Reversing illegal dividends

Reversing illegal dividends

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Situation is this:

Company declared illegal dividends 2 years running, lets say £50k in total, going concern and illegal dividend disclosure note was made in the accounts. The accounts weren't relied upon by anyone so the illegal dividend was never a problem.

Reality is that no-one ever takes action against this breach of the Companies Act unless the company goes into liquidation or HMRC challenge the illegal dividend as some other form of personal income, even then it becomes a personal tax matter.

However , in steps the regulator for that business (on an unassociated matter), sees the illegal dividends and requires the position to be reversed in order to comply with their own professional ethics requirements.

There are no personal tax liability implications as the directors have a large credit in excess of £50k on their directors loan account.

2 options as I see it:

1. Put through a  negative £50k dividend in the current year accounts, make a suitable disclosure note in the accounts to say what happened, debit the directors loan account. Hey presto, the balance sheet is solvent again.

2. Submit amended accounts to Companies House and HMRC for each of the last 2 years. The amended accounts are compliant and possibly no requirement for a disclosure on illegal dividends? Only thought I have here is that dividend minutes WERE prepared and approved, although now subsequently they are being reversed, is that technically possible?

Thoughts on the 2 options please. Or perhaps even another option I haven't considered.

Replies (26)

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By johngroganjga
17th Jun 2015 12:42

Who is the regulator in question?

 

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By User deleted
17th Jun 2015 12:48

Are you saying that the regulator has in fact stepped in?

Or is it hypothetical? If it is hypothetical then there is the 3rd option of doing nothing.

If in fact someone has requested that the situation be rectified, and has the authority to do so (or the shareholders have volunteered to remedy matters), my understanding is that the only valid option is to repay the illegal sums to the company. I may be wrong, but I don't think that you can merely re-classify them as debt. Then again, maybe you can (otherwise I don't know how you account for the repayment).

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By johngroganjga
17th Jun 2015 12:56

If the issue is, as I suspect, simply about the insolvent balance sheet the obvious solution is for the directors to capitalise their loan account.

That avoids needing to re-write history.

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By User deleted
17th Jun 2015 13:55

The company law solution is that the members pay back the illegal dividend received - s847 CA/06

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By Sheepy306
17th Jun 2015 15:01

Thanks for the replies and reference to s847.

The company is a law firm, regulator was doing a routine compliance visit, their issue is that the business has breached the Companies Act requirements by declaring an illegal dividend, not so much that the company was insolvent as a result.

The illegal dividend wasn't a major thing for them but they insist on it being rectified, ultimately it seems that it could be resolved in a couple of ways but I'd like to be 100% sure that however it's done it's done correctly, I don't want it dragging on or becoming a 'big thing' because we can't agree on the accounting treatment.

@ TaxGuru & BKD - I'm struggling to think of what the journals would be if the director/shareholder repaid the dividend either physically or simply by way of paper trail. The debit would be to either bank or directors loan account, but credit to where? I was thinking to dividends paid even though it will be a negative.

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By User deleted
17th Jun 2015 15:09

Don't ask me, I'm a mere tax adviser

John is the one to ask on all things accounting-wise.

Perhaps a prior-year adjustment to comparatives, but that's just guesswork on my part.

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By User deleted
17th Jun 2015 15:11

Journal applying s847 CA/06 if during the same accounting year:

Dr Shareholders Account

Cr Equity Dividend Account

(Being repayment due against illegal dividends paid on ......., as authorised by the board resolution dated ........... in accordance with s.847, as accepted by the shareholder - see letter dated .........)

 

Dr Director's Loan Account

Cr Shareholder/Director Account

(Being repayment due on illegal dividends settled against the director's loan per director's instrutruction dated .........)

 

 

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By bernard michael
17th Jun 2015 15:26

If an illegal dividend is paid in good faith s 847 doesn't apply and there is not need to reverse the dividend. I would challenge the regulator as to why he thinks the dividend is illegal. That is assuming your client accepted it in good faith

 

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Replying to DJKL:
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By User deleted
17th Jun 2015 16:44

Good faith

bernard michael wrote:
 If an illegal dividend is paid in good faith s 847 doesn't apply and there is not need to reverse the dividend. I would challenge the regulator as to why he thinks the dividend is illegal. That is assuming your client accepted it in good faith 

A dividend is paid in good faith, an illegal dividend is never paid in good faith!!

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Replying to Tax Dragon:
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By bernard michael
18th Jun 2015 09:46

Rephrasing

taxguru wrote:

bernard michael wrote:
 If an illegal dividend is paid in good faith s 847 doesn't apply and there is not need to reverse the dividend. I would challenge the regulator as to why he thinks the dividend is illegal. That is assuming your client accepted it in good faith 

A dividend is paid in good faith, an illegal dividend is never paid in good faith!!

