The Ups and Downs of Dividend Payments
Many directors of small companies pay themselves by way of a low salary, with the remainder by way of dividends. However, in 2020/21, due to Covid-19, this extraction policy of low salary, high dividend may be putting director-shareholders at risk.
It is important to ensure that dividend payments are correctly recorded and distributed. And thus, avoid the possibility of penalties or having to repay them.
Illegal Dividends
During the Covid-19 pandemic, with the likelihood of falling profits, it is important to get the dividend paperwork right. In the event that a business fails, the liquidators are likely to review the extraction policy. If the liquidator can show that dividends have been taken illegally, the director will likely have to repay the money to the company.
One section of the Companies Act 2006, that many sole directors are unlikely to be aware of, is s357. It states that a sole director should record all director decisions in writing. This means that every time an interim dividend is paid, there should also be a record made. This record must confirm that the director has considered the company’s financial position. It must acknowledge that there is sufficient profit and cash for a dividend payment to be made. The timing of making this record is important. It should be made when the dividends are declared and paid, not after the event to ‘catch up’ on the paperwork.
So, not only is it important to check that there is sufficient profit in the company. But also it is necessary to record the fact that this has been considered. Many accountants advocate quarterly rather than monthly dividends as a safer option. Paying monthly dividends without considering profit and keeping correct written records , may be deemed by HMRC to be salary payments made outside of PAYE.
Why accounting software can help
For a Husband and Wife business, where each owns 50%, the directors could be taking a monthly salary of £1,041.67. In which case, they would each utilise their full Personal Allowance of £12,500. With two directors, the annual employers NIC holiday of £4,000 ensures that no employers NIC is paid on their salaries. A lower salary of £732.33 per month would actually secure the same state pension and avoid any employee’s national insurance. However, the corporation tax relief on a salary of £12,500 rather than £8,788 is worth an extra £705. This exceeds their employee national insurance liability, so a full personal allowance salary is their chosen remuneration level.
It is not uncommon for one director to be the main client contact within the company. With the other working part-time to provide administrative support. The directors do not need to have formal employment contracts with the company. Therefore, the company will not be bound to pay the national minimum wage to either of them. One director could easily work in excess of 40 hours a week, whilst the other is working only part-time.
A part-time salary of £1041.67 should be justifiable given that this is for a director of the company. The directors are likely to have to meet to discuss such issues as key contracts or plan the direction of the company.
Using regularly updated accounting software, such as Xero, is the best method of checking that there is enough profit available to pay dividends. Each month, it’s possible to look at the previous months’ results and pay dividends based on what the business can afford. The directors must consider the monthly profit, the retained reserves in the Balance Sheet and, most importantly, the available cash. The dividends drawn are then posted to dividends in the Xero software.
The company’s accountants can draft pro forma minutes which the directors complete for each monthly dividend. These minutes are important as they record the decision to pay dividends based on available profit. They also demonstrate that the Directors are keeping the records required under the Companies Act 2006. Finally, a dividend voucher is prepared by the accountants at the end of the company’s accounts year. This is a record of the taxable income for each director/shareholder.
Their mix of salary and dividends is a sound method of tax efficient extraction and HMRC will have no grounds to challenge their extraction method.
What if the company doesn’t use accounting software?
Sadly, there are still companies who have no idea of their accounting profit until the accountants prepare the annual accounts, some time after the company’s accounts year-end.
This is less of a problem where the company has retained reserves of profit, which can cover the dividend draws. However, when a small limited company has only minimal retained reserves it is a ‘make and take company’. This means the directors pay out as much as the business can afford as soon as cash is available. In this scenario, how could the directors possibly ensure that their monthly dividends are “legal”?
There are basically two options. Post all dividend drawdowns to the director’s loan account. Or, alternatively, prepare monthly minutes which record specifically that the level of profit has been considered.
Where the monthly draws are put to the director’s loan account, when the numbers are available the accountants prepare paperwork for an interim (or final) dividend to clear the loan account. One problem with this is that there is only one dividend date. If the company year-end does not coincide with the tax year end it may lead to abnormally high dividends in a particular tax year.
Also, if the directors’ loan exceeds £10,000 during the tax year, there is a beneficial loan interest charge whilst the loan is outstanding. If the numbers were available each quarter, then the £10,000 balance is less likely to be exceeded. With accounting software in place, the loan account can be cleared quarterly rather than at the end of the year. So, for example, monthly draws of £3,000 cleared by a quarterly dividend of £9,000 would avoid a loan interest benefit.
