How you can help director-shareholders of owner managed companies avoid some common dividend pitfalls
Companies Act 2006 requires that amounts available for distribution are restricted to the amount of distributable reserves available at the point of dividend declaration.
It is unfortunately not uncommon for director-shareholders of owner-managed companies to be unaware of or disregard this fact and declare dividends in excess of distributable reserves. This usually happens when amounts are drawn before financial accounts are prepared and subsequently a sufficient retained earnings balance does not materialise.
One way to prevent this would be to maintain current and complete bookkeeping records throughout the year where management accounts could be prepared to assess the likely amount of distributable reserves. This would be particularly relevant if there is an intention to pay interim dividends.
In most circumstances declaring excessive dividends will be seen as incompetence rather than a genuine error, with consequences for director-shareholders to match this classification.
If, at the time of the distribution, the shareholder knows or should have reasonable grounds to believe that the distribution was being made in contravention of section 847 of the Act, they are liable to repay the balance drawn.
In It’s a Wrap (UK) Ltd v Gula [2006] EWCA Civ 544, unlawful dividends paid to members as ‘quasi-salaries’ (on the advice of their accountant to save tax!) were found on appeal to be repayable by the shareholders. Although shareholders were unaware of their unlawfulness, it was held that a shareholder was liable to return a distribution if they knew or should have been aware that it had been paid in circumstances which amounted to a contravention of the restrictions on distributions (irrespective of whether or not they knew of those restrictions).
Directors may become personally liable if they authorise an unlawful distribution which cannot be recovered. The repayment should be made as soon as the error is discovered, and not only in the event of liquidation. If the error is not corrected, the director may be held liable for any unlawful distributions due to a breach of their fiduciary and statutory duties relating to the protection of company’s assets.
The same principles apply to distributions in specie (except for in winding up) applying to the carrying values of assets, although in this case section 846 permits the revaluation gains to be included as distributable in determining the balance of relevant reserves. For more information about distributions in specie, see In Practice newsletter article in August 2018.
In the accounts of private companies in the notes or directors’ report, the directors should include references to the fact that distributions exceeded the value of distributable reserves and include an explanation of why the event occurred. This should be done irrespective of the accounting standards applied, including FRS 105.
Example 1
'The directors acknowledge unlawful dividends were declared and paid. No further distributions have been made and the directors are seeking to recover monies from the shareholders.’
Example 2
'At the time the dividend was paid the directors were not aware that there were insufficient profits available for distribution and the directors acknowledge that no further distributions can be made until there are sufficient profits available for that purpose.’
If and when the director becomes liable to return funds to the company this should be accounted for by debiting cash or DLA and crediting reserves, although until the amount is actually repaid it will not constitute distributable reserves. Minutes should be prepared and maintained on file to document the repayment.
The amount due back to the company will constitute a loan unless a salary is agreed.
Tax implication of unlawful dividends related to those of loans to participators of a close company or employment income. Section 455 tax will be due on any overdrawn balance not repaid within nine months of the year end, or PAYE and NIC will arise if the amount constitutes salary, with RTI reporting required as usual in a timely manner.
If as a result of the individual not consenting to the correction, there is a loss of tax due to HMRC (s455, PAYE) it will be necessary to consider making a suspicious activity report with the NCA, with usual considerations relating to a potential resignation from the engagement, whilst avoiding tipping off the client.