Learn legal aspects of dividend declaration
Dividends are a very common way to distribute profits of a business. They are declared by directors and paid out as per shareholding. Like any other aspect of running a limited company, they are regulated by law – the Companies Act 2006. Below, we explain what the main considerations are – if the regulations are not adhered to, a dividend might be deemed illegal and treated as a salary or a loan by HMRC, which carries tax implications.
Here are the main points covered in this article:
What is a dividend?
Are dividends tax-efficient?
The law surrounding dividends explained
Procedures to follow when declaring a dividend
What happens if dividends are not declared correctly?
What is a dividend
Dividends are paid to the company’s directors and shareholders as a reward for their investment. The sum comes from current profits or retained earnings and it is most often paid in cash, but can take any other form such as shares, stock or other property. There are no set rules as to when or how often dividends are paid. Usually, it is done once a year, but some companies choose to declare dividends more often, for instance quarterly. If there are no available profits or the company chooses to expand and invest in growth, it is not obliged to pay out any dividends at all.
Are dividends tax-efficient
Dividends are not deductible for corporation tax purposes – technically, they are not expenses, they are profit distributions. The profit available to pay out as a dividend is the figure after tax. In short – declaring dividends will not reduce tax liability of the company.
However, dividends have a lot of advantages for individuals – a separate divided allowance of £2,000 means that the first £2,000 of dividend income is tax-free, regardless of income from any other sources. They are also taxed at much lower rates – dividend income for basic rate taxpayers is taxable at 7.5% as opposed to 20%, which is the standard rate. If you fall into the higher tax band, your dividend income is taxed at 32.5% (as opposed to 40%) and additional rate taxpayers pay 38.1% tax on dividends compared to 45% payable on any other income.
If you run your own company, you have a choice of ways to withdraw profits and utilising them wisely will result in great tax-savings. To find out more on how to pay yourself tax-efficiently as a business owner, have a read of this article or contact us for a personalised advice.
The law surrounding dividends explained.
The company must have available profits or reserves and dividends declared cannot exceed these or else they might be deemed unlawful. For instance, if the company has £10,000 in a bank, but its reserves (retained earnings and current profits) are only £5,000, they can only declare £5,000 as a distribution. The fact that there is more held in bank is irrelevant as part of this sum might not belong to the company, it could come from a loan or other arrangement. The company must not distribute resources that it does not own. It is a legal responsibility of directors to ensure the correct dividend amount has been declared. They must prevent a situation when the business cannot pay creditors because its wealth has been distributed to shareholders.
If appropriate documentation is not kept, this could also prompt HMRC to deem dividends as illegal.
Illegal dividends are called “ultra vires”, meaning “beyond the powers” – the directors don’t have the power to authorise such distribution.
Procedures to follow when declaring a dividend.
As mentioned in the previous paragraph – certain procedures have to be followed when declaring dividends, otherwise there is a risk of them being deemed “illegal”.
Firstly, directors need to make sure they have well-maintained records to refer to – it could either be management accounts (most common in case of interim dividends) or statutory accounts (for final dividend declaration). Keeping accurate and up-to-date records is important to avoid illegal distribution. The financial statements should be produced soon after the end of the period they cover so that the dividends can be declared based on recent information. Old data cannot be relied upon as it does not reflect financial position of the business and its ability to pay declared dividend amount at the date of the issue.
Secondly, a board meeting needs to be held during which the directors propose dividends. The board meeting minutes must be produced, even if you are a sole director-shareholder. They must record the date, location, names of directors present, number of dividends per share and value payable per dividend. The document should be signed by a director.
Depending on the Articles of Association adopted by the company, directors might have the authority to approve final dividends. However, if that power is not granted in company’s constitutional documents, final dividends are approved by the shareholders at the general meeting. In this case, meeting minutes have to be produced as well.
Thirdly, shareholders need to be issued with dividend vouchers. They have to show date, company details, shareholder’s name and amount of dividend payable.
Sounds complicated or daunting? Contact us – we can help you produce accurate and timely statements, determine dividends to declare as well as assist with the paperwork.
What happens if dividends are not declared correctly?
If the matter is picked up by HMRC, they might argue the payment was not a dividend and reclassify all or part of it as a salary. That would give rise to additional tax and NIC becoming payable as well as attract late payment interest.
A further complication arises if a company becomes insolvent. It is directors’ duty to act in a responsible and proper manner and the assumption is made that they know, or should know the financial position of the business and therefore are fully liable for unlawful dividend distribution. If the shareholder who received illegal dividend does not pay it back, the directors will be personally pursued to repay the debt.
If the illegal dividends have been paid, directors can try to minimise the risk by adding a note to the dividend stating that shareholder has received an illegal dividend and that steps are being taken to recover the money. A further explanation can be added that no distributions will be made until profits are available.
There is a lot to running your own company and most of the business owners seek professional help. As a client of ours, you will get unlimited support and guidance at every stage of your journey. We can take care of your statutory obligation as well as help with management side of things – produce accurate and timely reporting and offer advice to enable you to make educated decisions and run your business in an efficient and compliant way.