It is always safer to prepare dividend minutes, specifically recording that the levels of profit have been considered at that date.. As an example, you could use the following sentence. “The directors have considered the levels of cash, debtors and creditors at this point in time and consider a dividend of £10,000 justifiable.”
It is not a good idea to prepare paperwork at the start of the year referencing future profits and dividends. For example: “Monthly dividends of £2,000 will be payable through the year where directors are satisfied that the profit levels justify such a dividend.” Not only is this practice more likely to lead to errors but it is more open to attack by HMRC.
What happens if dividends are illegal?
As already mentioned, director-shareholders often pay a low salary with the balance of remuneration in the form of dividends. Provided the company has sufficient distributable reserves, paying dividends is likely to be the cheaper option due to tax savings. However, the law requires that dividends are only paid if there is sufficient profit within the business. This is essentially to protect other businesses which have supplied goods or services to the company. Without this safeguard, director-shareholders would be able to pay dividends to themselves rather than paying the money owed to suppliers.
A recent tax case demonstrated that dividends paid illegally may have to be repaid to the company. Global Corporate Ltd v Hale [2018] EWCA Civ 2618 involved payments made to the director of Powerstation UK Limited. The case was originally heard in 2017, with the High Court considering two issues:
Firstly, whether the dividends paid to the director Mr Hale were unlawful. They had been paid in breach of s830 CA 2006 which states that distributions should be made from profits available. The court determined that Mr Hale knew this and was therefore liable to return the payments under s847.
Secondly, if the payments were not in fact dividends, whether the director had a right to be paid for the work he did for the company.
Due to the 2008 recession, Powerstation UK Ltd began to struggle financially, leading to a Creditors’ Voluntary Liquidation in 2015. Global Corporate Limited purchased various rights to action from the Liquidator. This included the right to bring a claim for “alleged illegal dividends and/or transactions at an undervalue” arising out of payments to Mr Hale.
Based on advice received from the company’s accountant, Mr Hale was paid a combination of salary and dividends. In addition to his nominal salary, he drew £1,383 per month as dividends, signing dividend tax forms each month. At each year end, the company’s accountant checked to see if there were sufficient distributable profits to support the dividends. And when there were not, the shortfall would be declared as PAYE earnings and additional payments made to HMRC. In its last trading year, there were no distributable reserves.
Provisional Dividends
Despite the director signing a form each month, the Court held that this was not sufficient. The Court held that the company’s Articles did not allow it to declare dividends without distributable profits. Mr Hale’s dividends were effectively provisional dividends, to be reviewed at the end of the year. This meant that the monthly payments in the final period of trading were never declared as dividends, and so the director could not be liable to repay them under s847 CA 2006.
Entitlement to be paid for work done
The High Court also held that Mr Hale was entitled to be paid for the work he had provided to Powerstation UK Ltd. The company would have been unjustly enriched if Mr Hale had not been paid the £1,383 a month in addition to his nominal salary. Also, this level of remuneration was not excessive in the circumstances. The remuneration was proportionate and fair and Mr Hale was entitled to payment on a quantum meruit basis.
At the time, many observers questioned whether this was the correct decision. In making ‘provisional’ dividend payments, the director was on to a win-win situation. If the company generated sufficient profit to allow dividends to be paid, the director pays less tax than had they been remunerated through PAYE. However, if profits are lacking, the director simply re-categorises the remuneration as salary. This whole system fails if taking these dividends makes the company unable to pay its creditors and the business fails.
Court of Appeal Decision
The Court of Appeal later overturned the High Court decision and declared that the dividend payments contravened s830. This made them illegal dividends that needed to be repaid to the liquidator. This decision makes it clear that dividends must be based on the latest set of accounts before declaring the dividend. Also, unless the company’s articles permit it, a dividend declaration cannot subsequently be retracted to allow a claim for remuneration on a quantum meruit basis.
So what does this mean for Owner-Managed businesses?
The important precedents in the above case are that reclassifying dividends to salary when a company is insolvent is unlawful. This means that the original dividends paid out will need to be repaid.
If a company does not have sufficient reserves to support dividend payments, it may be prudent to increase the salaries. While this is less tax efficient for the directors, it will avoid being liable for paying illegal dividends. This approach ensures that dividends (or a director’s loan) will not need to be repaid if the company becomes insolvent. Also, to avoid a claim for excessive remuneration, salaries paid to directors must be properly authorised by the shareholders. They must also reflect the work performed by the directors.
Dividend waivers
Dividend waivers may have a place during the Covid-19 pandemic. A dividend waiver could be applied whereby one or more shareholders give up their right to a dividend. This then enables dividends to be distributed to those shareholders who still need their dividends.
