connected people), the company becomes liable to pay an amount equivalent to 32.5% of the loan, such amount being refundable to the company as and when the ‘loan’ is itself repaid to the company by the shareholder. But this view actually seems very difficult to reconcile with the legal position. To quote HMRC’s own summary of this:
“Where a dividend is paid and it is unlawful … and the recipient knew or had reasonable grounds to believe that it was unlawful then that shareholder holds the dividend (or part) as constructive trustee … such a dividend (or part) is void for the purposes of … the income tax charge on distributions. … 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. The company has not parted with title to the sum that it purported to distribute, which as a consequence remains part of its assets under a constructive trust.”
But surely a fairly rudimentary knowledge of trust law reveals that treatment of the amount as a loan to the shareholder is a contradiction of the above? The proper accounting for an amount to which the company still has title is to show it as cash available to the company in its balance sheet, not as a loan to anyone. It’s not known whether this point has ever been made to HMRC, but it does seem, to this writer at least, to be a plain contradiction; and any attempt by HMRC to assess the 32.5% ‘loans to participators’ tax should be resisted.
In situations where the shareholder did not know, and did not have any reason why they ought to have known about the dividend being illegal, HMRC will tax it as a distribution in the normal way. However, they make clear, in their manual, that they will not often be inclined to accept that shareholders in a close company did not know enough about its finances to realise that there were not enough reserves to pay dividends.
