Insolvency – When Are Shareholder Dividends Unlawful?

Published on 23^rd August 2023

When a corporate insolvency occurs one of the biggest frustrations our members experience is when they can see large dividends have been paid out to shareholders. 

We’re delighted to be able to explore this subject with the author of this article & Top Service friend, Brendan Clarkson (PKF).

What is a Dividend? 

Dividends are the payments a company pays to its shareholders out of its profits as a return on their investment.

Many shareholder directors take part of their remuneration as dividends – but failure to comply with legal requirements set out in the Companies Act 2016 could have serious consequences.

Why Pay Dividends?

It is common practice for director shareholders to take a nominal salary (or even no salary at all) and take most of their drawings by way of dividends. This approach reduces tax costs as PAYE / NIC are not payable on dividends.

From April 2023, the first £1,000 of dividend income will be received tax-free, but any dividends received in excess of £1,000 will be taxed at a higher rate depending on an individual’s income tax bracket.

Tax is then paid on income from dividends above the dividend allowance. However, tax is not paid on any dividend income that falls within an individual’s personal allowance (the amount of income that can be earnt each year before paying tax).

The table below gives a general idea of how much tax is paid on dividends: 

Dividend Payments – The Law

The payment of dividends is governed by UK law and specifically, the Companies Act 2006 (part 23). This states that:

• A company can only pay a dividend out of accumulated realised profits after accumulated losses.
• Directors must refer to accounts showing the company’s profits, losses, and liabilities, such as the last set of published annual accounts. Interim accounts can be used if reasonable judgement can be made on the state of the company’s profits, losses, assets and liabilities, provisions, share capital and reserves.
• Directors have a duty of care to act in the best interests of the company and its creditors. This includes exercising reasonable care, skill and due diligence and promoting the success of the company, safeguarding its assets, and taking reasonable steps to ensure debts can be settled as they fall due.

Unlawful Payment of Dividends

Unlawful dividends can arise in several different ways, including where profits have been miscalculated or an incorrect figure from the accounts is used, where there is poor record keeping or if the company is insolvent.

To minimise the risk of unlawful dividends being paid, directors should consider the following:

• Use the last circulated set of published accounts or up-to-date management accounts to calculate dividend payments.
• Seek advice from the company accountant to make sure figures are calculated correctly before paying a dividend.
• Keep adequate records of board meetings, conversations, and paperwork each time a dividend is declared. Adequate record keeping and processes will assist a company should any issues arise after a dividend is declared. This includes recording what figures were used to calculate the dividend payment.
• Seek professional advice either from an accountant or an insolvency practitioner if there is any concern around the company’s financial position.

Unlawful Dividends in Insolvency

Unlawful dividends in the context of insolvency refer to dividend payments made by a company that is insolvent or on the verge of insolvency.

Insolvency occurs when a company is unable to pay its debts as they become due or when its liabilities exceed its assets.

When a company becomes insolvent, it’s directors have a duty of care to act in the best interests of the company’s creditors, rather than prioritising the interests of its shareholders. 

Directors must take into consideration the company’s financial position and its ability to meet its obligations before taking or authorising any dividend payments.

If a company pays dividends when it is either insolvent or if it becomes insolvent as a result of paying the dividends, then those dividends may be considered unlawful.

Unlawful dividends in insolvency can have the following consequences:

• Repayment. If the company enters an insolvency process, the appointed insolvency practitioner has the power to demand the repayment of unlawful dividends.
• Directors Liability. Directors who authorise unlawful dividend payments may be held personally liable and be required to solely repay the full amount back to the insolvent estate.
• Misfeasance. If a director’s actions in relation to the payment of unlawful dividends are found to be improper or in breach of their duties as a director of the company, they may be held liable for misfeasance. Misfeasance claims can be brought against the director of a company by the appointed insolvency practitioner or by one of the company’s creditors and may result in the directors being ordered to repay or compensate the company.

An insolvency practitioner has a duty of care to all creditors and must report on the affairs of a company and the behaviour of the director. This could lead to further action against the director such as prosecution and disqualification.

The specific rules and consequences regarding unlawful dividends in general and in company insolvencies are outlined in the Insolvency Act 1986 and the Companies Act 2006.

It’s always worth seeking legal advice from a qualified professional when dealing with dividend distributions to ensure compliance is adhered to with regards to specific company laws and regulations.

*Information contained within this guide is correct as of April 2023.