The tax consequences of not repaying an 'illegal dividend'

Dividends can only be paid from a company’s available undistributed profits. Even if the bank account is in credit, there must be sufficient accumulated realised profits (less accumulated realised losses) per the Companies Act 2006.

• A dividend may be paid in a loss-making period if retained profits from prior years make the overall result a profit.

• A dividend cannot be paid if retained losses make the overall position a loss, even if the current period made a profit.
  If paid without sufficient profit, the dividend is ‘illegal’ (unlawful distribution), meaning the company is effectively trading insolvently.

Tax implications
• Company – An illegal dividend is treated as void; the shareholder is treated as not having received a distribution. If the shareholder knew or should have known it was illegal, they must repay it. If not repaid and the shareholder is also a director/employee, the payment falls under the ‘loans to participators’ rules.

• Must be repaid or written off within 9 months and 1 day after year-end, or a tax charge of 33.75% of the gross amount applies (even if the company is loss-making). Tax is repaid when the loan is repaid.

• Shareholder/Director – The ‘loans to participators’ rules don’t apply if the loan is under £15,000 and the full-time working director owns <5% share capital.

• Payments over £10,000 are ‘employment-related loans’, triggering a benefit in kind with a 3.75% notional interest rate. Requires P11D reporting and secondary Class 1A NIC.

• If the loan is formally released, it is treated as repaid. Overdrawn reserves oblige directors to attempt recovery from shareholders.

• Liquidation implications – Directors may be personally liable for illegal distributions if this breaches fiduciary duties. On liquidation/administration, conduct for the previous 3 years is reviewed; illegal dividends can be reclaimed. Recovery time limit is 6 years from declaration/payment date (whichever is later).

Practical point – HMRC often flags illegal dividends when they see dividends paid with negative reserves (easy to spot via iXBRL-encoded CT returns).