In Focus: Tax  

Directors risk falling into dividend 'tax trap'

Directors risk falling into dividend 'tax trap'
 Photo: Andrea Piacquadio via Pexels

Company directors and owner-managers could fall into the tax trap of paying 'illegal' dividends to themselves, a tax specialist has warned.

Sunil Bhavnani, a technical partner at tax and advisory firm Blick Rothenberg, said especially at the end of the tax year if tax planning is being rushed, directors run the risk of becoming personally liable for company liabilities.

This is because directors of owner-managed businesses often pay a portion of their income as dividends.

With the end of the tax year fast approaching, directors will once again be turning their minds to declaring an annual payment. 

However, tax regulation around dividends, company law capital maintenance requirements and directors' fiduciary duties has become increasingly complex. 

Bhavnani explained: "The rules around dividends and distributions can be complex. If the requirements are not met such that the dividend is unlawful, the directors will need to act quickly.

“A shareholder is required to repay an unlawful distribution if they know or have reasonable grounds for knowing that it was made unlawfully at the time of payment.

"In the case of a distribution made otherwise than in cash, the shareholder will have to pay the company a sum equal to the value of the distribution at that time.”

The capital maintenance requirements of the Companies Act 2006 state any distribution can only be made where distributable profits exist, irrespective of the level of surplus cash in the business.

The determination of distributable profits is usually made by reference to the balance on retained earnings shown in the last set of financial statements. However, directors must consider changes in financial position and performance after the balance sheet date. 

This is even more pertinent, given the financial difficulties many companies have fallen into as a result of the Covid-19 pandemic, Bhavnani said.

He said: "If the financial performance has deteriorated, losses have reduced the level of the retained earnings balance. Directors may therefore need to draw up interim accounts to evaluate the position if a distribution is to be made many months after the year end.”

In view of the pandemic, he said it was vital to ensure appropriate accounting adjustments are made in any set of financial statements for matters including:

  • Bad and doubtful debts,
  • Provisions for surplus or obsolete inventory,
  • Impairment of site premises which are not being used,
  • Provisions of onerous leases,
  • Early recognition of losses on contracts that will no longer be profitable.

The directors will need to consider whether adjustments for such matters need to be made in any interim accounts for dividends paid some time after the year end.

Bhavnani added: "Directors are also subject to fiduciary and other duties. These include the obligation to safeguard the company’s assets and take reasonable steps to ensure that the company is in a position to settle its debts as they fall due."

These debts could include pension scheme liabilities or other creditors.

He said: “Directors should consider both the immediate cash flow implications of a distribution and the continuing ability of the company to pay its debts as they fall due.