What are dividends?

What is a director dividend? Chartered Accountant and Licensed Insolvency Practitioner Elliot Green FCA FABRP of Oliver Elliot explains the conditions for a dividend and the consequences of an unlawful dividend.

Director Dividends

What is a dividend?

A dividend is a shareholder’s right or entitlement to a return on their investment in a limited company, typically in the form of a sum of money.

It is not merely the payment of a sum of money from the limited company to its owners. For many SMEs it is not unusual for it to be taken by company directors who are also shareholders instead or additional to a basic salary.

It is common to refer to the payment of a dividend with the dividend itself. However, the payment of a dividend is not really the dividend. Payment of the dividend is satisfaction of the liability arising from the declaration of the dividend.

The Companies Act 2006 enables shareholders to receive dividends, subject to certain conditions. In a nutshell, a dividend can only be paid from profits. This is to protect the company’s creditors so that a company’s wealth or money is not extracted by the shareholders at their expense.

How do you declare a dividend?

If a director wishes to pay a dividend to the limited company’s shareholders, he or she must declare the dividend, otherwise it is not created.

To declare a dividend, the board of directors need to pass a board resolution to formalise matters. The resolution should ensure that it refers to the accounts that are relied upon to justify the dividend. These are referred to as the ‘relevant accounts’ accounts.

Why are dividends declared?

Dividends are declared because the company’s shareholders that own the company will want to receive a return on their investment in the company. Such return can typically take two forms:

  • receipt of regular dividends
  • sale of the shareholding

Dividends can also, but less commonly, be taken in the form of assets, known as a ‘distribution in specie’. Similar principles still apply.

What happens if you failure to declare dividends?

If payment is made to a company’s shareholders intending it to be a dividend without having been properly declared, then the transaction is not a dividend. The consequence of such a failure is that the transaction may well have to be reversed and repaid to the company, as was the case in the matter of BM Electrical Solutions Ltd & Anor v Belcher [2020] EWHC 2749 (Ch) in which the following was notably said by the court:

  • “Mr Belcher complains that he is hampered in his defence as he has no paperwork or records available, saying he had handed them over to “the insolvency agency”. Significantly, he goes on to say that he still has the server and computer with the Company’s accounts package on them, but that he has tried and cannot access them.”

In that case Mr Belcher had to repay sums of money to a company in liquidation running close to £190,000.

What are the conditions for a dividend?

Distributable Reserves

In order to consider what is a dividend, or perhaps what is an illegal dividend, it is necessary to break down the key features of dividend set out in the legislation.

Dividends can only be declared out of profits. Section 830(1) of the Companies Act 2006 states: “A company may only make a distribution out of profits available for the purpose.” The profits available for a dividend are the accumulated realised profits.

Profits are neither simply cash in the limited company bank account and nor the ‘net’ profit figure shown on the last profit and loss account of the company; they are the accumulated profits. These should be shown on a company’s balance sheet as part of the reserves.

Relevant Accounts

A dividend must be declared with reference to ‘relevant accounts’. These ‘relevant accounts’ are those prescribed by legislation as the form stipulated to enable justification of the dividend. This is a mandatory requirement in Section 836(1) of the Companies Act 2006:

“Whether a distribution may be made by a company without contravening this Part is determined by reference to the following items as stated in the relevant accounts—

(a) profits, losses, assets and liabilities;

(b) provisions of the following kinds—

(i) where the relevant accounts are Companies Act accounts, provisions of a kind specified for the purposes of this subsection by regulations under section 396;

(ii) where the relevant accounts are IAS accounts, provisions of any kind;

(c) share capital and reserves (including undistributable reserves).”

What is an unlawful dividend?

Unlawful and illegal dividends by directors are dividends that are declared at a point when the company does not have enough distributable reserves.

If companies fail to comply with the above conditions, the dividend will be unlawful.

What are the consequences of unlawful dividends?

The consequence of unlawful and illegal dividends for an insolvent company is that the director will be unable to ratify the breach of duty and liable to repay the dividends back to the company.

Sometimes unlawful dividends are paid to shareholders when the directors incorrectly determine what available profits the company may have. This could be due to a mixture of poor record keeping and/or possibly even inaccurate accounts.

If dividends are paid when a company is insolvent, or it may become insolvent as a result of that payment, then recovery claims may well be brought by the insolvency officeholder against the shareholders and the directors.

Backdating dividends

The strict nature of the dividend rules means that they must be taken seriously. They cannot be addressed as an afterthought after the year-end for accounting purposes to justify a director’s receipt of company money. The dangers of backdating dividends should not be underestimated; you must declare the dividend first and then you can draw it, not backdate it into the accounts after the year-end.

Profits made by a limited company are distributed to shareholders through the declaration of dividends. Quite often, for example in the case of owner managed businesses, the directors and shareholders of the company are the same. In such businesses, directors might take a minimum salary and consider the rest of their remuneration as a dividend.

While some SMEs’ dividends may be considered a tax-efficient means for directors to be remunerated, before a company is able to pay a dividend it must have enough distributable reserves with reference to ‘relevant accounts’. If these conditions are met, the company then still needs to comply with the declaration formalities before the dividend is paid and not after the event.

So important is the matter of backdating, not just in the context of dividends but more generally, that company directors should note the comments made by Lord Justice Robert Walker in the matter of Malcolm Huntley Potier v Secretary of State for Trade and Industry and also Secretary of State for Trade and Industry v John Douglas Solly in the Court of Appeal (CCRTF 97/1419 CMS2):

“It is a regettable fact that respectable professional men, including solicitors and accountants, seem to think nothing of preparing minutes of fictitious (or ‘notional’) meetings and getting clients to approve them, looking on that as done which ought to have been done. They should take cases like this as a warning that if their clients later prove to have been acting dishonestly, they may find themselves in a position of some difficulty.”

About the author

Elliot Green FCA FABRP of Oliver Elliot is a Chartered Accountant and Licensed Insolvency Practitioner, having undertaken over 1000 formal insolvency appointments over a period stretching close to nearly 20 years.

See also

Notice of dividends (2510)

What are the responsibilities and duties of a company director?

What is the difference between wrongful trading and fraudulent trading?

Find out more

Companies Act 2006 (Legislation)

Tax on dividends (GOV.UK)

Image: Getty Images

Publication date: 14 September 2021

Any opinion expressed in this article is that of the author and the author alone, and does not necessarily represent that of The Gazette.