Get it Right: Dividends

This article was written for the Association of Accounting Technicians (AAT) magazine ‘Accounting Technician’.

A dividend is a type of return on investment to the shareholders of a business. In practice they are also one of the most common types of income for director-shareholders of private entities. Many directors who are shareholders receive a mix of salary and dividends and, in some cases, this type of remuneration structure can be tax efficient.

There are strict rules in company law that need to be complied with where dividends are concerned. If these rules are not followed correctly, any dividends may be unlawful and this, in itself, can have potentially serious consequences. In some cases, shareholders may be required to repay unlawful dividends.

This article will cover two of the most common types of dividend:

• Final dividends. These are paid once a year once the final accounts have been prepared. They are recommended by the directors and approved by the shareholders.
• Interim dividends. These are dividends that are paid during the year and are usually declared by the directors.

Realised profit

Dividends are a form of ‘distribution’ to the shareholders. Section 829(1) of the Companies Act 2006 (CA 2006) states that a ‘distribution’ means every distribution of a company’s assets to its members, whether in cash or otherwise. There are some exceptions in section 829(1) which relate to issues of shares, reduction of share capital, redemption or purchase of shares and distributions of assets on winding up.

In order for a dividend to be lawful, it must be paid out of distributable profit (CA 2006, s 830(1)). A company’s ‘distributable profits’ are its accumulated, realised profits (so far as not previously utilised by distribution or capitalisation), less realised losses (so far as not previously written off in a reduction or reorganisation of capital duly made).

Paragraph 3.9 of Tech 02/17BL Guidance on Realised and Distributable Profits Under the Companies Act 2006 states that a profit is realised, as a matter of generally accepted accounting practice, where it arises from:

(a)        a transaction where the consideration received by the company is ‘qualifying consideration’; or

(b)       an event which results in ‘qualifying consideration’ being received by the company in circumstances where no consideration is given by the company; or

(c)        the recognition in the financial statements of a change in fair value, in those cases where fair value has been determined in accordance with measurement guidance in the relevant accounting standards or company law, and to the extent that the change recognised is readily convertible to cash; or

(d)       the translation of:

(i)         a monetary asset which comprises qualifying consideration; or

(ii)        a liability,

denominated in a foreign currency; or

(e)        the reversal of a loss previously regarded as realised; or

(f)        a profit[1] previously regarded as unrealised (such as amounts taken to a revaluation reserve, merger reserve or other similar reserve) becoming realised as a result of:

(i)         consideration previously received by the company becoming ‘qualifying consideration’; or

(ii)        the related asset being disposed of in a transaction where the consideration received by the company is ‘qualifying consideration’ or;

(iii)       a realised loss being recognised on the scrapping or disposal of the related asset; or

(iv)       a realised loss being recognised on the write-down for depreciation, amortisation, diminution in value or impairment of the related asset[2]; or

(v)        the distribution in kind of the asset to which the unrealised profit relates; or

(vi)       the receipt of a distribution in the form of qualifying consideration when no profit is recognised because the distribution is deducted from the book value of the investment to which the unrealised profit relates (eg, a distribution which is credited to the cost of investment because it is in substance a return of capital), in which case the appropriate proportion[3] of the related unrealised profit becomes a realised profit; or

(g)        the remeasurement of a liability, to the extent that the change is readily convertible to cash.

According to Tech 02/17BL, the term ‘qualifying consideration’ comprises:

(a)        cash; or

(b)       an asset that is readily convertible to cash; or

(c)        the release, or the settle or assumption by another party, of all or part of a liability of the company; or

(d)       an amount receivable in any of the above forms of consideration where:

(i)         the debtor is capable of settling the receivable within a reasonable period of time; and

(ii)        there is reasonable certainty that the debtor will be capable of settling when called upon to do so; and

(iii)       there is an expectation that the receivable will be settled; or

(e)        an amount receivable by a company from its shareholder where and to the extent that[4]:

(i)         the company intends to make a distribution to the shareholder of an amount equal to or less than its receivable from that shareholder; and

(ii)        the company intends to settle such distribution by off-setting against the amount receivable (in whole or in part); and

(iii)       within the meaning of paragraph 3.5 and 3.5A of this guidance, (i) and (ii) are linked.

Keep in mind that if any dividend (or part thereof) is paid out of non-distributable profit, the dividend will be unlawful. For example, if a dividend is paid out of unrealised profit such as a fair value gain on investment property.

Unlawful dividends may need to be repaid back to the company by the shareholders. In other instances, for example, HMRC may view such transactions as being part of a shareholder’s salary which will attract income tax and national insurance contributions if it can be proved that the dividend is unlawful or has not been documented properly.

The accounts

Dividends can only be paid out of distributable profit. Hence, the directors must have accounts which show there are sufficient distributable profits available to make the dividend. Those accounts must be either:

• the company’s last accounts;
• if those accounts suggest there are insufficient distributable profit available to make the dividend, the dividend must be justified with regard to more up-to-date interim accounts; or
• if the dividend is being declared in the company’s first accounting period, ‘initial accounts’ must be prepared.

Regard must be had to the ‘wider picture’ because the accounts are just one aspect that must be considered. The directors must also consider:

• the financial position of the entity at the time the dividend is declared;
• availability of cash in order to pay the dividend; and
• the future financial position once the dividend is declared. The directors must keep in mind that the entity must still be in a position to meet its ongoing obligations to creditors.

Articles of association

A company’s articles of association will usually contain provisions relating to dividends. For example, an entity’s articles of association may stipulate that dividends can only be paid on fully paid shares, or that dividends may be restricted to a certain class of shares. In practice, shareholders may be entitled to receive dividends in proportion to the number of shares they hold, but do check the articles of association because they may specify a certain way in which the dividends have to be authorised. At all times in the dividend process, the objective is to ensure that the dividend remains lawful.

Documentation

Sufficient documentation is crucial. Without correct documentation the dividend will not be lawful and this can bring about serious consequences.

Dividend documentation should be correctly prepared including the relevant minutes of meetings and tax vouchers. Interim dividends are normally paid by the directors during the year and a final dividend is declared by the directors and approved by the shareholders. Interim dividends must also be appropriately documented.

Dividend documentation cannot be back-dated. Any dividend declared after the year end for the previous year can only be deemed to be paid in the year of declaration. If dividend documentation is back-dated this will be classed as fraud.

Recognition in the financial statements

FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland at paragraph 32.8 prohibits a dividend being recognised as a liability in the financial statements if that dividend is declared after the reporting date. This is because no obligation will exist at the reporting date.

Also, keep in mind that if the obligation is not adequately documented (e.g. if there are no minutes or the shareholders have not approved the final dividend) there will still be no legal obligation at the reporting date and hence the dividend should not be recognised.

[1] Where the related profit has been capitalised, it will not be available for transfer from unrealised profit to realised profit.

[2] If the write down is subsequently reversed, an equal amount should be regarded as becoming realised. In other words, the amount of profit regarded as becoming realised is equal to the cumulative amount of any write down treated as a realised loss.

[3] In the case of (iii) and (iv), the loss is treated as a realised loss under paragraph 3.15 [of Tech 02/17BL]. However, part of this realised loss is compensated by a reclassification from unrealised to realised profit.

[4] Paragraph 3.11(e) [of Tech 02/17BL] sets down generally accepted accounting practice that the receivable can be regarded as qualifying consideration in certain circumstances. The effect of this is that making a distribution settled by offset against the receivable is an alternative procedure to a distribution in kind of that receivable.

Category: Accounting and standards, Audit