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Busy Practitioner by Mark McLaughlin CTA (Fellow) ATT TEP

Mark McLaughlin CTA (Fellow) ATT TEP, General Editor of TaxationWeb, considers lawful and unlawful dividends and their tax consequences.For many private company owners, extracting income by dividends rather than salary or bonus will often be more tax-efficient. However, before dividends can be considered as a strategy for extracting profits from the family trading company, the Companies Act requirements for lawful dividends must be addressed. Failure to address those requirements could result in the dividends breaching company law. This can also give rise to some unfortunate tax consequences.

Lawful and unlawful dividends

Lawful dividends are broadly those that comply with Company law requirements. Company law issues relating to family company dividends include checking whether the company’s Articles of Association permit directors to declare dividends. In addition, it is necessary for the company to have sufficient distributable profits for dividends to be paid. Profits available for distribution are identified by reference to ‘relevant’ accounts (Companies Act 1985, s 270). These will normally be the company’s last annual accounts (s 271), except where the last accounts show insufficient reserves to legally declare the dividend. ‘Interim accounts’ (s 272) or ‘initial accounts’ (s 273) may be required in those situations.

Initial accounts may be appropriate for new companies intending to pay an interim dividend in the first accounting period, to enable a reasonable judgement to be made in determining amounts available for distribution (i.e. by reference to profits, losses, assets, liabilities, provisions, and share capital and reserves). Properly prepared, up-to-date management accounts may therefore be necessary if dividends are to be paid in the first accounting period. If the directors have properly followed the Companies Act requirements for distributions, the dividend payments will be lawful, even if the annual accounts subsequently show insufficient distributable profits.

An ‘innocent’ shareholder in receipt of an unlawful dividend is not generally required to repay it. However, company law requires a shareholder to repay the dividend if he knows or has reasonable grounds to believe that the dividend was unlawful (Companies Act 1985, s 277(1)). The time limit for recovery of dividends from the shareholder is generally six years from the date of declaration or its declared payment date, whichever is later (Limitation Act 1980, s 5).

In family or owner-managed companies, problems often arise if interim dividends are paid during the accounting period. When the company’s annual accounts are prepared, it may transpire that the company had insufficient distributable reserves to cover the dividend. It could be argued that the director shareholder knew, or had reasonable grounds to believe, that the dividend was unlawful. In HMRC’s view CA 1985, s 277 will apply ‘in the majority of such cases’ (CTM 20095, para 28).

It’s a Wrap

In It’s a Wrap (UK) Ltd v Gula and another [2006] EWCA Civ 544, a company’s claim under CA 1985, s 277(1) against director shareholders in respect of dividends paid to them was successful. The company made trading losses in its 2001 and 2002 accounting periods. However, dividends were paid in respect of those years. The company went into liquidation in 2004, and the company (through its liquidator) brought proceedings against the director shareholders for the dividends to be repaid.

The Court interpreted CA 1985, s 277(1) to mean that the shareholder was unable to claim that he was not liable to repay a dividend because he was unaware of the Companies Act restriction. He was liable if he knew or ought reasonably to have known of the facts which meant that the dividend payments resulted in the Companies Act being contravened, whether or not he knew of the statutory restriction. This decision affirms the general principle that a person is deemed to know the law, so that ignorance of it is no excuse. It also acts as a warning to director shareholders of owner managed businesses in particular to ensure that when dividends are paid the appropriate steps have been taken to confirm that the company has sufficient distributable reserves.

The view expressed by HMRC is that director shareholders of private companies should normally be aware (or have reasonable grounds to believe) if a dividend is unlawful. Their guidance on unlawful dividends in the Company Taxation Manual indicates that those dividends would be void, and that the director shareholder would normally be treated as holding the funds as constructive trustee for the company (CTM 20095, para 29). Their approach follows the decision in Precision Dippings Ltd v Precision Dippings (Marketing) Ltd & Others [1986] Ch 447. In that case, Precision Dippings paid a £60,000 cash dividend to its parent company PDM, without being aware that the payment contravened company law. Both companies had the same directors. The company later became insolvent, and was liquidated. The company’s liquidator sought an order for the dividend to be recovered from PDM. The Court ruled that the dividend payment was ultra vires and was therefore recoverable.

Tax consequences

There are a number of potential tax implications of unlawful dividends in such circumstances. For income tax purposes, the dividend is treated as void, and the shareholder is not treated as having received a distribution. In the case of a close company, HMRC would probably argue that the dividend represents a loan to a participator, on which the company is liable to a 25% charge under TA 1988, s 419. However, relief is available (under s 419(4)) if the dividend is subsequently repaid.

Alternatively, if the shareholder was unaware and had no reasonable grounds to believe that the dividend was unlawful, the dividend should be treated as a distribution for income tax purposes, and the shareholder will not be treated as a constructive trustee.

Problems can also arise if dividends are not properly declared or paid. In many small private companies, there is often some confusion over whether a dividend is interim or final, and when dividends are actually ‘paid’. Final dividends are normally treated as paid on the date of the resolution approving the dividend, unless a future payment date is specified. It should therefore be relatively straightforward to ascertain the date of payment. However, in the case of interim dividends being credited to a director’s loan account, HMRC consider that payment is not made until an entry is made in the company’s books. The Company Taxation Manual (CTM 20095, paragraph 8) states:

‘A dividend is not paid and there is no distribution, unless and until the shareholder receives money or the distribution is otherwise unreservedly put at their disposal, perhaps by being credited to a loan account on which the shareholder has the power to draw.’

This crediting often takes place in a later accounting period than the directors’ resolution to pay the interim dividend, such as when the company’s year end accounts are prepared. A practical planning point is therefore to ensure physical payment of dividends to shareholders immediately after their declaration (e.g. by cheque), followed by the re-introduction of those funds to the company with a corresponding credit to the loan account.

Mark McLaughlin CTA (Fellow) ATT TEP
July 2006

The above article is taken from ‘Busy Practitioner’, a monthly journal from Tottel Publishing. To order a subscription to ‘Busy Practitioner’, click here