I should have stated that if a dividend is paid (and received in good faith) that subsequently transpires is illegal S 847 doesn't apply,ie if the dividend is paid when it is believed there are distributable reserves that latterly prove not to be the case

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By Sheepy306
17th Jun 2015 15:32

Dividend was issued with full knowledge that it was illegal so I would imagine that it does not fall within 'good faith', they just didn't think there would be any comeback, unfortunately the regulator considers a breach of the Companies Act as a breach of their own professional bodies ethics, hence why they want it rectified/reversed.

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By User deleted
17th Jun 2015 15:35

Bernard

The issue is not whether s847 applies. The question of an unlawful dividend is one of fact - it is unlawful or it is not. If it is unlawful, then s847 depends on another set of facts. But whether s847 should or should not apply is irrelevant - if the regulator requires an unlawful dividend to be rectified, then it should be rectified, quite apart from any company law requirements.

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Replying to andrew1211:
By johngroganjga
18th Jun 2015 13:43

.

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By User deleted
18th Jun 2015 10:01

You make a good point, Bernard

What is the actual unlawfulness in this case? Was there an actual deficiency of reserves at the time of the dividend? If not - eg dividend was based on last statutory accounts (as permitted by company law) - and the deficiency arose only as a consequence of poor subsequent results, the dividend is not unlawful.

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By johngroganjga
18th Jun 2015 10:18

Going back to the question asked by tho OP, the right approach is option 1, and certainly not option 2. Option 2 is not right because the previous accounts were correct and do not need amending.

But with either option the recipients' personal tax returns presumably require amending?

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By bernard michael
18th Jun 2015 11:53

Fawlty just a moot point

S.847(2) states that "If at the time of the distribution the member knows or has reasonable grounds for believing" that the dividend has been paid illegally, he is "liable ... to repay it (emphasis added) ... to the company".

Conversely if the member does not have reasonable grounds this section does not apply 

To the OP

The illegal dividend is only illegal in so far as it exceeds the reserves. Therefore  a total dividend declared may be considered illegal where part of it is legal. I would therefore only reverse out the part that was "illegal" if that satisfies the Regulator

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Replying to Paul Crowley:
By johngroganjga
18th Jun 2015 12:15

Law

bernard michael wrote:

The illegal dividend is only illegal in so far as it exceeds the reserves. Therefore  a total dividend declared may be considered illegal where part of it is legal. I would therefore only reverse out the part that was "illegal" if that satisfies the Regulator

I am no lawyer, but I am not sure that when push comes to shove the courts deal with things in that way.

I have had leading counsel explain to me on more than one occasion that it is settled law in England and Wales that if a company pays a dividend any part of which is not covered by available profits (or reasonably assumed to be so covered) the whole of it is illegal not just the excess.

I have pointed out to leading counsel that this means that creditors of insolvent companies which have paid illegal dividends are, perversely, better off (all things being equal) than creditors of companies that have paid only legal dividends. Leading counsel have agreed that that is the case but repeated that that is nevertheless what the law says.

 

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Replying to Paul Crowley:
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By User deleted
18th Jun 2015 13:25

Unlawful distribution

bernard michael wrote:
 The illegal dividend is only illegal in so far as it exceeds the reserves. 

That's not correct.

S.847 starts with saying 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. And the part which it refers to is Part 23 i.e. s.829 et seq.

Unlawful distribution is one that contravenes any of the provisions of part 23, which could be for e.g.836 where relevant accounts have not been considered. Further, since generally it's the directors that manage the company and not the shareholders (disregarding one-man-band for a moment), s.847 simply provides a solution for the shareholders to repay the dividend back to the company where there was an unlawful distribution.

An old case often referred to is Precision Dippings Ltd v Precision Dippings Marketing Ltd& Others [1985]. Also there is this recent case (It's A Wrap (UK) Ltd) worth having a look.

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By User deleted
18th Jun 2015 12:47

The law

Counsel's opinion seems to be at odds with the statute (I cannot comment on any case law that is also at odds with it). s847 is quite clear, recognising that only part of a dividend may be unlawful, and requiring only that unlawful part to be repaid.

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By bernard michael
18th Jun 2015 14:51

Perhaps I missed out a step in my thinking

Yes the whole dividend per se is illegal. However when it comes to correcting it you should reverse it in its' entirety and distribute new " legal"dividends up to the vale of the reserves.

The net effect is that you only repay the "illegal" part

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By Gimlet2008
24th Jun 2015 13:21

Is there a consensus

Is there any consensus re the above as t would be interesting. Repaying it seems the only option that makes any sense as presumably as been stated, it is void as a dividend. I think probably dangerous to do anything else? Just trying to see if that is a consensus, or near consensus ! 

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By Tom 7000
24th Jun 2015 15:27

You may have missed the point here...

 

 

You say

The company is a law firm, regulator was doing a routine compliance visit, their issue is that the business has breached the Companies Act requirements by declaring an illegal dividend, not so much that the company was insolvent as a result.

