Many directors think they have a right to the money in their company’s bank account. However, withdrawing funds as a dividend is more complex. Specific rules and procedures must be followed to ensure compliance with the law.

Understanding Dividends

A dividend is a share of the company’s post-tax profits distributed to shareholders. To legally declare a dividend, the company must have enough retained profits to cover the payment. Before deciding on a dividend, it’s crucial to check the company’s financial status.

Illegal Dividends

If a dividend is paid without sufficient profits to back it, this is known as an ‘illegal dividend’. This could happen even if the company’s bank account shows a healthy balance on the withdrawal date. It’s the retained profits that count, not just the cash in the bank.

For example, a company could be making a loss in the current period but still pay a dividend if there are enough retained profits from previous periods. Conversely, if the company made a profit this year but has carried forward losses from previous years, resulting in an overall loss, it cannot pay a dividend.

Why Some Shareholders Might Prefer Not to Take Dividends

Sometimes, shareholders may prefer to avoid taking their dividend, even if the company can afford it. This can be for several reasons, including tax considerations. For instance:

1. Tax Rates: If one shareholder is a higher-rate taxpayer while others are basic-rate taxpayers or non-taxpayers, it might be advantageous for them to waive their dividend.
2. Child Tax Credit: Receiving a dividend could push a shareholder’s income over the limit for Child Tax Credit.
3. High-Income Child Benefit Charge: This charge applies if a shareholder’s income exceeds a certain threshold, which can be affected by dividend payments.

Waiving a Dividend

If a shareholder doesn’t want to receive a dividend, they can waive their right to it. This means they give up their entitlement, and the waived amount will stay in the company’s bank account. The other shareholders still receive their shares as usual.

Alphabet Shares

To manage dividend payments more flexibly, companies sometimes use ‘alphabet shares‘. These are different classes of shares (e.g., A shares, B shares) that allow dividends to be paid at different rates for each class. This can be useful in situations where shareholders have different tax or financial considerations.

“When a dividend is waived, the waived amount stays in the company, potentially increasing funds available for other shareholders. However, HMRC may scrutinise such arrangements, arguing that the waiver indirectly provides funds for an arrangement or settlement, which could be challenged under anti-avoidance rules.”

Settlement Rules

Settlement rules are designed to prevent tax avoidance. They apply when the person giving up an asset (the settlor) retains an interest in it or if the settlor or their spouse benefits from the arrangement. If HMRC deems that the waiver constitutes a settlement, the dividend would still be considered the original shareholder’s income.

Deciding whether to take a dividend isn’t just a financial decision; it has significant legal and tax implications. Directors need to be aware of these implications to avoid illegal dividends and potential issues with HMRC. By understanding the rules and planning carefully, you can manage dividends effectively and compliantly.