Directors warned about the risk of paying illegal dividends

Directors need to be careful to avoid paying illegal dividends or they could become personally liable for company liabilities, warns tax and advisory firm Blick Rothenberg

Sunil Bhavnani, a technical partner at the Blick Rothenberg, said: ‘It’s common for directors of owner managed businesses to pay a portion of their income as dividends and with the end of the tax year fast approaching, directors will once again be turning their minds to declaring an annual payment. 

‘The rules around dividends and distributions, governed by company law capital maintenance requirements and directors’ fiduciary duties, can be complex. If the requirements are not met such that the dividend is unlawful, the directors will need to act quickly.

‘A shareholder is required to repay an unlawful distribution if they know or have reasonable grounds for knowing that it was made unlawfully at the time of payment. In the case of a distribution made otherwise than in cash, the shareholder will have to pay the company a sum equal to the value of the distribution at that time.’

The capital maintenance requirements of the Companies Act 2006 require that any distribution can only be made where distributable profits exist and that is irrespective of the level of surplus cash in the business.

The determination of distributable profits is usually made by reference to the balance on retained earnings shown in the last set of financial statements. However, directors must consider changes in financial position and performance after the balance sheet date. 

Bhavnani warned: ‘This is particularly relevant if the financial performance has deteriorated losses and reduced the level of the retained earnings balance. Directors may therefore need to draw up interim accounts to evaluate the position if a distribution is to be made many months after the year end.’

In view of the pandemic, care will need to be taken to ensure that appropriate accounting adjustments are made in any set of financial statements for matters such as:

  • bad and doubtful debts;
  • provisions for surplus or obsolete inventory;
  • impairment of site premises which are not being used;
  • provisions of onerous leases; and
  • early recognition of losses on contracts that will no longer be profitable.

‘The directors will need to consider whether adjustments for such matters need to be made in any interim accounts for dividends paid sometime after the year end.

Directors are also subject to fiduciary and other duties. These include the obligation to safeguard the company’s assets and take reasonable steps to ensure that the company is in a position to settle its debts as they fall due. Debts will include trade creditors and loan borrowings but other factors may be important such as liabilities towards pension schemes.

‘Directors should consider both the immediate cash flow implications of a distribution and the continuing ability of the company to pay its debts as they fall due,’ said Bhavnani. ‘Directors must consider whether the company will still be solvent following a proposed distribution. Directors may be personally liable should the company become insolvent.’

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