It is often common practice for small businesses to structure payments to a director (who is also a shareholder) through a combination of dividend payments and salary, in order to minimize PAYE liabilities and reduce tax. Consequently, rather than be paid a salary, a director is "remunerated" by dividend payments. This works when the company declaring the dividend has sufficient distributable reserves – but when it does not, those payments are unlawful and can be clawed back under s847 of the Companies Act 2006.
It is also often the case that a director is paid by monthly interim dividend payments, albeit that at the time of payment it is not yet known whether there will be sufficient distributable reserves to justify the payment. If at the end of the financial year it turns out that the company did not have sufficient distributable reserves, the payment is re-characterised as salary and PAYE will be accounted for at that point. This payment structure can work (although the original payment to the director is illegal), but what happens where there is an intervening insolvency that occurs before the payments are reversed?
The above is effectively what happened in the case of Global Corporate Limited – v – Hale. Here, the director and sole shareholder, acting on the advice of his accountant, received payment for his services by salary and interim dividend payments, with the latter being reversed at the end of the accounting period if the company did not have sufficient distributable reserves. The director did not knowingly do anything wrong and acted upon his accountant's advice. But, when the company entered liquidation, it transpired that the dividend payments had been paid at a time when the company did not have sufficient distributable reserves.
The payments to the director were expressly declared as interim dividend payments, they were declared to HMRC as such, the director signed a tax dividend form and the payments were taxed on the basis that they were dividend payments. However, Judge Matthews determined in 2017 in Global Corporate Limited v Hale that the nature of the payments meant that they were not dividend payments at all and therefore s847 could not apply given that:
(a) it had historically been the practice of the company to reverse payments paid as interim dividends if at the end of the financial year it transpired that there were insufficient distributable reserves. Therefore, the decision to make the payments as dividends was no more than a "decision in principle", which would be confirmed at the end of the financial year once the company accountant had ascertained whether there were sufficient distributable reserves out of which a lawful dividend could be paid; and
(b) there was no valid or definitive decision to pay the money as a dividend at the time of payment because at that point it was not known whether there would be distributable reserves.
A new defence to s847 claims?
The decision opened the door for a director to defend a claim for repayment of unlawful dividends on the basis that the interim dividend payment was not a dividend payment at all. Instead, a director could argue that the decision to pay an interim dividend was only a decision in principle until determined at the end of the financial year or at some future point.
Unsurprisingly, the first instance decision was appealed.
At what point do you determine whether a payment is a dividend payment?
The Court of Appeal overturned Judge Matthews' decision, instead finding that the point at which the legality of an interim dividend payment is assessed is the point at which payment is made, not by reference to a future act.
Officeholders will be pleased that certainty has been restored, clearing up any questions over whether interim dividend payments made are indeed dividend payments! It is now clear that a payment declared in accordance with s830 of the Companies Act 2006 is vulnerable to attack under s847 if there are insufficient distributable reserves available at the time to make the payment lawfully.
Impact on accounting practice
We doubt that the judgment will alter the practice of paying director/shareholders by way of dividend and salary to maximize tax savings, albeit that the Court did not sanction the practice of paying a director/shareholder in this manner.
In fact, the Court noted that if a company subsequently realises that a distribution should not have been made and it should have been treated as remuneration this does not "cure the illegality of the original payment". Importantly the Court said that: "The most [a company] can do [when realising that there are insufficient distributable reserves] is allow the monies to be notionally repaid and then re-applied in a way which does not contravene the provisions of s830 and is otherwise a lawful application of the assets of the Company".
It is therefore clear that until an interim dividend payment (declared in accordance with s830) is reversed, reclassified or notionally repaid, it is an illegal payment and therefore unlawful from the point of payment, if at that time there were insufficient distributable reserves.
But, I relied on my accountant's advice!
Whilst the director in this case said "he paid his accountant to deal with these things", a director still has to apply that advice and understand the risks. It is not clear whether he was advised of the risk of challenge if the company entered an insolvency process, and if he had been, would he have structured things differently? Who knows. However, this decision highlights not only the importance of taking professional advice but also considering and applying it. Paying for someone else to "deal with" things is not always enough.
At a time when corporate governance and director and shareholder accountability is under review and set for change, this decision gives more reason for directors to ensure that they understand not only their s172 obligations and duties as directors but understand the implications of relying solely on advice without applying their own mind to it.
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