The Nature of Dividends
A dividend is a type distribution of assets by a company to its shareholders. Most shareholders will be familiar with a dividend as a cash payment from a company to a shareholder, but distributions may also be of non-cash assets or a mixture of both cash and non-cash assets. For most company owners, dividends tend to be the most tax efficient way of extracting profits from a company and for this reason, they will often structure part of their remuneration to be received in this way.
The determination of what amounts to a dividend is based upon the substance of the transaction and not just itslegal form so that sometimes, transactions that may not seem at first to be dividends will end up being treated as such. For example, where a company sells an asset to a shareholder at below market value, the undervaluation could be seen as a distribution and therefore subject to the attendant tax consequences. Likewise, where a private company makes a term loan at no interest to one ofits directors who is also a shareholder, it too may end up being classed as a distribution under dividend legislation.
Dividends are an appropriation of a company’s profits after it has accounted for all of the taxes it is liable to pay (i.e. they are a usage of the post-tax profits a company has made). They are not an expense for the company and therefore do not qualify for tax relief in the same way that other expenses do.
Distributable Profits and Dividends
The basic rule applicable to all companies is that a dividend may only be paid out of realised profits less any realised losses. In addition, public companies (Plc’s) have to meet some further tests relating to their net assets before determining what they can distribute as dividends.
The question of what amounts to a realised profit is important and in its simplest terms may be understood as meaning a profit that has arisen from a transaction in which either cash has been paid, is payable (i.e. owed to the company as a debtor at the accounting date), or involves some other form of consideration that is easily convertible to cash (e.g. traded shares).
By contrast, profits that arise from transactions such as revaluations of assets (e.g. property) are generally considered not to be realised and cannot therefore be used to pay a dividend. However, a gain arising from a revaluation of quoted shares held by a company possibly could be distributed (because the shares could easily be sold and converted to cash) whilst a gain on unquoted shares would not be considered as distributable (because they aren’t easily converted to cash).
Gains that arise from the issuance of shares above their nominal value (share premiums) are not distributable and may not be used to pay dividends.
Realised profits for the purposes of determining dividends are the total accumulated realised profits of the business less its total accumulated losses. Because a company is not obliged to distribute all the profits it makes, any undistributed profits can be carried forwards and accumulated, allowing them to be distributed later.
In Example 1 below where all the profits shown are realised profits, £300k of the total profit in Year 1 is distributed as dividends and £100k is retained within the business. In Year 2, the total profits available for distribution are the £450k profit for that year plus the £100k left over from year 1 – a total of £550k. After paying out a £300k dividend, there is still £250k left within the business which is carried forward to following year. It is for this reason therefore that in Year 3, even though the business makes a loss for the year, it is still possible to pay a dividend from the retained profits brought forward.
A further consequence of this rule is illustrated in Year 5. In that year, whilst the business makes a profit of£125k, it is not possible to declare a dividend because there are brought forward losses of £150k (so cumulatively, the business still has net losses of £25k).
How Companies Issue Dividends
As noted earlier, a company is not obliged to declare a dividend. However when it does, dividends generally tend to fall into one of two categories:
- Interim dividends
- Final Dividends
An interim dividend is a dividend which is paid by the directors simply determining the amount of the dividend and resolving to pay it to shareholders. A decision by the directors to pay an interim dividend does not create a debt due to the shareholders and the directors’ decision can be revoked prior to actual payment.
A final dividend is recommended by the directors at the annual general meeting of the company at which the accounts are laid but is voted upon and approved by the shareholders. In contrast to an interim dividend, the declaration of a final dividend does createa debt between the company and the shareholders which is enforceable immediately or (if specified) at some time in the future.
In making a recommendation for either an interim or final dividend, directors must consider whether there has been a significant deterioration in the company’s financial position between the end of the financial year and the dividend date such that the payment of a dividend could imperil its future operation. Even where there hasn’t been a deterioration and there are sufficient profits to pay a dividend, directors should always consider before making a recommendation whether the payment of adividend could harm the development of the business (e.g. by creating a cashflow problem) or whether it would otherwise be imprudent to do so (say, because they know that a major investment or commitment is imminent).
