Sarah Bradford considers when shareholders may need to repay dividends that they have received back to the company.
One of the perceived advantages of operating a business as a personal or limited company is the ability to extract profits as dividends and benefits from the lower dividend tax rates.
In addition, there is no National Insurance contributions (NICs) liability on profits extracted as dividends. However, when paying dividends, it is necessary to comply with the company law requirements and be mindful of the consequences of paying dividends illegally.
What is a dividend?
A dividend is a distribution of a company’s post-tax profits to its shareholders.
The rules on dividends apply to all distributions, not just dividends. A ‘distribution’ is a transaction that transfers value to a shareholder. However, for the purpose of this article, the focus is on dividends.
Sufficient retained profits?
As a dividend is a distribution of post-tax profits, it can only be paid if the company has sufficient retained profits from which to pay the dividend. Before declaring a dividend, it is necessary to check that this is the case.
The starting point will be the last set of statutory accounts prepared. The retained profits at the balance sheet date should be sufficient to cover the proposed dividend.
However, before paying an interim dividend, the company will also need to take account of what has happened since the last set of accounts was prepared. Some time may well have elapsed, and a lot may have happened.
If the previous accounts show insufficient retained profit, but the company has done well since the accounting date, the preparation of management accounts may be sufficient to demonstrate that the company now has sufficient profits from which to pay the dividend.
If the company’s position has worsened since the balance sheet date, it is also prudent to consider whether the company’s retained profits remain sufficient to pay the proposed dividend. It is good practice to keep evidence to show that at the time that the dividend was paid, the company had enough retained profits.
Dividends must be paid in accordance with shareholdings
Where a dividend is paid, it must be paid to all shareholders of the same class of share in proportion to their shareholding. Each must receive the same amount per share.
The need to pay dividends in proportion to shareholdings is avoided by having an ‘alphabet’ share structure whereby each shareholder has their own class of share, for example, ‘A’ ordinary shares, ‘B’ ordinary shares, and so on. Where this is the case, if the company only wishes to pay a dividend to the shareholder with ‘A’ ordinary shares, they only need declare a dividend for that class of share – there is no requirement to also declare a dividend for other classes of share.
Dividends must be properly declared
A dividend is only a dividend if it is properly declared.
Where the directors want to declare an interim dividend, this must be done at a Board meeting. The directors must consider the company’s financial position and demonstrate that the profits are sufficient to pay the dividend. This should be documented in the minutes. Interim dividends are treated as the income of the director when paid or credited to the director’s loan account.
Final dividends are declared at the annual general meeting (AGM). The final accounts should show sufficient retained profits. Final dividends are treated as paid when declared.
Consideration must also be given to requirements in the company’s memorandum and articles of association.
Unlawful distribution
If a company pays a dividend without having sufficient retained profits from which to pay that dividend, the dividend is unlawful. The consequences of paying an unlawful dividend are set out in the Companies Act 2006, s 847, which requires the shareholder to repay the unlawful dividend (or unlawful part of it) to the company.
Paying a dividend where the company lacks the reserves to do so may also result in a negative balance sheet, which brings its own problems.
Repaying the dividend
Where a dividend has been paid in cash and that dividend is unlawful, the simplest course of action is for the shareholder to repay the amount of that ‘dividend’ back to the company.
Example: Insufficient retained profits
A Ltd is Andrew’s personal company (i.e., he is the director and sole shareholder).
The company’s balance sheet shows that the company has retained profits of £1,000.
Andrew wishes to withdraw £5,000 from the company. He declares a dividend of £5,000, paying the cash into his personal bank account.
The company does not have sufficient retained profits to pay a dividend of £5,000. As the retained profits are only £1,000, this is the maximum amount that can be paid by way of dividend. The excess over the retained profits represents an unlawful dividend.
To comply with the requirements of the Companies Act 2006, Andrew must repay this. He transfers £4,000 from his personal bank account to the company bank account to correct the situation.
A loan - not a dividend
To the extent that a dividend is unlawful and must be repaid to the company, HMRC treats it as a loan to the director rather than as a dividend. A dividend can only be paid out of retained profits, and where the profits are not sufficient, the payment cannot be a dividend.
Treating an unlawful dividend as a loan to the director has its own tax implications.
Where the company is a close company (as is usually the case for a personal or family company), a loan to a director which is not repaid within nine months and one day from the end of the accounting period in which it is paid will trigger a section 455 charge on the company. This means that when the company pays its corporation tax for the period (due nine months and one day from the end of the accounting period), it must also pay an amount of tax on the outstanding loan balance. This tax (‘section 455’ tax) is charged at a rate that is equal to the upper dividend tax rate, which since 6 April 2022 has been 33.75%.
The tax is not corporation tax, and crucially, if the loan is later cleared, the section 455 tax paid on it becomes repayable nine months and one day after the end of the accounting period in which the loan balance was cleared.
Where the shareholder is an employee or director, if the loan balance is more than £10,000 at any point in the tax year, a tax charge will also arise under the benefit-in-kind rules. The recipient will be taxed on the difference between the interest that would be payable at the official rate of interest less that (if any) actually paid. The company will also face a Class 1A NICs charge.
Good practice
Directors of personal and family companies should avoid simply taking dividends from the company whenever they need cash for personal use without any consideration of the company’s financial position.
They must ensure they are aware of the company law requirements governing dividends and that there is compliance with those requirements.
Practical tip
Before declaring a dividend, the directors should check that the company has sufficient retained profits from which to pay the dividend, and document that this is the case. The directors should also ensure that the dividends are properly declared and paid to shareholders of the same class in accordance with their shareholdings. If an illegal dividend is paid, it should be repaid to the company at the earliest opportunity.
