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Accruing illegal dividends

Owner-managed consultancy business, sole shareholder, company is £1k insolvent. No creditors whatsoever, other than my fees and a £2k directors loan account in credit!

Director has taken a £7k salary during the year and has no other income, he wants to issue himself a £25k dividend in order to make use of his personal tax bands this year, the dividend will simply be credited to his directors loan account and drawn down in future years when the company starts making some money.

I've briefed him on the fact that it would be illegal dividends and that should the company go into liquidation in future then he would have to repay the dividend, however he now knows the risks and to be honest the business will never go into liquidation, it's simply a consultancy business just outside of IR35 territory.

As far as I'm concerned I feel that I've covered my back with regards to giving advice, which will also be given in writing.

Can HMRC object to this? The dividend will one day be paid. Would welcome some thoughts on the practicalities of this please. And also does anyone else put a note in the accounts stating that an illegal dividend has been issued or is that considered overkill? No banks or suppliers will be relying on these accounts so a note doesn't really concern the client.

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He can't declare a dividend if there are no reserves in the company.  What are the retained profits?

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Thats the simple answer I couldn't think of! Thanks, time to stop working for the day.

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But ...

... if he hasn't taken it, he can't repay it!

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hmmm

there is generally a lot of misunderstanding regarding "illegal" dividends and what HMRC can or cannot do.CA2006 merely prescribes circumstances when a dividend can under civil action be liable to be repaid to the company. One of those is if the shareholder knew or should have known that the dividend breached the conditions laid down by the Act. In the absence of such recovery action the dividend remains a dividend .In other words the dividend does not cease to exist merely because it appears to have breached the Act.

This then begs the question of who would take such recovery action. Principally the directors or a liquidator empowed to act on behalf of the company. HMRC have no right of action in this context thus have no say in whether it is or is not a dividend that is determined entirely by the facts.In the case of most of our clients therefore "illegal" dividends are fine unless there is a prospect of recovery by a liquidator.Obviously not a good idea to recommend them though !

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Exactly ...

... so in a service company with no creditors apart from the directors subordinated loan, and good prospects of later profits ...

I would add I wouldn't do this, but advisable and possible are completely different animals.

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Dividend or salary
I'd be concerned about HMRC saying they can't be dividends so they must be salary and wanting NICs from your client.

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as Frankie Howerd used to say

no no and thrice no. HMRC have no such powers contrary to popular myth. The dividend ceases to be a dividend if recovery action by the company succeeds and only then.As ever stick to the facts and legal position rather than HMRCs propaganda and you tend to be OK.

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Queens Moat Houses?

pembo wrote:

no no and thrice no. HMRC have no such powers contrary to popular myth. The dividend ceases to be a dividend if recovery action by the company succeeds and only then.As ever stick to the facts and legal position rather than HMRCs propaganda and you tend to be OK.

 

Am really interested in this - what's your basis for saying so? It would appear to go against Queens Moat Houses.

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Article on 'illegal dividends'

... one of the first corporate governance articles I wrote for accountingweb detailed what was deemed an 'illegal dividend' and what is needed for a dividend to be allowed by HMRC.

The comments are still valid and confirm the consequences of making illegal dividends

 See SeSee 'Dividends Checklist - get the details right' - see link below

http://www.accountingweb.co.uk/topic/tax/dividends-checklist-get-details-right/470525 

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liquidations

are a different issue however if HMRC have otherwise won this argument through case law that would appear to be a question of poor representation rather than any inherent legitimacy to their argument.Trouble is there is as usual much scaremongering and pandering to perceived powers that just do not exist in law however as ever HMRCs view is why let that get in the way of a good story.

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Based on experience I agree with pembo's view.

I inherited an investigation where a director had declared dividends on his personal tax return from a company that did not survire it's first full year. HMRC wanted to treat the amount as PAYE as in their view the monies couldn't be dividends as there were no accounts on which to vote them. They asked for management accounts etc. I replied that management accounts were irrelevant, the dividend may have been illegal but the recourse for that was with the company and as it hadn't been repaid it was therefore still a dividend. They backed down and actually agreed with my view.

But a word of caution I have also seen an investigation where HMRC argued illegal dividends in accounts were effectively a directors loan account debit and wanted the s419 tax on the amount. Thereby effectively taxing the same amount twice as it had already been declared as a dividend on the personal tax return. In that case the negative reserves sorted themselves out the following year and s419tax was due back. Effectively all that was at stake was interest from one year to the next. We agreed as it wasn't worth the time arguing to save a small amount of interest.

