A great many companies pay their directors largely in dividends, rather than through the PAYE system, as a more tax-efficient means of remunerating them. As a Court of Appeal insolvency case illustrated, however, it is vital to remember that companies that do not make profits cannot lawfully pay dividends.
The case concerned a company that paid one of its directors £23,511 in what were described as interim dividends over a 16-month period. After the company entered creditors’ voluntary liquidation, its liquidators argued that, at the relevant time, the company had insufficient distributable reserves of profits out of which dividends could be paid in conformity with Section 830 of the Companies Act 2006.
The liquidators subsequently assigned their right to sue the director for return of the money to a third party. After launching proceedings, the assignee argued that the company had for some years been balance sheet insolvent and therefore not in a position to lawfully pay dividends. The director, however, pointed out that he had worked hard in the business for many years and had never taken excessive remuneration.
In ruling on the matter, a judge found that dividends had been chosen as a means of remuneration in order to minimise tax and that they were in reality compensation for work done by the director. Although the company was not entitled to pay dividends, the judge dismissed the assignee’s claim on the basis that they had only been awarded in principle, subject to confirmation by the company’s accountants at the end of the financial year.
In upholding the assignee’s appeal against that ruling, however, the Court found that the judge had reached the wrong conclusion by focusing too much on the director’s state of mind and intentions. The payments had been expressly declared as dividends and taxed accordingly. They were clearly distributions of the company’s assets within the meaning of Section 830 and, in the absence of sufficient profits, were unlawful. The ruling meant that the director was obliged to repay the sums.