The adverse impact of coronavirus on some companies’ trading fortunes now means business owners need to watch out before they calculate dividends, as they may be liable for losses should the business subsequently fail.
The law on distributions applies not only to dividends, but to any form of distribution to shareholders. Put simply, a distribution is any transaction that transfers value to a shareholder, or any other related party, because they are a shareholder. This includes gifts and other transactions at undervalue.
Typically drawings by owners (school fees, holidays, non-business personal expenses) are charged to their personal loan accounts with the company and then, to redress their overdrawn position, a dividend is declared to repay the sums due before the company’s accounts are finalised.
Why are dividends different?
Dividends are different because they represent a distribution of post-tax profits to the company’s shareholders, payable to all shareholders in proportion to their shareholding.
The key difference, compared to remuneration, is that shareholders are required to repay unlawful dividends received, if they knew of the facts that made them unlawful (even if they did not appreciate that they made the dividends unlawful). Where shareholders are also directors, facts known to them in either capacity will be relevant in this context.
What are the profits available?
The starting point is to look at the last annual accounts. The balance will often show ‘retained’ earnings or ‘accumulated profit and loss’ reserves. It is important to determine which of those reserves qualifies as available to pay dividends.
By law, only those profits that have been ‘realised’ are available for distribution as a dividend. Profits from normal trading activity are typically realised profits, as opposed to unrealised profits from, for example, a revaluation of the company’s property, which are not automatically available for distribution until the revaluation is realised from the property’s sale. The accounts will usually distinguish between reserves which are realised and those which aren’t.
Further issues may arise if the company is subject to an audit, and additional considerations apply where the auditor’s report is qualified. Under the Companies Act 2006, an auditor’s statement will be required, demonstrating that the qualification does not affect the proposed dividend.
What if the financial position has deteriorated since the accounts?
Directors must consider their position carefully, as any deterioration since the date of the accounts will reduce the reserves from which a dividend may be paid. Any subsequent losses could eliminate the potential for legitimate dividends to be paid. This is of particular concern where business owners have made regular withdrawals, debited to their director’s overdrawn loan account, with the intention of remedying the overdrawn loan position through the declaration of a dividend.
If the company then fails, the director/owner will find themselves liable for a claim, either to repay the overdrawn loan account position as a debtor of the company, or a claim for the receipt of an illegitimate dividend. Not helpful if the money has already been spent!
What if the financial position has improved since the accounts?
In this case, new accounts should be drawn up to determine the profits available. Subject to the ongoing working capital needs of the business, dividends can then be declared, and money withdrawn from the business.
Should the company pay dividends, even if it has profits available?
The directors should still consider the potential impact paying dividends might have on the company’s cashflow. Will the company remain solvent? This means considering the immediate cash flow implications of a dividend, and the continuing ability of the company to pay its debts as they fall due. Clearly, directors of companies in financial difficulties should seek appropriate professional advice in such circumstances.