 

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I don't know the case law situation.

It seems crazy though if HMRC don't have any powers here. Going back to the OP it's so clearly an illegal dividend and presumably being taken at the expense of HMRC, as a one man band contractor is only really going to have HMRC as a major creditor. 

Clearly questions over whether dividend or salary/loan is one thing and taking capital out the business at expense of the creditors is another thing, but both are matters that HMRC have very good reason to care about.

Very interested to hear more about the legal position either way.

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Queens Moat Houses

had nothing to do with HMRC arguing that a dividend is illegal or the ramifications of that. Facts in case law have to square to have any standing in law and the burden of proof is on he who asserts.

Lets follow the logic. Negative reserves at start and end of AP in which a dividend is paid. Does that mean the dividend is illegal ? No...the company could have had a fantastic first 6 months and disastrous last 6. Unlikely admittedly but law is based on fact not supposition. So that would have to be proven in court to establish the principle in the first place.Who is going to take such action ? HMRC ? Why would they as what would be the basis of such action ? Where is their loss unless a liquidation ? Bottom line is that a dividend remains a dividend until it is paid back to the company following  successful action based on law not HMRC spin.

Turning this on its head it is not unknown for HMRC to succesfully tax businesses that are prima facie illegal. To follow the dividend logic how could they as QED those businesses do not exist because they are illegal ? Or again are HMRC bending the rules to suit ?

Unless someone can actually quote a legal precedent (as opposed to anectodal experience) rather than churning out HMRC propaganda then I for one will not lose any sleep.

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Relevant Accounts

pembo wrote:

had nothing to do with HMRC arguing that a dividend is illegal or the ramifications of that. Facts in case law have to square to have any standing in law and the burden of proof is on he who asserts.

Lets follow the logic. Negative reserves at start and end of AP in which a dividend is paid. Does that mean the dividend is illegal ? No...the company could have had a fantastic first 6 months and disastrous last 6. Unlikely admittedly but law is based on fact not supposition. So that would have to be proven in court to establish the principle in the first place.Who is going to take such action ? HMRC ? Why would they as what would be the basis of such action ? Where is their loss unless a liquidation ? Bottom line is that a dividend remains a dividend until it is paid back to the company following  successful action based on law not HMRC spin.

 

Sorry, you're way off here. A dividend must be declared by reference to relevant accounts. Unless those relevant accounts show distributable profits, there is nothing to distribute. It is not sufficient that there are profits to distribute, there must also be accounts prepared to show this. HMRC won on this point recently (was in relation to Stamp Duty and sub-sale relief, but can't remember the name of the case at the moment).

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I disagree with Pembo's analysis

Too much weight is put on the term 'illegal dividend' because there is no such thing. A dividend is a distribution of profits. If there are no profits, there can be no dividend, illegal or otherwise.

A dividend, which is a distribution of available reserves, can only ever, by definition, be legal.

If a payment is made, and there are insufficient reserves, that does not constitute a dividend which is illegal. Calling a payment a dividend does not make it so. Since there can be no distribution if there's nothing to distribute, the payment must be something else.  But if HMRC tried to argue that it was salary I'd send them packing.

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A loan

Presumably you would call it a loan then if you are ruling out salary or dividend. I'm not sure that argument would have been useful for my client above.

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sorry guys

but you are missing the point here by some distance. The presumptive assertion is that a dividend is lawful unless proven otherwise which is what most case law has been about.What you I or HMRC think is irrelevant.Thus a third party whether HMRC or whoever would firstly have to get judgement to that effect. If the directors did not have accounts to back it up then that would naturally not help but would not in itself be conclusive.Only a court would rule on that not HMRC or anyone else.In this context to say that there is no such thing as an illegal dividend is nonsense unless you want to split hairs over whether illegal means the same as unlawful. To quote CA2006:

Consequences of unlawful distribution:(1)This section applies where a distribution, or part of one, made by a company to one of its members is made in contravention of this Part.

(2)If at the time of the distribution the member knows or has reasonable grounds for believing that it is so made, he is liable—

(a)to repay it (or that part of it, as the case may be) to the company, or

(b)in the case of a distribution made otherwise than in cash, to pay the company a sum equal to the value of the distribution (or part) at that time.

etc.

Note that the burden of proof is subjective to the shareholder and nowhere does it say that the consequence is that the distribution does not exist.QED until proven in court and paid back then the distribution exists even though it may be unlawful. Think of it like robbing a bank. Just because it is unlawful doesn't mean that the robbery did not take place.Merely that there are remedies available to society for the culprits.

