Illegal Dividends
Definition and Legal Requirement
The payment of a dividend is governed by the Companies Act 2006 and can present problems for Directors who may need professional advice to avoid the dividend being deemed illegal. An illegal dividend can expose Directors to personal risk. Each situation is, however different depending upon the circumstances of a particular case.
Once a company enters into Administration or Liquidation the appointed Administrator or Liquidator is required to investigate whether any illegal dividends have been paid. This is done by analysing the company’s financial statements and books and records.
Ramifications
When an Administrator or Liquidator establishes that an illegal dividend has been paid there are a number of ramifications, the most important being:
- Details of the illegal dividend will form part of the Director’s conduct report that the Administrator or Liquidator is required to submit to the Insolvency Service. This will impact upon the Insolvency Service’s decision to commence disqualification proceedings;
- A Director may be found guilty of Misfeasance, which could result in an order to compensate the company and/or the shareholders could be ordered to repay all or part of the dividend received; and
- If a dividend is not repaid, HM Revenue & Customs may look consider to treat the amount received as salary, resulting in a demand for unpaid income tax and National Insurance contributions.
Defence
To avoid an illegal dividend claim being brought, it is essential to ensure that before paying the dividend there are sufficient distributable reserves available. This may be determined by reference to the last annual accounts, although these may be historic in which case reference may be made to properly prepared management account.
The next step is to investigate whether there are any current matters that may create losses and/or create a contingent or prospective liability. Regard should also be made as to the cashflow position and whether the company is meeting its obligations as and when they fall due.
When satisfied that a dividend can be paid it is then necessary to pass a resolution and prepare dividend vouchers.
Frequently Asked Questions
To declare a lawful dividend, there are a number of legal requirements that must be met before paying the dividend. These requirements are (i) the company must have sufficient, distributable reserves available, (ii) the dividend must be justified by reference to the company's accounts, (iii) the company must be balance sheet and cashflow solvent, (iv) the dividend should be approved by the board and must be in accordance with the company’s articles and (v) the Director must comply with their fiduciary duties.
It is very easy for Directors to make dividends that are unlawful. This can be done by ‘technical error when declaring a dividend to the shareholder’, ‘backdating previously issued dividends’, ‘failure to maintain accurate company accounts and sound record keeping’, and using incorrect or miscalculated company profits which can lead to illegal dividends.
Developing and maintaining sound internal controls and accounting records will restrict the risk of issuing illegal dividends to shareholders. Seeking financial and legal advice on when it would be appropriate to release dividends to shareholders would help to avoid making illegal dividends.