 

Either it has reserves to pay a dividend or it doesn't and it increases the insolvency so your point doesn't quitemake sense

 

So what you are saying is the legally quaified Solicitors knowingly breached the companies Act taking the company insolvent ...I am surprised they wern't struck off....

 

Next you were the accountant who  knew they were deliberately doing it and condoned their illegal activity...similar fate

 

Then you said its ok to brake the law by doing it as no one bothers...ok...You dont get punished for driving at 150mph in a 30 limit either...until someone catches you

 

But how will they ever catch you unless someone  then puts it on a public forum ...

 

Did you also make a money laundering report?

 

Did you value their WIP under UITF 40 too to see if there were additional profits to cover the dividends?? Or would that have created a tax bill so you didnt bother....cos normaly lawyers have lots of that as its the risky part of the job..

 

 

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Replying to Justin Bryant:
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By Sheepy306
24th Jun 2015 16:08

And breathe.......

Okay, calm down Tom7000. I'll address the matters which seem to be of concern (to you):

1. Correct, SRA aren't bothered about the insolvent balance sheet, they're satisfied with the underlying financial position of the firm and directors, details of which aren't really relevant to my original question. Their issue is simply that the firm breached the companies act, which inturn they are saying is a breach of SRA ethics. Their only requirement is that the position is rectified, the directors are in a position to do so but I requested Aweb users thoughts as to the mechanics of the reversal and any other possible options. There have been some helpful replies.

2. As stated already, the company didn't have the reserves to pay a dividend, they knew that, they nonetheless issued a dividend, it was illegal. There have been no repercussions of this, except from their regulator. If other repercussions occur then they will be addressed accordingly. I've not commented on whether the directors were right or wrong for doing so, merely that it happened, and what the reality is.

3. The directors have not been struck off, I have dealt with the SRA for years, I would not expect them to strike a firm off in these circumstances.

4. Yes they are a client of mine, I advised them of the options and the potential consequences, they made an informed decision, they are dealing with the consequences of doing so with their regulator. The action was fully disclosed in the accounts, on my files and in written correspondence. My own regulator will not be striking me off, I can assure you.

5. I didn't say that it was 'okay to break [sic] the law', I clearly stated that it breached the Companies Act, I'm just in touch with reality as to what the practical and tax consequences are. If someone wants to drive at 150mph then I'm sure that they know the consequences too and will deal with them accordingly.

6. Public forum - what's your point here?

7. Money laundering report - just to clarify.......you want me to state on a public forum as to whether I made a money laundering report on one of my clients?

8. UITF40 - Well aware thank you, and yes. "cos normaly lawyers have lots of that as its the risky part of the job"..........I haven't even mentioned what area of law the client operates in, let alone what their fee structure is (CFA, hourly rates, fixed fee etc), what size the firm is, how long they've been trading or how often they bill, so not sure that such a sweeping statement can be applied here.

In response to a couple of other replies, the directors will be very high earners in a couple of years time but for the tax year in question they were basic rate tax-payers, the dividend issued kept them below £40k income so there was no personal tax liability. The issuing of the dividend was (possibly) in order to utilise their basic rate band and draw it down in future years. Their personal tax returns will need to be amended, but there will be no tax implications.

Thanks for the replies to date, they've been very useful.

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By Sheepy306
24th Jun 2015 16:16

@ Basil and John

Thanks for the detailed replies. Option 1 was my preference and belief, so I'm glad that we agree in this regard.

It has also always been my belief that the whole dividend would be illegal, not just part of it, however there does now seem to be some difference of opinion on this. I do not believe that reversing only part of the dividend would be acceptable to the regulator, so we will reverse the whole thing, it's not a battle that would really benefit the client in the whole scheme of things.

Thanks Basil for the detailed wording, I shall use some of that if you don't mind!

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By Montrose
24th Jun 2015 17:35

A Law firm?

Forgive my enquiry, as Tom 7000 has asked, but what kind of a law firm knowingly breaks the law?

How come the regulator takes such a lenient approach- what kind of regulator is this. Have they enquired if the law firm has advised others to do the same?

Has Sheepy 306 been required to carry out an audit? Is there a consequential breach of the Solicitors' Account Rules?

Montrose

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By johngroganjga
25th Jun 2015 13:59

I suggest that if you don't like the approach the SRA takes you should take it up with them. We are told that they have taken vigorous action over what they consider to be a breach of their ethical rules. I am not sure what more you would expect.

Sheepy can speak for himself, but if he had been instructed to carry out an audit I imagined he would have mentioned it. It would have been a very unusual thing for an audit exempt company to have done.

Not sure what you are asking is a breach of the SAR - the failure to have the firm's accounts audited or the making of dividend payments in excess of the available profits. Either way when I last studied the SAR they went nowhere near either of those matters. As you will be aware they are almost entirely about handling client money, not the firm's own money.

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