Anyone who invests in a company is taking a chance, hoping that the directors, as representatives of the company, will use the money to increase the company’s profit. In return for taking this chance, a shareholder receives ‘payback’ usually as a share in the distribution of profits in the form of a div, however. payment is not automatic.
For a dividend to be paid, a company needs to have sufficient ‘distributable profits’ to cover the dividend at the payment date. ‘Profits’ in this instance are ‘accumulated, realized profits,’ less ‘accumulated, realized losses’ i.e. accumulated profits from the current and/or previous periods after covering any losses. Therefore, only dividends paid out of accumulated profits can be made. Paid where there are no ‘distributable profits’ or made out of capital are termed ‘illegal’ under the Companies Act 2006.
How do you know a dividend is ‘legal’?
Whether a div has been paid ‘illegally’ may only come to light when the final accounts are prepared for that period. Only then can it be confirmed whether sufficient ’distributable profits’ were available when the div was paid. There is a statutory requirement for full accounts to back up the payment of a final dividend, but there is no such requirement when making an interim div. However, the advice is to prepare management accounts before declaring any div just to ensure sufficient distributable profits are available to support that payment.
You might also like to read: Do you have to take a div? Reasons why not to.
Tax implications of ‘illegal’ dividends
Should the dividend be found to have been issued ‘unlawfully’, HMRC will treat the div as not being received and the shareholder will be required to repay the amount paid. The time limit for recovery of dividends is six years from the date of declaration or the declared payment date, whichever is later. The only time such a div will be treated as a distribution and the shareholder is not required to repay is if the shareholder was unaware of the illegality of the payment and had no reasonable grounds to believe that the div was so. However, lack of knowledge may be difficult to prove with director/shareholder dividend payments in owner-managed companies.
If a shareholder cannot repay the div, HMRC can argue that the payment was incorrectly designated and was, in effect, a loan. Should the loan not be repaid or written off within nine months and one day after the year-end, then the company is liable for a tax charge. The percentage rate is the same as the higher div rate at 33.75%.
The tax charge payable by the company may not be the only tax implication. Should the total of all outstanding loans from the company exceed £10,000 at any time during a tax year, then the director is considered to have received a benefit in kind from their employment unless interest is paid.
What are the alternatives?
- If cash is needed but cannot be paid via a div due to the above, an alternative is a withdrawal as a salary or bonus, but this comes with extra tax and NI costs.
- If payment can be made partly in cash and partly for services or goods which could be normally settled personally, such arrangements count as taxable benefits in kind. Such benefits in kind may be taxable at a lower tax rate than 33.75%.
- A company can repay share capital and share premium by crediting the company’s profit and loss account, thus allowing the company to pay a div where which creates positive balance sheet reserves.
Where illegal div are discovered, a note should be added to the year-end accounts. The director must immediately cease taking any further div until the company has accumulated future distributable reserves.
Why dividend legality matters and common mistakes directors make
One of the most common misconceptions among directors of owner-managed companies is that dividends can be paid as long as there is cash in the bank. In reality, div are governed by accounting profits, not cashflow. A company can have strong cash reserves but still lack distributable profits, making any div payment unlawful under the Companies Act 2006.
Another frequent mistake is relying solely on interim dividends without preparing up-to-date management accounts. Because interim div do not require statutory accounts at the time of declaration, directors may unknowingly pay dividends that later turn out to be illegal once year-end accounts are finalised.
This issue is particularly risky where the director and shareholder are the same person. HMRC is more likely to challenge dividend payments in owner-managed businesses, especially where losses exist or reserves fluctuate. Once a dividend is classed as illegal, it can trigger repayment obligations, section 455 tax charges, and potential benefit-in-kind implications.
Understanding the rules around distributable profits allows directors to avoid costly mistakes, plan remuneration properly, and protect themselves from unexpected tax liabilities.
FAQs
Dividend decisions can have serious legal and tax consequences if made incorrectly.
If you would like to review your company’s distributable reserves or check whether dividends have been paid correctly, feel free to contact AccounTax Zone for tailored advice.
Partner note:
Corporation Tax Act 2010, section 455
