In this article, we will discuss what dividends are and the various implications they have on a company and individual, giving some insight based on experiences from our own clients.
What are dividends?
Dividends refer to the distribution of company profits to the owners of the business. Therefore, they are only applicable to companies, as opposed to takings by owners of a sole trader or self-employed business which are generally referred to as drawings. So, you may think of dividends as the owners’ reward from the business for their own benefit, on the back of the company’s good and profitable performance.
Some companies however prefer to keep profits in the business rather than distributing them to the owners, so that they could fund for future growth and expansion of the business.
Types of dividends
For most companies, there is only one type or category of owners referred to as “ordinary shareholders”, which consequently means that any distributions to them are ordinary dividends. The dividends are declared to the shareholders proportionately based on the number of company shares held.
There are however some companies that have complex shareholding structures which ensure that dividends are distributed in order of preference based on agreed shareholding terms stipulated within a company’s articles and memorandum of association. A common example is where ownership includes “preference shareholders” who hold shares that have preferential rights to the company. Any dividends issued to them are preference dividends and are declared to them first before being distributed to the ordinary shareholders.
The most common form are of course cash dividends which are paid out of the company’s cash resources. This would however require an assessment by the company of its cashflows before and after to ensure that the business is not left cash stranded after distributing funds to shareholders.
At times, the company does not have enough cash resources but still has more than enough accumulated profits to distribute as dividends. In this case, the company can opt to issue dividends other than in cash, and this form of distribution is referred to as a dividends in specie. Assets of the company can be distributed such as physical goods (such as inventory, property, vehicles, etc…) or the company can choose to issue its own shares to existing shareholders for free, commonly referred to as “bonus shares”. The value of the dividend in specie is usually considered to be the market value of asset distributed.
The distribution of dividends in the UK and IOM is governed by the relevant jurisdictions’ companies acts. The most recognised requirement by law is that dividends can only be declared if the company has enough “distributable reserves”. In other words, the company needs to have positive accumulated profits before and after the dividend is declared. Accumulated profits are shown in the balance sheet of a company’s accounts.
The reason for the above requirement is to protect the creditors of the company as the debts owing to them by the company are given preference over any distributions to be made to the owners. The directors of the company therefore need to perform an assessment of whether they will be able to repay their debts after the dividend is declared. If there are unable to do so, the distribution to the owners is considered unlawful.
The other consideration pertains to authority over who can declare dividends. As a general rule (usually stipulated in the company’s articles of association), the directors of the company are the ones who have the powers to decide on the declaration of a dividend, rather than the owners. Many small companies are owner-managed however, therefore the decision rests with the same person or group of individuals.
Closing down a company
A company may choose to close down for various reasons, including transferring operations to a new company or simply ceasing operations. We noted from some of our clients that there might some assets, cash or otherwise, still in the company that effectively would require distributions back to the owners. These would constitute dividends which have the tax implications detailed below.
Moving funds out of the company
Dividends are one of many ways funds can be moved out of the company, including during the closing down of a company. Other ways to move funds (salaries, dividends, loans) have been discussed in our previous article at the following link, together with associated implications: https://www.invicta-accounting.com/blog-post/sole-trader-or-limited-company/
In both the UK and the IOM, dividends are effectively taxed in the hands of the individual owners who receive them. Any dividends received from companies should be declared in the owner’s individual tax return.
The basic rule of calculation is that for the 2019/20 tax year in the UK, any dividends received above the personal allowance threshold of £12,500 plus dividends allowance of £2,000 will attract tax. Therefore, you can receive up to £14,500 dividends tax-free. The overall tax you pay will depend on other types of income you earned during the year in addition to the dividends (e.g. salaries, interest, etc…). More details on taxation of dividends in the UK can be found at the following link: https://www.gov.uk/tax-on-dividends
In the IOM, only the personal allowance of £14,000 for the 2019/20 tax year is used as a threshold for tax-free dividends. Dividends received above this amount will attract tax. Again, overall tax position of the individual will depend on other forms of income they receive.
Dividends declared by a company are not considered “an expense” of the company, but rather a distribution of profits to the owners of company, therefore they will not be allowed as a deduction from taxable income of the company when calculating company tax.
In both the UK and IOM, if a company receives dividends from another company, it will include the dividend income in its company tax return and will be tax on its profits which include the dividend income.
Shareholder or director loan accounts
A common occurrence for most small companies is the existence of shareholder loan (or current) accounts. In some instances, they are also classed as a director loan (or current) if the director is also the owner of the company.
Shareholder directors often draw funds from the company through the year and the company keeps track of those withdrawals in a loan receivable account, reflecting funds owed to it.
As noted with some of our clients, at times the shareholder director is unable to repay the loans back to the company. It is commonplace for the company to reach an agreement with the director to classify those as dividends at the end the company’s financial year, as long as the requirements stated in the “requirements” section above are met.
If the loans however remain unpaid, there could be tax implications for the company year after year for as long as the loans remain outstanding. More information can be found at the following link: https://www.gov.uk/directors-loans/you-owe-your-company-money. Similar rules generally apply both in the UK and IOM.
What Invicta can do for you
Most of our clients found our expertise in dealing with dividends both at the company and individual level to be highly fruitful. Computations and tax implications can become complex due to the many tax rules associated with dividends, but we have a lot of experience in assisting clients to determine the optimum positions when it comes to dividends and overall tax implications.
We can perform detailed calculations based on various scenarios depending on your circumstances. If we look after the books of your company as well, we are in the perfect position to conduct detailed analyses of your company’s performance and overall position for purposes of determining the right level of dividends which also meet the requirements of law. We will have a deeper understanding of your numbers and access your records to perform computations which best optimize your financial position.
Call us on 01624 672358 or email us at firstname.lastname@example.org for a free consultation.