A company’s articles of association then typically set out the process for paying dividends. Final dividends are usually paid annually after the annual accounts have been approved.
The articles typically provide:
- for the directors to recommend a dividend
- for the dividend to be declared by ordinary resolution (e.g. by vote at an AGM or written resolution)
- that the members cannot vote to pay more than the amount recommended by the directors. Articles also typically provide for the directors to pay “interim” dividends at any time. The tests of lawfulness of a dividend need to be applied not only at the start of the process but up to the point at which the dividend becomes a legally binding liability on the company.
This occurs when:
- a final dividend is declared by the members (even if, as is usual, stated to be due at a later date); or
- at the point when an interim dividend is actually paid.
The company should keep appropriate records relating to the payments, e.g. evidence that the dividend was supported by relevant accounts and minutes of directors’ or shareholders’ meetings. Under tax legislation, the company must send to the shareholder a certificate stating the amount of the dividend and the date of the payment.
Dividends and Shareholders
A central tenet of company law is that all shareholders of the same class must be treated the same. One of the consequences that flows from this is that all shareholders of the same class must receive the same dividend per share if one is declared.
Where shareholders wish to ensure that different shareholders have differing dividend and/or voting rights, they will need to issue different classes of shares to each shareholder. The most common way of doing this is to issue “alphabet” shares (‘A’,‘B’, ‘C’ shares etc.) and declare different rates of dividend for each share class.
In some circumstances, a shareholder may choose to forego their dividend by waiving their right to receive it. There are many reasons why shareholders may wish to waive their rights to a dividend (e.g. a family company may wish to share some of its profits with family members whilst retaining the remaining profit in the company to fund further growth. In this case the parents may waive their dividend while paying dividends to their children). Where a dividend is to be waived, there is a formal process to follow to ensure that it cannot be challenged :
- A Deed of Waiver is required for all shareholders waiving their dividend. The deed must be signed by the shareholder, witnessed and returned to the company;
- For final dividends, the waiver must be in place before the right to receive a dividend arises. For interim dividends, the waiver must be in place before the dividend is paid;
- The waiver may be for a set period or may be open ended.
- There must be sound commercial reasons for waiving a dividend. If HMRC suspect that a dividend waiver is being used to avoid the payment of tax, they may challenge it and ask for it to be set aside.
Unlawful Dividends and their Consequences
An unlawful dividend arises where money is extracted from a company that does not have sufficient accumulated retained profits to pay it. One way in which this may happen is where directors pay out interim dividends in anticipation of profits that eventually fall short or don’t materialise. Another may be where a final dividend is declared without fully taking account of a company’s updated financial circumstances.
Whilst there are no criminal sanctions for the payment or receipt of unlawful dividends, if at the time of distribution, a shareholder knows or should have reasonable grounds to believe that the distribution was being made unlawfully, they are liable to repay the amount received.
Directors may become personally liable if they authorise an unlawful distribution which cannot be recovered. The repayment should be made as soon as the error is discovered, and not only in the event of a winding up. If the error is not corrected, the director may be held liable for any unlawful distributions due to a breach of their fiduciary and statutory duties relating to the protection of company’s assets.
In addition, there may be tax consequences if as a result of repaying an unlawful distribution, a director’s account remains overdrawn nine months after the end of the financial year. The company may be liable to a s.455 corporation tax charge on the overdrawn balance or there may be additional PAYE and NIC’s to pay for the recipient and the company if the amount is treated as salary.
Tax Consequences of Dividends
For the company itself, as dividends are paid out of post-tax profits, there are no additional tax consequences for lawful dividends paid by a company (the consequences of an unlawful dividend have been considered earlier).
For recipients, total dividend income should be declared on the annual self-assessment tax return where it will be assessed to income tax as unearned income.
In the tax year 2023/24, an individual may earn upto £1,000 of dividends free of any tax (in 2022/23 this was £2,000). This is in addition to the normal tax-free allowance of £12,570 for 2022/23 and 2023/24.
