Tax consequences of ‘illegal’ dividends
Company law dictates a company can only pay dividends out of available undistributed profits. The Companies Act 2006 details the correct administrative procedures which need to be followed which is beyond the scope of this article.
Where dividend payments are made which are not backed by sufficient undistributed profits there can be significant tax issues for both the individual concerned and the company.
It is important to note the difference between undistributed profits and the company bank account. Where the company bank account is in credit it may be tempting to authorise a dividend, however this is the primary cause of ‘illegal’ dividend distributions.
‘Retained profit’ is defined in the Companies Act 2006 as being ‘accumulated realised profits less accumulated, realised losses’.
The simplest way to consider retained profit is to think of it as the total post tax profit / loss made over the life of a company less any distributions made in the form of dividends – in reality other factors can be brought into the retained profits calculation but for most small businesses this is as complex as the calculation gets.
This means a dividend can be paid in a loss-making period provided that there are sufficient ‘distributable’ / retained profits brought forward. This can be seen at the bottom of the balance sheet in the set of financial statements prepared by your accountant. It is important to look at this figure as illegal dividends may still be paid out where a company makes a profit but still has negative retained profits.
Tax implications – Shareholders
If a dividend is declared where there are insufficient retained profits, such that the dividend is deemed to be ‘illegal’, the dividend is treated as being void and the shareholder is treated as not having received a dividend distribution.
Where the shareholder who received the dividend knows or should have known the dividend (or part thereof) was illegal, that shareholder is liable to repay the dividend back to the company.
This rule catches out director shareholders since directors have a statutory obligation to ensure there are sufficient retained profits from which to make a dividend distribution.
Indeed, HMRC’s Corporation Taxes Manual states that ‘when dealing with private companies controlled by directors who are shareholders, such a member [shareholder] ought to know the status of the dividend’.
If the dividend is not repaid by the shareholder who also happens to be a director or employee of the company, the company will be deemed to have made a loan to the shareholder.
As it is unlikely interest would have been paid on this distribution the shareholder will be liable to a benefit in kind tax charge under the rules for taxable loans to employees. A notional rate of interest will be charged on the loan where the distribution exceeds £10,000 at any time in the tax year.
P11D forms will also need to be completed to account for the ‘beneficial interest’ on loans which exceed £10,000. As with all P11D benefits, Class 1A National Insurance will need to be pad by the company on the benefit.
Tax implications – Company
HMRC will likely argue the dividend represents a ‘loan to a participator’. This will bring the company within the tax rules under CTA 2010 s455. Such a charge arises when a company lends money to its directors or employees and the loan is not repaid within 9 months and 1 day of the accounting period end.
The rate of tax payable by the company is the same as the higher ‘dividend tax’ rate of 32.5% on the gross loan paid to the company ‘participators’. This amount is payable even if the company is loss making.
To avoid this tax charge the loan needs to be repaid or written off by the due corporation tax due date being 9 months and 1 day after the end of the accounting period. Partial repayments attract a pro rata refund.
Making illegal dividends can make the company look insolvent. Negative balances on the balance sheet can affect the company’s ability to gain credit from a lender or suppliers and may breach current loan agreements – it may also provide HMRC with an excuse to start an enquiry.
While it is possible to make ‘illegal’ dividends the tax implications can be onerous for both the company and shareholder. Before making any dividend distribution it is important for directors to confirm there are sufficient distributable profits in the company accounts. Where any distributions have been made which exceed the company’s available distributable profits it may be worth seeking professional advice to see what can be done to mitigate any tax liabilities.