It is increasingly common, particularly in owner managed companies, for the director/shareholders to take remuneration by way of a modest salary, topped up by dividends. Such a practice helps to minimise the overall tax position on the remuneration paid whilst at the same time optimising the rewards for the director’s endeavors.
As long as the correct paperwork is prepared, the payment of dividends in this way is a perfectly acceptable strategy in terms of tax legislation. Certainly we have used it as a non-contentious tax planning measure for clients for many years.
For some, the approach may be relatively new, having only recently become ‘limited’ and thus being able to take advantage of this tax efficient remuneration practice. For others it may have become the norm for a number of years.
This is perhaps where some concern may arise, as there is a very real risk with businesses showing a decline in profitability that the dividend payments may now fall foul of the Companies Act. The main reason being that whilst there may be cash in the business to make the dividend payments the profit and loss account shows insufficient levels of profit, or distributable reserves, for such payments to be made.
There is sometimes a general presumption that dividends may be paid out of any cash that happens to be in the bank account at the time. But it’s not really as simple as that. The basic principles are to be found in the Companies Act 2006. In general, a private company can distribute the whole of its accumulated realised profits less its accumulated realised losses. As well as the statutory matters, account must also be taken of any provisions in the company’s Memorandum or Articles restricting dividends.
It is a fundamental rule of law that dividends may not be paid out of capital. So, for example, a dividend based on accounts which show available profits would be ultra vires if made after subsequent losses have eliminated those profits. Directors who make an unlawful or imprudent dividend may be held personally liable to account for it to the company.
The Companies Act makes shareholders liable to repay a distribution if, at the time of the distribution, they knew, or had reasonable grounds for believing, it to be illegal.
The message here is that before declaring a dividend the directors must be as certain as they can be that there are sufficient distributable reserves available, including taking into account any corporation tax on profits earned since the last annual accounts were prepared.
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