Considerations when paying a dividend

Understanding how to transfer value from your business without falling into legal or financial pitfalls is important for any director or shareholder and getting it wrong can lead to significant consequences. In this blog, we will help you further understand the rules surrounding dividends, ensuring your decisions remain compliant with legal and financial requirements.

When we start working with a company, we often hear or see the same common misconceptions or misunderstandings when it comes to dividends. These can be (but are not limited to):

A lack of understanding of what a dividend is as opposed to a drawing or withdrawal from a company.
Thinking that a dividend can be ‘paid’ without undertaking the due process or checks.
That dividends can be ‘paid’ to shareholders with no baring to their shareholding.
That dividends can be decided when preparing the final accounts i.e. backdating!

Of course, we hope that it is not the case (especially on point 4). Our article explains more about dividends, the requirements and the thought process directors and business owners need to consider.

Is the payment a dividend, or something else entirely?

When it comes to transferring money or value from your business, it’s essential to be clear about what kind of payment you’re making. Is it a dividend, a director’s salary, a loan, or something else entirely? Misclassification of a payment has the potential to lead to unexpected consequences, including legal or tax issues.

Any transaction that benefits a shareholder – or someone connected to them – may be considered a “distribution.” This includes not only traditional dividends but also gifts, loans at below-market rates, or other ways of transferring value. For directors who are also shareholders, balancing dividends, salaries, or withdrawals through director’s loan accounts is common. Despite this, it’s important to remember that the law focuses on the substance of the transaction, not what you call it.

To stay compliant, document decisions clearly.

What sets dividend payments apart from other types of payments?

Dividends represent a distribution of post-tax profits to shareholders, paid equally to all holders of the same class of shares and in line with the company’s constitution e.g. the articles of association. Unlike other payments, dividends:

Can only be paid from profits available for distribution, as defined by company law.
Must follow strict legal guidelines; directors authorising unlawful dividends can be held personally liable.
May need to be repaid by shareholders if deemed unlawful, especially if they were aware of the circumstances.

How can you determine if your profits are available to pay dividends?

To establish if your company can pay dividends, start with the latest annual accounts shared with shareholders. Look for “retained earnings” or “profit and loss reserves” in the balance sheet. For smaller businesses, these may appear as general “capital and reserves.” It’s crucial to identify which part of these reserves qualifies as distributable.

Legally, only “realised profits” can be used to pay dividends. For example, profits from regular trading often qualify, however revaluations of assets or some intra-group transactions may create reserves that are classified as unrealised and cannot be used for dividends.

Taking time to review accounts thoroughly can help avoid legal and financial risks.

Assessing financial position

When making a decision to declare dividends, it’s insufficient to only review the latest annual accounts.

If realised profits have been reduced by subsequent losses, available funds for dividends may be lower. Directors must review the company’s current financial position before making payments accordingly.

If profits have increased, directors might prepare “interim accounts” to confirm that the available profits are sufficient.

Interim accounts should account for tax on profits to date and reflect any required adjustments, even if not reflected in the management accounts.

Even with available profits, directors must evaluate whether paying dividends is practical. For example, they should consider the cash flow impact and funds the company may require for any upcoming obligations.

Are there additional considerations for groups of companies?

In a group, dividends must come from profits in each individual company’s accounts. Even if the overall group is profitable, a subsidiary with losses cannot distribute dividends.

Intra-group transactions, such as loans or asset transfers, must be handled carefully, and seeking professional advice is strongly recommended to ensure compliance with the legal requirements.

What is the process for paying dividends?

Checklist for directors:

Ensure dividends are covered by realised profits in the latest accounts or interim accounts.
Verify profits have not been reduced by subsequent losses.
Confirm the payment won’t jeopardise the company’s financial health.

Most company articles of association outline the process for paying dividends, typically requiring:

Directors’ recommendation and approval by ordinary resolution.
Documentation, including meeting minutes and dividend certificates for shareholders.

For interim dividends, ensure legal tests are met at every stage, from decision-making to payment. Keeping thorough records is essential.

Closing thoughts

Dividends are a powerful way to distribute profits, but they come with strict legal and financial requirements. By understanding the rules, documenting decisions carefully, reviewing your financial position and seeking professional advice where needed, you can handle any complexities with confidence.

We would like to acknowledge the ICAEW blog ‘Paying dividends – the essentials’ as a valuable resource when writing this blog.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firms mentioned.

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