Dividend needn’t be ‘unlawful’

August 11th 2022

A set of draft company accounts have been prepared and they show that the director shareholders received “unlawful dividends”. What are the tax consequences of this and how can they best be managed? Jane McWilliam provides advice.

The last couple of years have been tough with many businesses having had significant contractions in profits compared to normal years. The impact of this is now becoming more apparent as companies prepare their annual accounts. The lower profits are bad enough but some director shareholders who take most of their income as dividends face an additional problem.

Before a company can pay a dividend, it must have profits available. If dividends paid exceed a company’s profits (current plus brought forward), they are deemed unlawful. But that is not to say that company law does not permit them.

A shareholder who receives an unlawful dividend must repay it, or the part of it which is not covered by profits. In other words, it’s a de facto loan. This rule does not apply to dividends paid to shareholders (typically minority shareholders) who aren’t privy to the dividend approval process and could not reasonably be expected to know if the company had sufficient profits. Instead, they are taxable on the dividend as if it were not unlawful. This let out doesn’t apply to shareholders who are directors as they are always able to know or find out the company’s profit situation.

In the past, HMRC often argued that rather than unlawful dividends being a loan they were earnings (in effect salary). These days it accepts that unlawful dividends create a loan.

By maintaining the proper paperwork for dividends you’ll also leave little or no room for HMRC to argue that an unlawful dividend can be treated as salary.

Once the total amount of dividends paid unlawfully has been worked out it must be attributed to each shareholder in proportion to their shareholding and recorded as a loan to them in the company’s records. Naturally, they must repay the loan, although there is no deadline for this.

If a shareholder doesn’t repay their loan within nine months following the end of the company’s accounting period in which the dividends were paid, the company is “close” (controlled by five or fewer individuals) and the shareholder has a “controlling interest” in it (that is, they own or control 5% or more of the company’s ordinary share capital), it must pay tax equal to 33.75% of the loan that hasn’t been repaid.
If the shareholder owes the company more than £10,000 (taking account other amounts they already owe), a tax charge based on the benefit in kind rules applies. As the taxable amount is only 2% of the debt this charge is usually not significant. A more tax and financially efficient solution which broadly achieves the same result as if the dividend had not been unlawful, is for the company to waive the loan.

Dividends paid more than a company’s profits count as a loan to the shareholder, the result of which can be additional tax charges. However, these can be avoided by the company waiving the loan resulting from the “unlawful dividend”.

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