When implementing a waiver policy, certain procedures must be followed. A formal Deed of Waiver must be, signed by all shareholders who are exercising their rights to relinquish their dividend entitlement. The Deed is then retained by the company. The preparation of a Deed of Waiver is a “reserved legal activity” under the Legal Services Act. This means that only those who are members of the Bar or the Law Society (or who work for an employer who is authorised as such) are entitled to draw up such Deeds.
A dividend waiver should be for genuine commercial reasons and not lead by the desire to avoid or mitigate tax. Covid-19 could be a good reason as it would enable a family-owned business to keep reserves of profit and cash. For example, by not paying out to retired director-shareholders, whilst remunerating director-shareholders who are actively involved in generating profit.
Paying out less in dividends enables the company to retain funds to use for a specific or earmarked purpose. If a shareholder decides to waive their dividend, the specific purpose for retaining these funds must be recorded.
As with all legal records, timing is important. The Deed of Waiver must be in place before the right to receive a dividend arises. If the company is paying interim dividends, this is the day before the dividend is paid. For final dividends, this is the day before entitlement to the dividend arises (normally at the AGM). This is because at this point the shareholder has a legally enforceable right to the declared dividend.
What if the Dividend Waiver creates a “settlement”?
The tax office uses the settlements legislation (ITTOIA 2005) to attack what is referred to as ‘income shifting’ in family businesses.
The argument used by HMRC is as follows:
A planning scheme to divert income to a family member is a bounteous arrangement. This falls within the statutory definition of a settlement. Where a settlement is made by an individual and the persons benefitting from the settlement are his spouse and/or minor children, the income of the settlement is taxed on the settlor.
Therefore, where income is diverted to a spouse, by means other than the outright gift of an asset, it would effectively bounce-back and remain taxable on the settlor.
HMRC apply the same idea to dividend waivers where one spouse waives their rights to a dividend. Thereby enabling the company to pay a higher dividend to their spouse. The waiver represents a right to income rather than the gift of an asset. HMRC are only likely to attack dividend waivers under the settlements rules where the arrangement is “bounteous,”. The test is whether there would have been sufficient profits to pay dividends on all the shares, including those which are subject to the waiver. If there is insufficient profit, there is ‘bounty’, which brings the settlement rules into play.
The requirement to retain sufficient profit to cover the waived dividend relates to both the year the dividend is paid and the profits on a cumulative basis. This means that every time a waiver is used, it is necessary to calculate how much profit would be available if the dividends had been paid out and not waived by some shareholders. If not, the arrangement is bounteous and if the person benefiting from the arrangement is a spouse (or minor child) of the shareholder waiving the dividend, the benefit is bounced-back and taxed on the deemed settlor.
For this reason, although waivers are effective in tax planning, they require both legal documents and keen accounting to ensure that there is no future tax repercussion.
The company should not have a problem if:
- the waiver is commercially justifiable
- legally documented
- not excessive
- put in place in advance of the dividends being declared
Repetitive waivers should be avoided where possible. If dividend waivers are a tax planning arrangement which the company wishes to repeat, there is a more effective solution. This would be via the creation of ‘Alphabet’ shares.
Alphabet Shares
Alphabet shares are a way of creating ownership in the company whilst enabling the directors to declare dividends payable at different rates to different shareholders. So, all the shares carry the same statutory Rights. If there are 50 A shares owned by one director and 50 B shares owned by another, they each still own 50% of the company. Alphabet shares can be set up when the company is first formed. However, it is also possible to issue them during a company’s trading life.
How can I safeguard my income?
To safeguard income, the directors need to safeguard the company. By only paying dividends based on profit, the business is more likely to succeed and grow. Ensuring that it is not drained of cash will allow the company to continue to provide the director-shareholder with income.
Following the prescribed procedures for dividends and ensuring everything is correctly recorded will guard against attack by HMRC. Where profits are down, it is advisable to consider paying a higher salary in the short-term. This ensures that dividends cannot be classified as illegal and subject to repayment in the event that the business fails.
How can I ensure my dividend payments are legal?
By employing a chartered accountant, you will ensure that you are getting the best advice with regards to HMRC compliance. At Vital Statistics, we offer our clients a comprehensive accountancy and business advisory service. We will assess your business requirements and offer you the correct level of advice to guide you through all aspects of your company’s finances. We offer a free initial consultation, so if you feel you can benefit from our services, then get in contact.
Reference
Global Corporate Limited v Hale (2017) EWHC 2277 (Ch) / [2018] EWCA Civ 2618
