Chris Thorpe highlights some traps to avoid when paying dividends.
The principal method by which a shareholder extracts profits from their limited company is to declare a dividend; this is the shareholder’s reward as an investor and risktaker.
Those owner-managed businesses will usually have shareholders who are also directors or employees – for which role they draw fees or salaries.
Why dividends?
Dividends are more favourable than salaries mainly because the former do not attract any National Insurance contributions (NICs), and because of the income tax regime – dividend tax rates are lower (8.75%, 33.75% and 39.35% from April 2022) and individuals have a dividend allowance of £2,000 each (though this will decrease to £1,000 in 2023, and £500 in 2024).
However, dividends do not attract a corporation tax deduction for the company (as they are paid from taxed profits), whereas salaries do; so in reality, whilst the majority of the profits will be extracted by dividends, there will usually be some salary (and pension contributions) to strike the best overall tax balance for shareholders and company combined.
When are dividends taxed?
The shareholder receives the monies (or assets, in the case of ‘in-specie’ dividends) for tax purposes when they are ‘paid’ (per ITTOIA 2005, s 384(1)); this means when there is an enforceable debt or right for the shareholder to receive it (Severn and Wye and Severn Bridge Railway Company [1896] 1 Ch 559).
A recent case (Jays v Revenue and Customs [2022] UKFTT 420 (TC)) highlights what happens when shareholders are not able to access their dividends. In that case, Marcus and Karen Jays declared dividends but these were paid to a ‘blocked account’, to which they did not have access (as part of a financing agreement with the bank). HMRC tried to assess the full amount of dividend to tax rather than the lesser amount received, but the tribunal held that the amounts paid into the blocked accounts did not constitute an enforceable debt because the shareholders could not gain possession of them.
‘Ultra vires’ dividends
A dividend can only be paid out of a company’s distributable reserves (i.e., the accumulated profits per the last set of annual accounts).
If dividends are declared from a close company more than those profits, they will be treated as loans (under CTA 2010, s 455); otherwise, if the shareholder knew (or had reasonable grounds to believe) that the dividend was ultra vires (i.e., unlawful) they will hold the monies on (constructive) trust for the company.
Tax on the individual shareholder
As noted already, the income tax rates on dividends are lower than that of earned income and attract no NICs; careful consideration of an individual’s other income and circumstances can mean that dividends can be tailored to ensure a minimal amount of tax is paid. However, if all shareholders are paid at the same rate, that might tip some shareholders into the higher or additional rates depending on their individual circumstances and marginal tax rate.
Therefore, to truly tailor dividends, ‘alphabet’ shares may be used to ensure different holdings are declared at different rates to suit the individual shareholder. Alternatively, a shareholder could waive their dividends, with funds going back into the company’s reserves rather than the shareholder being assessed on them. However, caution should be taken with family companies, lest these alphabet shares or waivers attract the attention of the ‘settlements’ anti-avoidance legislation.
Practical tip
It is vital to ensure that dividend payments are legal and that the company has the reserves to make them in the first place. Tailored dividends, via ‘alphabet’ shares, may help shareholders keep their personal tax liabilities to a minimum, but the shareholder’s and company’s overall tax position should be considered as a whole.
