Jennifer Adams looks at some important issues when considering whether the payment of dividends before 6 April 2022 should be undertaken.
When the Chancellor of the Exchequer recently announced additional investment into the Health Service via tax increases, it was the increase in National Insurance contributions that made the headlines. However, the government is also increasing dividend tax by 1.25%, and this will have an impact on shareholders, not least those of family and owner-managed companies.
The reaction to this announcement might be to withdraw as much as possible before 6 April 2022 to reduce their personal tax bill. However, some 'traps' need to be considered before taking such action, including those outlined below.
Trap 1: Insufficient profits
The Companies Act 2006 states that dividends can only be made ‘out of profits available for the purpose’, a company’s profits being the ‘accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses....’.
Therefore, the company needs to have set aside sufficient profits from the current and previous years to cover the dividend amount; this figure being the amount remaining after the company has paid its corporation tax. Should there be any such profits, the flexibility is that the total amount of dividend can be varied payment by payment, unlike a salary where the same amount must be paid regularly. However, having a credit balance in the bank account is not enough - profits must have been earned which have not been withdrawn.
A 'trap' is that following Covid, a company may be facing trading losses and impairment provisions that have reduced distributable profits such that there are insufficient distributable profits to cover dividends. A further 'trap' may be that director shareholders have already withdrawn monies as dividends, unaware of this 'accumulation' rule. Where a director shareholder receives a dividend when they know, or there were reasonable grounds to believe, that the distribution was unlawful, they must repay the dividend to the company.
Trap 2: Overdrawn directors’ loan account
In reaching the end of the accounting period, it is not unusual to find that insufficient repayments have been made to cover the amount that has been withdrawn, even after taking the salary and dividends into account. This is because the director has borrowed from the company (usually at no interest), and the loan must be repaid.
If there is not enough profit to pay a dividend, HMRC could contend that the overdrawn amount is really a 'loan to a shareholder'. This 'loan' needs to be repaid within nine months of the company’s year end; otherwise, there will be a tax charge on the company (and possibly a benefit in kind charge on the director in certain circumstances). The rate of tax that applies to overdrawn directors’ loan accounts is directly linked to the dividend upper rate, meaning that post 6 April 2022 the rate also increases from 32.5% to 33.75%.
Trap 3: Diverting dividends
For married couples, should one spouse be a higher rate taxpayer and the other a basic rate or non-taxpayer, it is generally more tax-efficient for the lower or nil rate taxpayer to receive at least some dividend income. This can be achieved by either creating a new class of shares (often termed 'alphabet shares') and allocating those shares to the spouse or transferring shares from one spouse to the other, or even from parent to child.
The 'trap' here is to ensure that the payments do not fall foul of the 'settlements’ anti-avoidance rules, which apply to ‘any disposition, trust, covenant, agreement, arrangement or transfer of assets’. These rules broadly provide that gifting shares to another will result in dividends on those gifted shares being treated as the donor's income.
Practical tip
Whilst dividends may continue to be the preferred option of extracting money, rising effective tax rates mean that alternative methods need to be considered, such as making pension contributions. With corporation tax rates also set to increase for many businesses from April 2023, there could be even more convincing reasons to consider such an approach.
