Profits made by a limited company are distributed to shareholders through the declaration of dividends. Quite often, for example in the case of SME businesses, the directors and shareholders of the company are one and the same. In such businesses, directors might take a minimum salary and pay the rest of their remuneration by way of dividend. For some time, this has been a tax-efficient means for directors to be remunerated.

However, before a company is able to pay a dividend, two main criteria must be met:

  1. The company must have profits available in order to make the dividend. This often is referred to the company having sufficient distributable reserves available; and
  2. Any dividend that is paid must be made with reference to the company’s relevant accounts. They may be the company’s annual accounts or specifically prepared interim or initial accounts. The accounts relied on, however, must show the company’s assets and liabilities, its share capital and include provisions for any future liabilities, such as corporation tax.

If the two main criteria are met, the company then needs to comply with certain formalities before the dividend is paid, including:

  1. The directors must pass a resolution before paying the dividend;
  2. Final dividends are normally approved by shareholders following a recommendation from the board, while interim dividends are normally determined by the board; and
  3. The shareholder must be given a dividend voucher by the company for tax purposes.

If companies fail to comply with the above requirements, the dividend will be unlawful.

Sometimes unlawful dividends are paid to shareholders when the directors miscalculate what available profits the company may have. This could be due to a mixture of poor record keeping and inaccurate accounts. Dividends may also be paid when the company is insolvent or it may become insolvent as a result of that payment.

In the event of the company’s insolvency, recovery claims inevitably will be brought by the insolvency officeholder against the shareholders and the directors.

Liability of shareholders

Section 847 Companies Act 2006 provides that if a shareholder knows, or has reasonable grounds to know, that a dividend they have received has been made in breach of the criteria set out above, then they are liable to repay it.

A shareholder will struggle to demonstrate they didn’t have the requisite knowledge if they are also a director of the company.

Furthermore, if the dividend is not repaid, there is a risk HMRC may consider that the dividend constituted “salary”, resulting in additional claims by HMRC for unpaid income tax and national insurance.

Liability of directors

If a director authorises a dividend to be paid when the company has insufficient profits available, the director is likely to have acted in breach of their statutory duties under the Companies Act 2006 (for example, failing to promote the success of the company for its shareholders). They may also be guilty of misfeasance under Section 212 Insolvency Act 1986.

A director is therefore at risk of a claim for damages and/or to repay or restore the funds amounting to the losses they caused to the company, plus interest, as a result of the dividend payment.

A director may also find themselves subject to disqualification proceedings by the Secretary of State.

It is therefore important that if a director believes or has reasonable grounds to know that their company does not have sufficient available profits, that no dividend is paid.

Reclassifying dividends

Some companies have paid dividends to their shareholders but then seek to reclassify them as a salary at the end of their financial year when the directors realise subsequently that the company had insufficient profits available at the time when the dividends were paid. This exercise normally takes place when the year-end accounts are prepared by the company’s accountants.

However, the recent Court of Appeal case of Global Corporate v Hale [2018] EWCA Civ 2618 has confirmed that the company must have sufficient profits available to make the dividend at the time it is paid. A liability to repay the unlawful dividend is not absolved if a subsequent decision is made to reclassify the dividend as salary at a later date, if transpires that there were insufficient profits at the time the dividend was declared.