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Avoiding Costly Pitfalls: Director Shareholders, Dividends, and s.455 Tax Liability

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Categories: Corporate solutions
Date published: 14/01/2025

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For director-shareholders in small to medium-sized businesses in particular, paying themselves through dividends is a common practice. However, this approach carries potential risks when correct procedures are not followed, particularly under s.455 of the Corporation Tax Act 2010, which can result in costly mistakes.

What is s.455 Tax Liability?

Section 455 imposes a temporary corporation tax charge on directors’ loans. This tax is payable alongside the company’s corporation tax bill but can be reclaimed from HMRC once the director’s loan is fully repaid. In many cases, companies advance money to directors as director’s loan, which is later “repaid” by declaring an end-of-year dividend that is credited against the director’s loan account. While this process can work seamlessly, mistakes often arise, resulting in unintended s.455 tax liability.

This issue arises because s.455 is specifically designed to prevent directors from taking interest-free loans from their companies as a substitute for salary or dividends. The tax acts as a deterrent, ensuring that director loans are either repaid promptly or appropriately accounted for as taxable income. If a loan remains unpaid nine months and one day after the company’s accounting period ends, the s.455 tax charge becomes payable. This creates a pressing need for directors to understand the rules surrounding dividends and director loans to avoid financial pitfalls.

This article will not consider the requirements of director’s loan payments but instead will focus on the risks of the dividend payments being classified as director’s loan payments.

How Do These Issues Arise?

On detailed audit, it can be surprisingly common to find the director shareholders paying themselves dividends which should correctly be classified as director’s loans, having no intention to do so. This can occur if dividends are not declared and paid in compliance with the Companies Act 2006 and in particular with the company’s Articles of Association. For example:

  • Distributable Profits Requirement: Dividends must be paid from distributable profits. While end-of-year accounts provide clarity, interim dividends require accurate management accounts to assess available profits.
  • Resolutions and Documentation: The company’s Articles often require specific resolutions by directors and shareholders to declare dividends. Without these, any payments to director shareholders could legally be classified as director’s loan.

Additionally, businesses often fall into the trap of assuming that informal agreements between directors and shareholders suffice to authorise dividend payments. However, informal arrangements without proper documentation can lead to significant complications if challenged by HMRC. The lack of formal resolutions and records can make it difficult to prove that a payment was as a dividend rather than a director’s loan as a matter of law.

Consequences of Incorrectly Declared Dividends

Failing to declare dividends correctly can have significant financial and legal implications:

  • Tax Liability and Penalties: If HMRC determines that payments were director’s loan payments rather than dividends, the company will incur s.455 tax liability. Although this tax is reclaimable once the loan is repaid, HMRC can impose penalties and interest for late payment. These penalties remain even after the s.455 liability is cleared.
  • Cumulative Financial Burden: In medium-sized businesses, years of misclassified dividend payments could result in penalties and interest amounting to millions of pounds. For struggling companies, this could mean the difference between recovery and liquidation.
  • Director Accountability: In cases of insolvency, HMRC may pursue directors for breaches of fiduciary duties or directly seek repayment of director’s loans. Directors could also face personal liability if they are found to have acted negligently or in bad faith.
  • Impact on Shareholder Relations: Misclassification of payments can lead to disputes among shareholders, particularly if some shareholders are unaware of or disagree with the arrangements. This can create additional challenges for businesses, especially family-owned or closely held companies.
  • Accounting Issues: Wrongly classifying the payments as dividends instead of directors’ loans is likely to mean that the statutory accounts are wrong and require corrections, perhaps going back some years.

Can Informal Decisions Save the Day?

In some situations, the common law principle known as Duomatic Principle, protected by s.281(4) of the Companies Act, may allow shareholders to evidence that decisions to pay dividends were made and the payments are indeed dividends and not directors’ loans. This principle requires evidence of:

  • An informal but unanimous and informed decision by all, and not only some, shareholders.
  • Compliance with legal and statutory requirements, save for requirements to pass formal resolutions.
  • Decision being made before the dividend was declared.

However, relying on the Duomatic Principle carries significant risks:

  • Informed Consent: To demonstrate informed consent, shareholders must have access to accurate management accounts showing distributable profits. Without this evidence, the Principle may fail as the decision cannot be said to have been informed.
  • Timing: Decision must predate the dividend declaration and it is not something that can apply retrospectively. This could be a particular concern if there is no written record whatsoever as the shareholders may find it difficult to prove the timing of the informal decision before a tax tribunal.
  • Statutory Limitations: The principle cannot override statutory requirements designed to protect third parties, such as creditors.

In practice, relying on Duomatic Principle often leads to disputes that must be resolved in tax tribunals a costly and time-consuming process.

Real-World Implications of Missteps

To illustrate the risks, consider the following hypothetical scenario:

A small business informally declares and pays dividends before the end of year accounts are prepared which would show distributable profits. Some shareholders do not review any management information and simply agree informally. HMRC investigates and determines that the payments should have been classified as directors’ loans. The company incurs s.455 tax liability, along with penalties and interest and the Company is unable to rely on the Duomatic Principle as the shareholders cannot demonstrate that the decision to approve the would-be dividend payment was informed. Facing mounting financial pressure, the company enters liquidation, and HMRC seeks to recover the tax liability or at the very least penalties and interest. In addition the liquidator seeks to recover directors’ loans.

This scenario underscores the importance of compliance and the potential consequences of seemingly minor oversights

Best Practices to Avoid s.455 Pitfalls

To protect your business from unexpected tax liabilities, penalties, and legal disputes, it is essential to establish robust processes for declaring dividends:

  • Maintain Accurate Management Accounts: Ensure that up-to-date management accounts are available to assess distributable profits, especially when declaring interim dividends. This includes forecasting future expenses and capital expenditures.
  • Follow Legal and Procedural Requirements: Adhere to the provisions of the Companies Act 2006 and your company’s Articles of Association. This includes passing formal director (and shareholder if so required) resolutions when declaring dividends.
  • Document Decisions Thoroughly: Keep clear records of all resolutions and decisions related to dividend declarations. This documentation will be invaluable if HMRC raises queries.
  • Conduct Regular Reviews: Periodically review your dividend declaration processes to ensure ongoing compliance. Engaging a professional advisor can help identify and address any vulnerabilities.
  • Invest in Training and Systems: Equip your financial and administrative teams with the knowledge and tools necessary to manage dividend declarations effectively.
  • Seek Professional Advice: When in doubt, consult with legal and tax professionals who can provide guidance tailored to your specific circumstances. Proactive advice can save your business from costly mistakes.

Conclusion

While paying dividends is a common practice for director-shareholders, missteps in declaring and documenting them can lead to severe financial and legal consequences. The risks associated with s.455 tax liability highlight the importance of compliance with statutory requirements and robust internal processes.

Investing in these systems and practices now can save your business from facing unexpected tax burdens and penalties years down the line. If you have any concerns about your company’s dividend practices or s.455 tax liabilities, our experienced legal team is here to provide guidance tailored to your needs. Contact us today to ensure your business remains on a solid legal and financial footing.

By taking proactive steps, businesses can avoid the stress and financial strain of dealing with HMRC investigations and penalties, ensuring a smoother and more secure financial future.

This article is for general information only and does not constitute legal or professional advice. Please note that the law may have changed since this article was published.

To find out more about our services, visit Corporate Solutions section of our website.

Call us now to discuss your case 0330 107 0106 or email us at business@imd.co.uk.

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Published by:

Olexandr Kyrychenko - Partner

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