Dividend Waivers

How are the profits of a Limited Company paid out?

The profits of a Limited Company are traditionally paid out in two forms:

– Salaries to its employees or Directors
– Dividends to its shareholders

The benefit of a ltd company is that the owners can decide how this split is made up and this split makes a big difference from a tax perspective. Salary is taxed at a higher rate than dividends and therefore most contractors will pay a low salary and higher amount of dividends.

What is a dividend?

Dividends are the profits of a Company being paid out to shareholders rewarding their investment in the Company. For big companies like Tesco for example the board of Directors will meet during the year and look at the Company’s performance and future strategy. As a result of this the Board of Director’s may propose a dividend to be paid to shareholders. How much will depend on what profits have been made and how much of those profits should be retained for the future growth of the Company.

In many small Companies the process is a lot simpler, with a sole Director or family business there will be no formal meeting of a Board and no discussion on what profits are to be reinvested. The decision becomes more about what profits need to be taken to ensure you have the money personally to live on and what the tax rates will be when taking a dividend.

For example if you need £20,000 out of the Company to buy a new car it may be that it’s best to delay until the next tax year as you can take the money out a lower tax rate.

Dividends can only be paid out of the profits of the Company so if a company has made profits of £50,000 (current year plus any brought forward profits) then £50,000 is the maximum dividend that could be paid. If a dividend is paid above this then it is deemed to be ‘ultra vires’ or an ‘illegal dividend’.

How are dividends paid?

Dividends are paid to the shareholders from the Company and can be paid out whenever you like, monthly, quarterly or yearly even it’s up to you.

Dividends should be paid out in accordance with the shareholding of the Company. So if the shareholding 50/50 then a dividend is paid 50% to one shareholder and 50% to the other. It is important to ensure that the dividend is paid into a joint bank account or the shareholders individual bank account.

Example:

Mr Bloggs holds 70% of the shares in the family company with Mrs Bloggs holding the remaining 30% of the shares. A dividend of £10,000 is declared in the year. The payment (and tax treatment) should be made as follows:

Mr Bloggs – £7,000 (£10,000 x 70%)
Mrs Bloggs – £3,000 (£10,000 x 30%)

What is a dividend waiver?

A shareholder can waive their rights to receive a dividend. So if Mrs Bloggs waived her right to a dividend in the above example a dividend of £10,000 is voted but only £7,000 is paid to Mr Bloggs with Mrs Bloggs receiving nothing.

It is important to ensure that there is sufficient profit to cover the whole dividend to be voted however. So in this example there must have been a total of £10,000 in profit even though only £7,000 was paid out, if not how could Mrs Bloggs have waived her dividend if there was not sufficient profits to pay it in the first place.
Procedures must be followed to avoid challenge by HMRC:

– Formal paperwork must be drawn up, called a Deed of Waiver, and signed by the shareholder waiving their dividend.
– The Deed of Waiver must not be done retrospectively.
– A dividend waiver must be used for commercial reasons and not for tax mitigation purposes.

Why must I exercise caution when using dividend waivers?

The main challenge from HMRC will not be on the Deed of Waiver being in place as this is a relatively straightforward document and is either in place or not but instead on the more subjective question of whether there is a commercial reason for the waiver.

If HMRC deem the dividend waiver not to be for commercial reason then it would be subject to settlements legislation whereby the tax loss to HMRC is put back on to the shareholder who waived their dividend, which could also include penalties and interest. Any HMRC enquiry will normally focus on some key areas:

– Was there a commercial reason for the waiver rather than being tax motivated?
– Is there a history of regularly using dividend waivers?
– Were there sufficient profits in the year to cover the waived dividend?
– Were there sufficient profits to date to cover the waived dividends?
– Was tax mitigated by using dividend waivers?

There have been some recent cases on the use of dividend waivers and more details can be seen here:

– Donovan vs HMRC
– Buck vs HMRC

What is a commercial reason for waiving a dividend?

One of the most common reasons for dividend waivers is that the profits that would have been taken as a dividend will be foregone by the shareholder in order to use within the business. An example of this may be a shareholder giving up their right to the dividend in order to use those funds to invest in a new machine which will increase productivity of a manufacturing business and therefore growing or increasing the profitability of the business. An extra level of evidence would be a record of minutes from a board meeting noting the discussion and ultimate decision to use the profits to reinvest.

 

If you’re new to contracting, our comprehensive guide to contracting should be able to answer any questions you may have. If you need further clarification on any point mentioned above, speak to us on 01962 867550 and our team will be delighted to answer your questions.

 

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