Why formalise dividends?
Owner directors normally choose to take most profits from their company by dividends. This nearly always the most tax efficient route. National insurance and, for base rate taxpayers, tax is not payable on dividends. Often, the company has little or no documentation to support dividends. The directors can explain and justify the payment and think this is sufficient.
This is not correct. HM Revenue and Customs argues that, where a payment does not comply with Companies Act requirements for dividends, it is not a dividend. So it must be either salary or loan, both of which have tax and national insurance implications.
In a recent case (PA Consulting Ltd) an establish principle was overthrown. Previously, HMR&C had accepted that payments to owner directors should subject to either Corporation Tax (dividends) or Income Tax (salary) but not both. Now, it appears that an incorrectly processed and documented dividend could be subject to both Corporation and Income Taxes. In addition there will be employer’s and employee’s National Insurance. The marginal tax rate could be over 60%. Correctly processed dividends can incur, perfectly legally, a marginal rate of 20%, a material saving.
Interim and final dividends
Without going into all the legal subtleties: Interim dividends are declared by the directors
- Final dividends are proposed by the directors and approved by the shareholders, normally once the year end results are available. If there is sore director who is also the sole shareholder, the company needs to document their actions in both capacities.
- A company does not have to pay dividends but if it does, the last dividend must be a “final” dividend as defined above. If, at year end, the directors decide not to pay any dividends further to the interims already paid, it can declare a zero final dividend.
A company can pay dividends only from distributable reserves. You should be able to see your distributable profits once your accountant has prepared your final accounts but will be too late to support interim dividends. You will need to maintain a continuous record of profit throughout the year. The bank balance in itself is not sufficient; you must take account of liabilities such as provision for corporation tax.
The company must issue dividend vouchers. It is legal to issue one voucher per shareholder that includes all interim and the final dividend. However, this may lead to confusion about the payment date (see below).
As far as HMR&C are concerned, the effective date of a dividend is the date on which payment becomes unconditional. This is normally
- Interims: the date the company pays the dividend; for directors, this can mean the date the company credits the director’s loan account
- Finals: the date the shareholders resolve to approve the dividends
The effective payment date for the finals is not normally the same as the date the company’s accounts report the dividend. The company may wait until it has its (draft) final accounts before deciding the final dividend. This could be almost 9 months after its year end. Once approved by the shareholders, the accountant will include the final dividend before publishing these accounts. The effect date is significant for personal tax planning. Timed incorrectly, dividends will fall into the wrong tax year. This may leave tax allowances unused in one year and push the shareholder over the base rate in the next.
Manipulation of distributions
Owners of small companies may seek to minimise personal tax liability but artificially adjusting size of dividend payments to each shareholder.
An example is a married couple jointly owning a company, each holding 50% of the shares. The husband works full time in the company; the wife has significant income from another job. They may try to reduce personal tax by paying the wife sufficient dividend to take her just up to the higher rate tax threshold. They pay the balance to the husband. For this example, the husband’s total income is then still below the higher rate tax threshold.
Careful handling is required for this to be legitimate.
The usual, and totally unacceptable, approach is to pay the dividend with no regard to the shareholding. A dividend is legally a payment per share; shareholders total dividend should be in proportion to their shareholding. In the example given, each should receive half the total dividend.
It is acceptable for a shareholder to forego their dividend. However, the company cannot simply reallocate this amount to the remaining shareholders. It must have sufficient distributable reserves to cover the whole dividend. It cannot pre-empt the decision to forgo the dividend. Of course, this may not be a problem if the shareholders want to leave reserve in the company to, say, fund expansion of the business.
Another approach is to issue a different class of share to one shareholder only (the husband in this example). The company can pay different dividends on different classes of shares, allowing it to pay a greater proportion to the husband. This approach is not always successful. It lay at the heart of the PA Consulting Ltd case mentioned at the start of this article. After court cases, HMR&C successfully reclassified the dividend as salary. This enabled them to apply income tax and national insurance to the payment.
The company must document dividends in a dividend register, see “Templates” for example.
The attached spreadsheet contains templates for:
- Dividend register
- Resolution to pay interim dividend
- Resolution to propose final dividend
- Shareholders approval
- Dividend voucher
- Instructions for use are included in a separate tab on the spreadsheet.
The correct process is not difficult once understood. The company must complete and document the process when declaring dividends. Attempts to create the necessary documentation retrospectively are fraud and would invalidate the dividend.
1. Declare an interim or propose a final dividend in meeting of directors
2. For finals only, shareholders resolve to approve the dividend
3. Prepare the documentation:
- Minutes to the meeting
- Shareholders approval for finals
- Dividend vouchers – not essential for interims
- Entry in dividend register
4. Prepare the documentation:Minutes to the meeting
5. Directors, secretary and shareholders sign the documents
6. File minutes and resolutions, distribute vouchers to shareholder
7. Pay or journalise dividend.