When Is A Dividend Not A Dividend? When It’s A Salary!

Mark McLaughlin highlights a recent case concerning a company’s claim that directors’ remuneration payments were actually meant to be dividends. 

Many director shareholders of family and owner managed companies are too preoccupied by running their business to deal with certain procedures and formalities (e.g. shareholders’ meetings). This relative informality can sometimes call into question the tax treatment of certain events or transactions.

It is not uncommon in owner-managed companies to see amounts withdrawn or credited to the director’s loan account(s) of the business owners. However, it can sometimes be difficult to establish the nature of those amounts, at least initially (e.g. are they bonuses, dividends or something else, such as loans?).  

Uncertainty caused by the lack of formality and documentary evidence can result in the company treating payments to its owners in a certain way, but later claiming that an error has been made and seeking to treat the payments differently. Alternatively, HM Revenue & Customs (HMRC) could argue that the payments should be treated differently to the way in which the company has treated them. In either case, there are potential tax implications for both the company and its owners.

For example, an underpayment of PAYE income tax and National Insurance contributions (NICs) could arise if the company is found to have paid remuneration to its director shareholders, and the payments were purported to be dividends. This could result in HMRC serving a ‘Notice of determination’ on the company for payment of the unpaid tax (under the Income Tax (PAYE Regulations), SI 2003/2682, reg 80), and issuing a direction for payment of the unpaid NICs (under the Social Security Contributions (Transfer of Functions, Etc) Act 1999, s 8). 

In Key Recruitment (UK) Ltd v Revenue & Customs [2014] UKFTT 755, the First-tier Tribunal (FTT) had to consider whether a company paid salary in error and the payments in question were actually dividends. 

In that case, the company originally submitted PAYE forms P35 and P14 for several tax years on the basis that certain payments made to director shareholders were remuneration. The company’s accounts supported the P35 figures. However, the company subsequently submitted amended forms P35 and P14 to HM Revenue & Customs (HMRC) for the relevant tax years, showing lower amounts of PAYE income tax and NIC liabilities. This resulted in an overpayment of deductions, which was repaid to the company. 

HMRC queried the amended returns with the company. The company explained that two director shareholders had given instructions that payments into their bank accounts should be for small salaries with the balance being dividends, but due to an error those instructions were not processed. The company also pointed out that the directors’ tax returns (which reflected the figures on the original forms P35 and P14) were prepared by an external accountant based on information provided to him, which did not reflect the directors’ original instructions. However, HMRC considered that the documentation provided by the company in support of its explanations was insufficient, and sought to reinstate the amounts originally declared on the forms P35.

The evidence produced by the company in support of the P35 amendments included copy handwritten notes from one of the directors to an accounts clerk (who later died). One memo concerned adjusting the previous year’s earnings to ‘small basic plus dividends’; another memo instructed that going forward ‘remuneration should be paid in a more tax-efficient way’. Personal diary entries by the director also mentioned meetings with the accounts clerk and another director, but contained no details which could properly be regarded as supporting the company's contentions. Unfortunately for the company, the tribunal was not satisfied that this evidence was sufficient. The company’s appeal was therefore dismissed.

Unfortunately for the company in Key Recruitment, lack of sufficient documentary evidence to prove that remuneration had been paid in error was fatal to its case. Other detrimental factors included that the company's accounts, and the self-assessment returns of the directors concerned, were consistent with the original forms P35 and P14 submitted to HMRC. In addition, the payments to the director shareholders were not in proportion to their shareholdings, and were therefore inconsistent with dividend payments. The company’s ‘error’ had also gone undetected for four years.   

It should be remembered that directors’ remuneration is normally an allowable corporation tax deduction in calculating a company's trading profits. Dividend payments are not allowable. Even if a company successfully claims that remuneration was paid in error (and therefore receives a repayment of PAYE tax and NIC overpaid), it may have a corporation tax liability in respect of the remuneration already claimed as a deduction. The tax position of the company owners may also need to be amended accordingly.

There are other (non-tax) issues which may need to be considered, if it is claimed that payments to company owners have been incorrectly treated.

Certain company law requirements must be satisfied for dividend payments to be lawful. The rules are set out in Companies Act 2006 (at Part 23 (Distributions)). For example, as a general rule, a company can only pay dividends out of profits available for the purpose (CTA 2006, s 830). 

In addition, a company must have articles of association, which regulate the management of the company. The contents of the articles may vary, including in relation to the payment of dividends. For example, the model articles on the UK Government’s website (www.gov.uk/limited-company-formation/articles-of-association) include a procedure for declaring dividends (para 30). This provides (among other things) that an ordinary resolution may declare a final dividend, and that a dividend must not be declared unless the directors have made a recommendation as to its amount.

Failure to comply with company law requirements renders the dividend unlawful. The tax and legal implications of unlawful dividends are beyond the scope of this article. However, if a company seeks to argue that payments to the company owners represent dividends, HMRC may wish to establish that the dividends satisfy company law requirements, assuming that sufficient documentary evidence exists.

Useful guidance on company law aspects of dividends can be found in HMRC's company taxation manual (see CTM20090-CTM20095).