Readers' forum - Paying a dividend

10 November 2005

Issue: 4033 / Categories:

Our client, TH Limited, has £250,000 of carried forward losses. The company has been revitalised and is heading for a profit this year, which we estimate at £50,000. Past losses can of course be set against this so that there is no corporation tax to pay.
The owners could of course draw salaries, but they would prefer to take at least part of their remuneration as dividends. At the end of the year, the profit and loss account will show a net cumulative loss of £200,000 and thus there will be no distributable profits available to pay a dividend. Is there a way around this problem?

Reply by Thicket:

The legislation covering dividends is to be found in Companies Act 1985, Pt VIII and, in particular,
s 263 which makes it clear that one of the requirements for a legally declared dividend is that it can only be declared out of distributable reserves available for the purpose. A company's profits available for distribution are 'its accumulated realised profits so far as not previously used for distribution or capitalised, less its accumulated realised losses so far as not previously written off in a reduction or reorganisation of capital duly made'.
Aster states that his client company will have net cumulative losses of £200,000 on profit and loss account, and asks what can be done. The following suggestions come to mind.
First, are there any unrealised profits which might be turned into a realised profit? An example might be freehold property standing at a profit which might be sold and leased back.
Secondly, a possible alternative is suggested by the definition above. This is to effect a capital reduction of the existing shares. This is likely to be an expensive exercise requiring court approval, and may not be either possible or practical.
These suggestions will not be appropriate if the dividend has already been paid. If so, then the consequences of paying an illegal dividend will have to be accepted. Technically, the remedy available to the company is to seek repayment from the shareholders. In the case of a private company, and providing creditors are paid on time, it is unlikely that anyone will demand repayment. An exception will be if the company becomes insolvent, in which case the liquidator will take action to recover funds on behalf of the creditors.
HMRC may seek to tax the recipients on the amounts received as employment income and seek PAYE and Class 1 NICs, but in most cases this can be resisted. There should be evidence that the payment has been made as a dividend with appropriate minutes; minutes of a directors' meeting for an interim dividend, and directors and a shareholders' meeting for a final dividend. There should also be dividend vouchers. Providing the payment is clearly made to shareholders in their capacity as such, rather than as an award for employment services, any argument that PAYE is due should be resisted.
The better interpretation is that the company will have made a loan to participators. Tax under TA 1988, s 419 will be due from the company at 25% of the loan that remains outstanding more than nine months following the year end. The participators will also be liable to a benefit in kind to the extent that interest charged is less than the official rate, currently 5% p.a. If the company forgives the loan, TA 1988, s 421 treats the recipient as receiving a dividend that is taxed under Schedule F. Thus, a higher-rate taxpayer will be taxed at an effective rate of 25% of the amount written off. It is likely that HMRC will seek to collect Class 1 NICs on this as a 'profit whatsoever' deriving from employment.

Reply by Distributor:

The answer to your question, I think, is simply 'no'. Whether a company has the ability to pay a dividend is not a tax matter, it is rather the application of company law based on the particular facts and the tax consequences flow from that. If a company does not have sufficient distributable reserves and the directors make a distribution, the distribution will be an unlawful distribution.
Companies Act 1985, s 277 provides that a recipient member who knows or has reasonable grounds to believe that a distribution or part of it is unlawful is liable to repay it or that part of it to the company.
The shareholders would knowingly be receiving an unlawful dividend from TH Limited if it were to pay one, as they would know that the company has insufficient distributable reserves at the time such a payment is made.
If such a payment is made, HMRC would seek to treat the payment as a 'loan to participators' if the company is a close company; i.e. one under the control of five or fewer participators. HMRC confirm this treatment in their Company Tax Manual at CT2007a and CT2007b and seek to tax the company under TA 1988, s 419 if this causes directors' current accounts to become debit balances. This can cause all sorts of problems, say if such a payment is classified by the company as a dividend and the company has submitted statutory accounts and corporation tax computations, completed P11Ds and the directors have filed their tax returns treating such payments as dividends and the company subsequently gets an enquiry into the matter. I have seen an enquiry letter from HMRC stating the following 'Where a close company is controlled by directors who are also shareholders, the directors ought to be aware of the ability of the company to fund a dividend … The company should be regarded as making a loan to the directors. The loan accounts need to be rewritten to enable the liability under TA 1988, s 419 to be determined'. They were basically asking for the accounts to be rewritten. They were, in essence, saying that the accounts are wrong, the P11Ds were wrong (as they did not disclose the director's beneficial loans), and the directors' tax returns were also wrong as they had not received dividends, merely received beneficial loans. As TH Limited does not have the ability to pay a dividend, it should not make a payment and classify such a payment as one.
The only way around the situation for TH Limited to be able to pay a dividend is for it to create a distributable reserve; i.e. make profits and rectify the adverse reserves position. This of course may take a few years. If your client wishes to draw funds from the company and the company has adverse reserves, the only way they can draw money is as a salary. HMRC will not challenge a commercial salary drawn from a trading company, even if this increases the adverse reserves position; such an expense is a normal commercial expense and is allowable under ITTOIA 2005, Pt 2 Ch 4, (formerly TA 1988, s 74). The basic analysis is that if the company does not have distributable reserves, it cannot make a distribution.