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Then we agree to disagree

If there's any hair-splitting to be done, it's the difference between a distribution and a dividend. If there are assets and/or cash then of course these may be distributed - as a matter of fact - to shareholders. But if the amount so distributed exceeds available reserves then it is an unlawful distribution. That is a matter of fact, not judgement - there either are sufficient reserves or there are not, and The Companies Act is quite specific in how you go about determining whether there are sufficient reserves: s836 - if the last stats show insufficient reserves you can't just proceed with the distribution in the hope that if you were later to draw up interim accounts they would show sufficient reserves. The wording of the law imposes an obligation there and then to prepare interim accounts in support of the proposed distribution.

The consequences of an unlawful distribution - perhaps requiring a repayment ot the company - do not alter the fact that the distribution is unlawful.

But whether or not the distribution is unlawful (or illegal, call it what you want) is beside the point.

A dividend is a payment of profits to shareholders. If there are no profits, there can be no dividend. Period. There may well be a physical distribution of assets - unlawful or otherwise - but if there are no, or insufficient, profits (as defined) then that distribution of assets must represent something else, since it cannot be a dividend.

You're welcome to have a further say. I'm done here - if we can't agree, we'll have to disagree.

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So what happens if...

"A dividend is a payment of profits to shareholders. If there are no profits, there can be no dividend. Period. There may well be a physical distribution of assets - unlawful or otherwise - but if there are no, or insufficient, profits (as defined) then that distribution of assets must represent something else, since it cannot be a dividend."

A dividend is paid based on available reserves in the last annual accounts which have been wiped out by post year end losses?

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Paul

It doesn't matter. Available reserves are defined in the Act - if the last stats show sufficient reserves then you have, according to the law, sufficient reserves with which to pay a dividend. If they don't show sufficient reserves then you don't - unless and only if you draw up interim accounts to demonstrate otherwise. It is a common misunderstanding that folk think you must always have to draw up interim accounts to show that there are sufficient reserves at the time - they are required only if the last stats don't do that.

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Yes - I am aware that interim accounts are not required

which is why I posed the question. It's an interesting discussion and I am trying to follow your argument. If a dividend is only payable out of profits and, as a question of fact, there are no profits we seem to have moved into a strange situation where we have a lawful distribution which nevertheless can't be a dividend. Either that or a dividend can be paid other than out of profits.

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I don't see what the problem is

 

Yes, it is a quirk of the system that allows one to make distributions at a time when there are in reality, at that time, insufficient reserves. But until such time as it becomes a requirement to draw up accounts every time a distribution is proposed that quirk will remain. So until that time, all you need concern yourself with is the legal definition of available reserves and whether or not the proposed distribution is lawful or unlawful.

Available reserves are defined. There either are, or there are not, as a question of fact, sufficient reserves as defined. A lawful distribution out of such reserves may be a dividend, but an unlawful distribution (unlawful in the sense that there are insuffiicent profits) can never be a dividend.

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Well I think we may have to agree to differ

As a question of fact, it is possible to lawfully pay a dividend when there are no reserves. If that is possible, I do not see why an unlawful distribution can not be a dividend - it merely has different consequences. After all it is possible, if rather naive, to have an unlawful dividend where there are reserves.

 

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OK we agree to differ

But what circumstances do you have in mind whereby you can have an unlawful dividend where there are reserves?

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A bit of a technicality I suppose

but where the only reserves are generated after the last annual accounts and no interim accounts are prepared.

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It's not a technicality

If you haven't prepared interim accounts then there are still no reserves - because the law defines what is meant by reseres available for distribution.

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We may be saying the same thing?

As a question of fact, there are reserves. But the distribution would be unlawful because the law does not recognise them until the accounts are drawn up.

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Question of fact?

What is your definition of reserves? It is not a question of recognition by the law - until accounts are drawn up the reserves simply don't exist. As I said earlier it would be incorrect, and unlawful, to proceed with a distribution in the hope that accounts drawn up afterwards indicate available reserves. (But like back-dating dividend paperwork, I've no doubt that it happens :)  )

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My definition

of reserves is, in brief, net accumulated profits arising usually but not necessarily from transactions. They exist whether accounts are drawn up or not. We're not disagreeing about whether they are lawfully distributable or not; they're not in the circumstances outlined unless accounts are drawn up - no one suggested creating backdated accounts.

Anyway to get back to the point. You seem to accept a dividend can be lawfully paid when there are no reserves in reality. So this statement appears to fail "If there are no profits, there can be no dividend, illegal or otherwise." Which is why I am a bit lost.

