Family Companies
When is a Dividend Not a Dividend?
ANDREW HUBBARD looks at the pitfalls for small companies making dividend payments to director-shareholders.
Family Companies
When is a Dividend Not a Dividend?
ANDREW HUBBARD looks at the pitfalls for small companies making dividend payments to director-shareholders.
No, your editor has not started a 'Jokes and Riddles' page in Taxation (after all, who could compete with the draftsman of FA 2003, Sch 22 when it comes to posing impenetrable riddles?) Instead he has asked me to write something about the practical problems associated with dividend payments in private companies.
Years ago, when I first started to advise on taxation, dividends in private companies were rare, because of the very high income tax rates which they triggered. Indeed there was legislation on the statute book ('what's an apportionment, Granddad?') to force companies to pay dividends. Now of course we are at the opposite extreme. The non-corporate distribution rate is designed to penalise (or should it be punish?) small companies that pay dividends. But, despite the latest developments in the s 660A saga, particularly the decision in Jones v Garnett, dividends still remain an attractive way of extracting profit from a family company. It is therefore no bad thing to remind readers of some of the basic issues surrounding private company dividends.
Corporate law
Of course any company law text-book will have a large section devoted to dividends. It will give a theoretical analysis of the nature of profits and of distributions; of the differing responsibilities of directors and shareholders in respect of dividends and of the differences between interim and final dividends. Such books stress the very clear distinction between the earning of those profits and, once they have been earned, the distribution of those profits to shareholders.
This is all well and good, and clearly the adviser dealing with large corporate clients needs to have a full grasp of the finer points. However, there is a huge gulf between the elaborate theoretical structure of corporate governance and what actually happens on the ground in practice in private companies. This was brought home to me at a lecture once when I was asked the question: 'is it enough to put the word dividend on the cheque book?' (I leave it to you to imagine what my answer was.)
Different function
The issue here is not simply the greater sophistication of the corporate world: it is that dividends in private companies have, in reality, a very different function to that envisaged by company law. Although a private company dividend is, in theory, a distribution of profit, in reality it is often no more than a means of 'remunerating' the owner of the family company in a tax-efficient manner. I put 'remunerating' in quotes, because clearly these dividends are not remuneration: it is just that they often look and feel like it! How often have we heard clients saying that they are 'paying themselves' in dividends? Advisers to family companies therefore have to shoehorn payments (to use a neutral word) to director-shareholders into the framework of dividends, using company law that was not really designed for that purpose.
The problem is essentially this: company law is based on the proposition that profits will be earned and then distributed, but in the sort of companies we are dealing with profits are distributed as they are being earned. Company law does of course recognise the possibility of interim dividends, but treats these as a special case: in our companies interim dividends are the norm and final dividends are the exception.
Put to the test
It is my personal view that if each and every dividend paid by a small family company was tested to the ultimate degree through the courts a very significant proportion of the total would be found to be defective in some way, either in terms of legal effectiveness or at least in terms of their timing. For the benefit of any Inspectors of Taxes reading this, I should stress that this is not a problem for my clients (says he, taking a deep breath and hoping for the best)!
Of course in the real world not everything will be tested to the nth degree, and probably most cases will be close enough to be accepted. But in situations where the client is pushing things to the limit — say not paying any remuneration at all or exploiting the timing of dividends to fall outside the income tax payments on account rules — there will often be a real risk that what is done is wide open to challenge.
Interim v final
We need to recognise the difference between interim and final dividends. A final dividend is approved by the shareholders at an AGM: an interim dividend is the responsibility of the directors. In most cases we will be dealing with interim dividends, and therefore we will concentrate on these for the moment.
In the first place we must ask ourselves whether the company's articles actually permit the directors to declare a dividend. If the directors do not have this specific power, dividends can only be declared by an ordinary resolution at a general meeting. The lack of such an express power would be unusual, but it is worth checking the point, particularly with older companies. Generally speaking, however, most up to date company articles will allow directors to declare dividends from time to time (for example Companies Regulations 1985, Table A Article 103).
Legal dividend
Having checked off this point, and established that the directors can actually declare a dividend, we have to consider what they need to do to ensure that they declare a legal dividend. It is worth stressing again here that dividends can only be paid out of distributable profits. Directors declaring an interim dividend therefore have a responsibility to ensure that there are actually profits available for distribution out of which the dividend can be paid. In a public company there are onerous requirements setting out the format of the accounts which have to be prepared in order to support an interim distribution. There is no such requirement for private companies, but this does not mean that there is a free-for-all. The directors still have a responsibility to ensure that there are profits available for distribution. There is no absolute standard of information set down for this, but directors are required to make a reasonable judgment of the position before they pay an interim dividend.
