Dividends and Director Loans
We sometimes see as part of the due diligence process on business sales reference (often in financial statements) to a 'dividend' when payments to directors who are also shareholders are recorded, and other entries to 'director's loan account'.
Unfortunately in some cases the legal formalities in relation to the above have not been complied with (or properly recorded) which is some cases could make the transaction unlawful.
Set out below is a very brief summary of what is required for each of the above in terms of legal process.
What is a dividend?
A dividend is a distribution of a company's post-tax profits to its shareholders.
When can we pay or declare a dividend?
Any dividend paid out by a company will normally be either a final dividend or an interim dividend.
Final dividends are usually paid out once a year and are calculated after the annual accounts have been drawn up. The dividend is recommended by the board of directors and declared by the shareholders.
Interim dividends can be paid at any time throughout the year and are calculated before the company's annual earnings have been determined and are decided solely by the board of directors.
As with all distributions, in order for a company to be able to lawfully pay a dividend, it must have sufficient distributable profits that are justified by reference to relevant accounts. Directors should discuss with their accountants which accounts those are and also the availability of distributable profits out of which to pay/declare the dividend.
The company must also have enough cash (or where relevant assets) to satisfy the dividend and must be solvent before and after its payment.
Having the cash but not enough distributable profits is not enough to satisfy the legal requirements to declare/pay a dividend
Company directors are under a common law duty to safeguard a company's assets and must also consider the company's future financial requirements before recommending or declaring or paying a dividend. They must have regard to the company's best interests generally and could be liable if they pay a dividend in an imprudent manner.
A director who authorises the payment of a dividend which contravenes the law, such as a dividend in excess of a company's distributable profits, may be in breach of their statutory and common law duties and may be personally liable to repay it to the company, even if the director is not a shareholder. The dividend is also unlawful. This can have detrimental ramifications. For example, an unlawful dividend is not void – the payment still stands – but any shareholder who received the unlawful dividend can be required to pay it back to the company if the shareholder knew (or had reasonable grounds for believing) that it was unlawful, and it could affect the future accounts of the company as they may not give a true and fair view. The directors of the company have a duty to report unlawful dividends in the company's accounts.
It is not possible to reclassify an unlawful dividend as a salary retrospectively.
In order to evidence the fact the correct steps have been followed in relation to the payment of dividends the necessary paperwork should be put in place and relevant checks in relation to payment of dividends made – for example, check the articles of association and shareholders agreements, banking documents for the process/restrictions on dividends.
The board should convene and hold a board meeting approving the payment/recommending to shareholders payment of the dividend (and if the shareholders are to declare the dividend convene and hold a shareholder meeting/if a private company use the written shareholder resolution process). The meeting should be carefully minuted (including recording the availability of adequate distributable profits, solvency and consideration of the financial positon of the company) and all relevant documents produced to the board meeting (such as relevant accounts, cash flow projections etc.) should be stored with the signed board minutes. This will be key evidence to help support directors decisions to pay/recommend payment of dividends if they are ever challenged in the future.
Loans to Directors
It has been relatively common practice for remuneration to directors who are also shareholders which is not employment related (for example a salary), for tax reasons, to be recorded as a loan to a director (director's loan account) and the loan is then sometimes cleared/reduced by a year-end dividend. It is particularly confusing for shareholder directors of small businesses to not treat the company's assets as their own in terms of their remuneration (where for example they may been used to being a sole trader before incorporating their business into a private limited company) where there is greater flexibility in taking money out of the business.
In some cases a dividend is declared/paid at the start of the year and loaned back to the company and the director shareholder is then repaid a certain amount monthly. The comments below are not aimed at that practice but as a general comment such loans are seldom documented and this can make for difficulties in the future as to the terms on which such loans have been made (for example interest, repayment dates etc.) so it makes matters cleaner if they are formally documented.
The basic starting point is that unless the transaction has been approved by a resolution of the members of the company, subject to certain exceptions, a company may not:
- Make a loan to a director of the company or of its holding company.
- Give a guarantee or provide security in connection with a loan made by any person to such a director.
If the director is a director of the company's holding company, the transaction must also have been approved by a resolution of the members of the holding company. There are procedural formalities that must be followed including providing the members/shareholders with a memorandum of the terms of the loan including certain prescribed information.
Where a company enters into a transaction or arrangement in contravention of the Companies Act legislation, the transaction or arrangement is voidable at the instance of the company subject to certain exceptions.
In addition whether or not the arrangement or any such transaction has been avoided, amongst others, any director of the company or of its holding company with whom the company entered into the transaction or arrangement in contravention (subject again to certain exceptions) is liable:
- To account to the company for any gain that he has made directly or indirectly by the transaction or arrangement.
- Jointly and severally with any other person so liable under the relevant legislation, to indemnify the company for any loss or damage resulting from the transaction or arrangement.
Therefore directors who knew about unlawful loans to other directors could be liable in effect to repay the loans even though they did not receive the benefit of them. This is a particular hot bed if the company goes in to an insolvency process.
Loans to employees or directors/officers (who are individuals) of the company may also be regulated by the Consumer Credit Act legislation and must comply with, or fall into one the exclusions or exemptions of such legislation, and this needs careful analysis before such loans are made by the company. The ramifications for failure to comply with the relevant Consumer Credit Act legislation can be quite severe including the repayment of the loan by the employee/director not being enforceable (at least not without a Court order) and civil and criminal penalties may also apply.
There may also be tax implications for making a loan to a director or person associated with them which should be considered with the company's tax advisers (for example where a close company makes a loan to one of its participators (including a director who is also a participator) (a participator is any person having a share or interest in the capital or income of the company, and in particular includes shareholders) and the loan (which is greater than £10,000) is not repaid within a certain timeframe (9 months after the end of the accounting period in which the liability arises) the company will have to pay s.455 of the Corporation Tax Act 2010 tax on the loan advanced in that tax year and depending on if interest is charged, the director may be subject to benefit in kind tax). If the loan to the director by the company is written off then that too will have tax consequences as well as potential for a deemed distribution (if the director is a shareholder) with the legal requirements that would need to be fulfilled in order to make such a distribution. In summary take tax advice before making loans to directors or writing them off!
In order to evidence loans to directors there needs to be a formal written loan agreement, a board meeting to approve the loan (subject to shareholder approval) and the content of that board meeting carefully minuted, including considering the solvency of the company, the corporate benefit, the ability of the borrower to repay the loan and their creditworthiness and the company's financial position. Shareholder approval will be required to the loan whether though a shareholders meeting (or if available, through the written shareholder resolution procedure) including preparing and sending to the shareholders a memorandum of the terms of the loan. A proper record of the above will be key evidence to help support the directors' decisions to make a loan to a director if they are ever challenged in the future.
A member of the Corporate law team here at Chattertons would be happy to discuss confidentially any thoughts you are having on a free, no obligation basis.
This briefing note is not intended to be a comprehensive guide and does not cover every aspect of the topic and is not intended to provide legal or other advice.