I was sitting on the fence before but I lfind myself leaning more and more towards Pembo's view. I am happy to be convinced otherwise but I am not there yet.

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That's not what I accept at all

I accept that a dividend can be paid only when the reserves - as legally defined - are available. It doesn't matter whether or not there are reserves 'in reality', whatever that 'reality' may be - I'm not interested in theoretical reserves (however you or I may choose to define them), only those that exist for the purposes of company law, which are those appearing in the accounts - annual or interim.

I've probably just pushed you off the fence. So be it

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Let's move on

"Yes, it is a quirk of the system that allows one to make distributions at a time when there are in reality, at that time, insufficient reserves."

"You seem to accept a dividend can be lawfully paid when there are no reserves in reality."

"That's not what I accept at all"

Anyway the Act still refers to it as a distribution even when unlawful so I think I am going to stick to that view. :-)

Time for bed said Zebedee.

 

 

 

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Interim accounts?

There now seems agreement that if there are no interim accounts then the last year end accounts are fine. I'd ask what interim accounts are though. 

If a business is running Sage (or whatever) and keeping it up to date, they can run a balance sheet whenever they want. Let's say they run a balance sheet report to see if they have the reserves, see they do and pay one (they then close the window). Are those interim accounts? They should be, but I suspect they're not. If they click print are they (probably)? Do they need to be signed?

The other point that occured to me is that it if I prepare a set of accounts exactly at the end of Year 1, with plenty of reserves. Even though I strongly suspect I have made huge losses for 21 months, I could continue to pay myself dividends until I have to prepare the next set of accounts (as long as I don't prepare any interim accounts). The suggestion seems to be that would be okay, but surely not. Perhaps it would be wrongful trading but that's a different issue.

 

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Interim accounts

I am out today so can't check the precise definition but broadly and assuming you are not a plc, which has more onerous requirements, interim accounts need to be adequate to make an informed decision. They do not need to be signed.

Yes re 21 months so long as the cumulative dividends do not exceed the distributable reserves in the last annual accounts; they will be lawful though probably not sensible. As you say other issues may come into play.

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TECH 02/10

paulwakefield1 wrote:

I am out today so can't check the precise definition but broadly and assuming you are not a plc, which has more onerous requirements, interim accounts need to be adequate to make an informed decision. They do not need to be signed.

Yes re 21 months so long as the cumulative dividends do not exceed the distributable reserves in the last annual accounts; they will be lawful though probably not sensible. As you say other issues may come into play.

 

I'm not so sure this is accurate. From my recollection ICAEW Tech 02/10 covers this and says there must be reserves on date which are declared on (by reference to relevant accounts) and on date when paid. Given requirement to keep adequate accounting records, directors must be aware of situation on date of payment.

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Thanks

I think you are right. I believe the proposed scenario works insofar as distriutions are specifically addressed in the CA but there is an overriding provsion that the CA provisions do not overrule other law. I suspect this is where my argument is flawed.

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be careful with this one

As with most small companies, the directos and shareholders are the same people.

Where the shareholder is aware that the dividend is unlawful, the shareholder will hold the dividend as a constructive trustee.

This unlawful dividend will not form part of the shareholders income for the year.

Also as the company has not parted with title to the dividend, the dividend will remain as part of the company's assets under a constructive trust.

Where the shareholder and directors are different people, and the shareholder is not aware that the dividend is illegal, then it is a different matter.

 

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all very interesting ladies

but again not focusing and missing the point.

Distributions are defined in law. A dividend is merely one type of distribution. CA prescribes circumstances whereby a distribution can be deemed to be unlawful.Those circumstances are a question of fact to be proven in law and until such time as that happens the distribution remains prima facie lawful. If it is proven in law that a distribution is unlawful then it is in certain circumstances liable to be repaid to the company. If that happens then the distribution is cancelled. If that does not happen then the distribution remains a distribution notwithstanding it is an unlawful distribution. That is why CA refers to an unlawful distribution that recognises that the transfer to the member is a distribution even though it is unlawful. If an unlawful distribution is not a distribution then it would QED not be called an unlawful distribution under CA.

If still unconvinced think of a company loan. Exactly the same principle applies. It may under CA be lawful or unlawful however remains a loan until repaid. The fact it is unlawful is irrelevant other than to the extent that there are remedies available under company law as with unlawful distributions. The only difference between a loan and a distribution in this respect is that one is capital and the other revenue.

Thus endeth the sermon.

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