Paying dividends in lieu of salary is common (and tax efficient) for the vast majority of SME businesses, however directors considering whether to pay a dividend during these current turbulent times should take a range of factors into account, as the decision is much more complex than many realise!
Whilst the last annual accounts of a company may show sufficient distributable profits to meet the Companies Act 2006’s statutory test to pay a dividend, there are other legal tests and other factors to consider before a company decides to pay a dividend.
Perhaps most importantly in times such as these is that the financial position of a company may have deteriorated significantly from that shown in its last annual accounts, as may its prospects for the immediate future. Two key tests are noted below, but directors should also consider the possible application of insolvency and other laws as appropriate.
Maintenance of Capital
Firstly, companies are required to update their consideration of the financial position from the balance sheet date of the last annual accounts to the date of the proposed dividend. In effect you need to prepare management accounts that show with a degree of certainty the current financial position of the company (at date of proposed dividend).
Put simply, if the company’s distributable profits have subsequently reduced then then it would be unlawful to make a distribution out of lost, now non-existent profits.
There are many reasons why distributable profits may have reduced not least being: trading losses due to Covid lockdown, reduction in the value of investments, losses on loans, write off of stock etc. This list is by no means exhaustive and professional advice should be taken when drawing up the management information.
Directors have a legal duty to look forward from the date of the would-be dividend before recommending or paying a dividend. The directors should consider whether following the payment of the proposed dividend, the company will still be solvent and be able to continue to pay its debts as they fall due.
This decision has to be made in light of the current and likely future financial position and needs of the company. For example, the fact that cash and liquidity needs during a period in which all or a part of the company’s business may, for an uncertain period, be shut down by public health restrictions or be operating at reduced levels through reduced demand or supply-chain disruption should be considered. In these circumstances, for many companies, the preservation of cash has become the top priority.
Generally, once a dividend is declared by shareholders it becomes a debt due to the shareholders and therefore cannot be simply cancelled. Directors, therefore, need to consider carefully whether a dividend can and should be paid before recommending that shareholders give their approval. If a company has declared a dividend which has not been paid and the directors now wish to cancel it, they should seek legal advice based on the specific facts and circumstances.
The current pandemic has cut a swathe through the profits and financial stability of thousands of companies which will unfortunately result in a number of business failures. Any dividends that have been paid when the directors could not prove there were sufficient reserves (at the time of payment), and the directors were not anticipating insolvency in the future, will become debts back to the company and a liquidator will pursue for repayment from personal funds.
This is a high-risk area, especially for smaller companies where dividends are often paid without consideration of the points above. If you are paying dividends, or simply want to know what your options are, please contact us using the web chat, call 0345 177 5500, or speak with your usual contact at Burgis & Bullock.