Thereafter, the amount of tax paid on dividends depends on an individual’s income tax band. For tax years 2022/23 and 2023/24 the rates are as follows
- Basic rate – 8.75%
- Higher rate – 33.75%
- Additional rate – 39.35%
For a tax payer receiving a basic salary of £9,100 and dividend income of £50,000 in tax year 2023/24 their income tax would compute as follows :-
There is no additional National Insurance to pay because dividends are treated as unearned income and not subject to NI deductions.
One question that often crops up at this point is whether a company owner/director is better off receiving their pay entirely as a salary through the payroll or (as in the example above) through a mixture of dividends and salary. On the face of it, the effective income tax rate of just 10.4% in the example is attractive (the equivalent tax on receiving the same gross income as a salary being 25.4%) but it should be borne in mind that ahead of paying a dividend, the company will have paid corporation tax at between 19% and 25% as well. If we were to look at the scenaro above in more detail, tax payable either as pure salary or as a mix of salary and divdends can be compared as follows :-
In this example, it has been assumed that the company pays corporation tax at 23%. As can be seen in this case, if the same gross salary level is maintained, the tax payer will receive more net income after tax with dividends but the overal cost to the company will be greater (£57k v/s £50.8k). If the salary is then increased to ensure the taxpayer receives the same net pay through a salary as with dividends, the impact on the company's retained profits increases significantly and the dividend delivers the best outcomes all round.
Hitherto, the advice to directors has generally been to take their remuneration as a mix of dividends and salary as this was the most tax efficient way of getting paid. However, reductions in dividend tax-free allowances and increases in the rates of corporation tax in recent years mean that nowadays, each case needs to evaluated indivdually on its own merits and there is no blanket rule pointing towards one method or the other delivering better outcomes. Therefore, the decision to receive pay as diviends, as salary or a mixture of both will depend upon the salary level required and will also take other factors into account as well.
Other Ways of Taking Cash Out of a Company
So far, the discussion has focussed on the use of dividends as a means of extracting cash from a company and in most cases, they will remain the most effective and efficient means ofdoing so. However, in some circumstances, dividends may be sub-optimal because this method of returning cash to shareholders is likely to result in taxable income for the recipient (instead of capital which can be taxed at a lower rate). It is also constrained by the amount of distributable profits available to the company and offers shareholders no choice as to the nature or timing of their receipt.
Another way of remitting cash back to shareholders is through the company buying back their shares. This method gives the company more flexibility over the timing of the repurchase and allows shareholders to decide whether they wish to participate or not. However, distributable profits or a fresh issue of shares will be required to complete the transaction and there are additional constraints on listed companies. The tax treatment of shareholders is also more complicated, with the receipt being treated as entirely capital (as in the case of an on-market purchase with the dealer acting as principal) or a mixture of income and capital.
Alternatively, a company may decide to undertake a capital restructuring, especially where the legal or tax drivers are especially strong. Restructurings will almost invariably involve a bespoke solution tailored to the particular circumstances of the business and come in many forms, examples of which include :-
· A cancellation of share capital. This can be a complex procedure for a reduction of capital which requires court approval. However the advantages are that it benefits all shareholders and does not require distributable profits. Furthermore, creditor protection requirements have become less onerous in recent years as the court has become more willing to look at the existing cash and working capital projections of companies, rather than analysing the position of each individual creditor. In addition, the procedure can be a lot simpler for private companies – they have been allowed to reduce their share capital without court approval since 1 October 2008, in which case they would be supported by a solvency statement only.
· A ‘B’ share scheme. This involves the creation of an additional class of shares (‘B’ shares) with cash being returned to shareholders either through the new shares being redeemed, bought back orcancelled in a reduction of capital or through shareholders electing to receive a special dividend on their ‘B’ shares. Such a scheme, however, requires distributable profits.
· Payment of cash by a new holding company inserted on top of the group. This avoids the need for distributable profits, allows for flexibility in the manner in which cash is returned, and all shareholders participate. However, it can be one of the more complex ways to return capital, often involving a court scheme and, if the company is listed, a new application for listing and publication of a prospectus.
The tax treatment of such transactions is particularly complex and there are a number of anti-avoidance rules which require consideration. Specific tax advice should always be sought where a capital restructuring is contemplated.
