Dividends can only be declared out of a company’s available undistributed profits and even if the bank account is in credit as at the date of withdrawal, it does not necessarily mean that sufficient profit has been made to cover the payment. ‘Profit’ in this instance is defined in the Companies Act 2006 as being ‘accumulated realised profits…less ....accumulated, realised losses’. Therefore, a dividend could be paid in a loss-making period, provided that there are sufficient 'distributable'/retained profits brought forward making an overall profit. Conversely, a dividend cannot be paid if a profit has been made in an accounting period but retained losses brought forward mean that the overall result is a loss.

If a dividend is paid without a sufficient amount of profit to substantiate the payment, this effectively means that the company is trading as insolvent and breaking (company) law. It is a dividend that has been paid that should not have been at the time and as such is 'illegal' (termed ‘unlawful distributions’ in the Companies Act 2006).

Tax implications

· Company

If a dividend was declared when there was insufficient retained profit, the dividend is treated as void and the shareholder is treated as not having received a distribution. Where that shareholder knows or should have known that a dividend (or part thereof) is illegal, that shareholder is liable to repay the dividend (or the proportion that exceeds available reserves) to the company if it has already been distributed.

If the dividend is not repaid and the shareholder is also a director or employee, the payment will fall under the ‘loans to participators’ rules. Under these rules, the loan needs to be repaid or written off by the due date of nine months and one day after the year end otherwise a tax charge will be levied on the company. The tax rate is the same as the higher 'dividend tax' rate of 33.75% of the gross amount paid. This amount is payable even if the company is making a loss. Once the loan is repaid, the tax will also be repaid.

· Shareholder/director

The 'loans to participator' rules do not apply should the 'loan' be less than £15,000 and the director/shareholder is a full-time working director whose interest in the company is less than 5% of the share capital.

However, any director in receipt of a payment exceeding £10,000 is treated as having received an 'employment related loan'. As it is unlikely that interest would have been paid, this deemed loan will trigger a benefit in kind with a notional interest rate charged (currently 3.75% per annum). P11D forms will need to be completed to account for the ‘beneficial interest’ and the company will be liable to pay secondary Class 1A NIC.

Note that if the loan is formally released by the company, this would be treated as if the loan had been repaid. If the company’s reserves are overdrawn, the directors are obliged to try to recover the funds from the shareholders.

· Liquidation implications

In extreme circumstances, the directors of the company may be held personally liable for an 'illegal' distribution as being a breach of their fiduciary duties to the company. In reality, this is only likely to happen if the company enters liquidation or administration.

It is routine for the liquidator or administrator to review the conduct of the directors over the three years prior to insolvency and, if it is found that a dividend has been paid ‘illegally’, then the liquidator or administrator can apply for the director to repay the amount withdrawn. The time limit for recovery of such dividends is six years from the date of declaration or its declared payment date, whichever is later.