How does a business return profit to its owners? The usual way, if the business is incorporated as a company, is by paying dividends to the shareholders.

Also referred to as ‘distributions’, dividends are so called because the amount to be paid is divided among the company’s shareholders according to the number of shares held.

This article outlines some points to consider when payment of a dividend to shareholders in a private company is proposed (additional considerations apply to public and listed companies).

Distributable profits

To protect the interests of creditors, a company may pay dividends only from profits available for the purpose, known as ‘distributable reserves’. The definition of distributable reserves is technical, and the directors should ask the company’s accountants to advise on the distributable reserves available when a dividend is being considered. The accountants should also be asked to advise on tax aspects of a proposed dividend.

A distinction is made between final and interim dividends.

Final dividends

Final dividends are paid once a year, with reference to the company’s annual accounts.

A company’s articles of association typically provide that the directors may make a recommendation as to the amount of any final dividend, which is then approved (or ‘declared’) by the shareholders.

The shareholders may approve the directors’ recommendation by passing a written resolution or at a general meeting. They may decide that a lower dividend should be paid, but they cannot declare a dividend that is higher than the amount recommended by the directors.

Once a dividend has been declared by the shareholders, the company is obliged to pay it, either immediately or (if the shareholders’ resolution so provides) on a future date as stated in the resolution.

Interim dividends

Interim dividends may be paid at any time and are usually decided solely by the directors, without the need for shareholder approval.

The directors should make their decision with reference to properly prepared interim accounts. The accounts referred to when deciding to pay an interim dividend should be filed at Companies House.

Unlike a final dividend, the company is not obliged to pay an interim dividend (unless, unusually, the interim dividend has been declared by the shareholders). The board can change its decision to pay an interim dividend at any time until the dividend is actually paid.

Amount of dividend

If a company has shares of more than one class (for example, ordinary shares and preference shares), the classes may have different rights to participate in dividends.

Otherwise, all shares will rank equally, and shareholders will be entitled to participate in any dividend according to the number of shares held when the dividend is declared. It is often a requirement that the shares in question are fully paid.

Method of payment

This too is a matter for the company’s articles, which may provide that dividends may be made by bank transfer, by cheque, or by such other means as may be agreed with the shareholder in question.

Directors’ duties

When deciding whether to recommend a dividend, the directors should have regard to their duties to promote the success of the company, to exercise reasonable care, skill and diligence, and to safeguard the company’s assets.

As already mentioned, it is essential that the company has sufficient distributable profits available to pay the dividend proposed. Distributions out of capital are unlawful, and a director who authorises payment of a dividend in excess of the company’s distributable profits may be personally liable to repay the company.

As well as reviewing the accounts, directors should have regard to any events that have taken place since the accounts were prepared and to the company’s future financial needs. The directors may be liable if they resolve to pay a dividend that is imprudent in the light of the company’s cash flow requirements. They may also be liable if a dividend is paid when the company is insolvent.

Other payments to shareholders

Finally, it should be noted that other payments made to shareholders, such as gifts, or transactions at an undervalue, while not formally declared as dividends, are nevertheless classed as distributions. These too may only be made from distributable profits, and in considering any such payments the directors should have regard to their duty to promote the success of the company for the benefit of its members as a whole.

Key points for directors

When considering payment of dividends, directors should ensure that they take proper advice from the company’s accountants and that they follow the applicable provisions of the company’s articles.