Asking the question
How often does this actually happen? What evidence can the directors actually produce, if they were asked the question, to show that they did take account of the availability of distributable profits before they declared the dividend? In a company whose last set of accounts disclosed significant accumulated profits this should not be a problem, but many companies are extracting profit by way of dividend as they go along. How can the directors truly say that they have considered the issue if they don't know their reserves position?
It is a counsel of perfection to suggest that directors should prepare interim accounts and hold a board meeting every time that they want to declare an interim dividend, but it is my view that they should at least make some attempt to acknowledge the importance of the issue. If the company is one where the cash in hand is broadly equal to profit, a reference to the current cash balance would probably be enough. In cases where profits are volatile, there ought to be some attempt to determine the level of profits.
Perhaps at a minimum the directors should be encouraged to sign a document along the lines of 'the directors considered the availability of distributable profits. The company had profits available for distribution at the last accounting reference date and in the opinion of the directors continues to trade profitably'. This might not get the directors all the way should the issue go before the House of Lords, but it is a lot better than doing nothing.
Early years
There are particular problems in the early years of a business, where there is no history of reserves to fall back on and where the profit position is often far from clear. In my view, in strict law it is probably almost impossible for the directors to meet the requirements for the payment of an interim dividend before the first set of accounts has been prepared, but this will not, of course, stop them trying! If your small company clients do want to start off with a policy of paying dividends, it may be fruitless to try to persuade them to wait until the accounts are prepared, but do at least try to ensure that they don't become too greedy too early.
Of course the problem is that the small companies who are most at risk of not paying proper attention to the practicalities of dividend payment are the very companies who are least likely to be prepared to pay the fees to enable an accountant or tax adviser to ensure that things are done properly. It would be easy to take the high ground and say that these companies should therefore be steered away from dividends, but this is unrealistic: dividends are now very much part of the family company armoury and clients will probably take their business elsewhere if you make life too difficult for them. In practice all one can do is to alert companies to the problem and to try to get them to make some attempt to go through a paperwork routine every time a dividend is paid.
Date of payment
The next issue is determining the date on which the dividend is paid. Here again there is an important distinction between final and interim dividends. A final dividend is due and payable at the date on which the resolution declaring the dividend is passed in a general meeting. This is modified if the resolution gives a later date for the payment of the dividend. In the case of an interim dividend, however, there is no such mechanism. Interim dividends are not due and payable until they are actually paid — the date of any resolution is not relevant.
Where an interim dividend is paid in cash, there is no problem in identifying the date. Often, however, a dividend is credited to a director's loan account. There is no doubt that crediting to a loan account does constitute payment, but identifying the precise point of payment can be far more difficult. Because the date of the dividend is the date of payment it follows that there cannot be any possibility of retrospection. In other words the date on which the dividend is actually charged to the loan account is the date of payment. Where the directors themselves maintain a record of the loan account this should not be too much of a problem, but where, as will usually be the case, the company's adviser writes up the books, the date of crediting to the loan account will be the date on which the books are written up and the relevant entries are posted to the loan account.
Of course this bites in two different directions. It may well be that the true date of a dividend is in a later tax year than was supposed, in which case there will be a delay in the payment date of any higher-rate tax. But if the purpose of declaring the dividend was to clear an overdrawn loan account, then that loan account will remain overdrawn for longer, with all of the consequences that follow.
Failed dividends
Finally, in what can only be a brief discussion of what is in fact a very complex area, we need to discuss the consequences of getting things wrong. To come back to my opening riddle: 'when is a dividend not a dividend?' — the answer must be 'when it is simply a transfer of money from the company to a shareholder' — in other words a loan! And readers of Taxation over the last few weeks will know exactly what unpleasant consequences can flow from this.
In the real world it is unlikely that the Revenue will examine each and every dividend in depth. There is, however, no doubt that in those enquiry cases where an analysis of a director's loan account is asked for, the Inspector may well look in detail at whether or not what purports to be a dividend was actually lawfully paid. By that time the damage might already be done. All of a sudden your client will come back at you: 'you told me that it was tax efficient to pay dividends — how come it has ended up costing me extra money!' You might suddenly have sympathy for the Chancellor's attempt to dissuade small companies from paying dividends. And that is something that you never thought that you would find yourself saying.
Andrew Hubbard is Director of Taxation, Tenon Group plc, and President of the ATT.
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