The risks of unlawful dividends during the coronavirus pandemic

The effects of the COVID-19 pandemic are having a dramatic effect on the global economy. Many businesses are suspending trading activities and furloughing staff, which in turn is affecting cash flows.

Profits made by a limited company are distributed to shareholders through the declaration of dividends. Quite often, for example in the case of SME businesses, the directors and shareholders are one and the same. Here, directors might take a minimum salary and pay the rest of their remuneration by way of dividend as it is a tax-efficient means for directors to be remunerated.

However, before a company is able to pay a dividend, two main criteria must be met:

1. The company must have profits available in order to make the dividend. This often is referred to the company having sufficient “distributable reserves” available; and
2. Any dividend that is paid must be made with reference to the company’s “relevant accounts”.

Several points arise out of the second criteria:

• The “relevant accounts” are normally the company’s most recent annual accounts, or if they do not show sufficient available profits, specifically prepared interim accounts.
• The accounts relied on, however, must show the company’s assets and liabilities, its share capital and include provisions for any future liabilities, such as corporation tax.
• Before making any dividend, a company must consider any events that have arisen since the date when the “relevant accounts” were made and the date when it is proposed the dividend should be paid.

These points are particularly relevant now as a result of COVID-19, where the “relevant accounts” relied upon may have been prepared before the social distancing restrictions were announced by the government. As a result, the accounts may no longer be accurate, given the possible effect on future cashflow and expenditure caused by the COVID-19 restrictions.

Reclassifying dividends as salary

The Court of Appeal has previously confirmed that the company must have sufficient profits available to make the dividend at the time it is paid. This means it is not possible for a company to reclassify a dividend payment as salary at a later date if it is subsequently discovered that the company had insufficient profits at the time the dividend was declared.

Consequently, if there is a risk that a company will no longer have available profits as a result of the COVID-19 restrictions, a director who had been receiving dividends in lieu of salary should consider whether they instead should, from now on, draw their renumeration via the company payroll and pay PAYE and National Insurance contributions in the usual way.

Liability of shareholders

Section 847 Companies Act 2006 provides that if a shareholder knows, or has reasonable grounds to know, that a dividend they have received has been made in breach of the criteria set out above, then they are liable to repay it.

A shareholder will struggle to demonstrate they didn’t have the requisite knowledge if they are also a director of the company.

Furthermore, if the dividend is not repaid, there is a risk HMRC may consider the dividend constituted “salary”, resulting in additional claims by HMRC for unpaid income tax and national insurance.

Liability of directors

In the event of the company’s insolvency, claims inevitably will be brought against the directors.

Although the government recently announced it intends to “suspend” the wrongful trading laws, that will not affect a director’s liability for potential claims for breach of their statutory and common law duties by permitting the dividend to be paid and/or misfeasance and/or transaction at an undervalue claims under Insolvency Act 1986.

A director therefore is at risk of a claim for damages and/or to repay or restore the funds amounting to the losses they caused to the company, plus interest, as a result of any unlawful dividend payment.

A director may also find themselves subject to disqualification proceedings by the Secretary of State.

Consequently, if a director believes or has reasonable grounds to know that their company either does not or is unlikely to have sufficient available profits as a result of the COVID-19 restrictions, no dividend should be paid.

Unlawful dividend claims are issues on which members of the Keystone Restructuring and Insolvency Team regularly advise officeholders, directors and shareholders. Should you require specific advice regarding the payment of unlawful dividends, please feel free to contact a member of Keystone Law’s team.