Paying dividends - how to get it right

This blog outlines the process and the requirements for paying a lawful dividend.

It is important to be aware that there is a strict legal framework governing the payment of dividends. This framework applies whatever the size of company. If the correct process is not followed then the dividend will be unlawful and there can be potentially serious consequences.

What is a dividend?

A dividend is a way for a company to return cash to its shareholders.

Dividends are a useful (and potentially tax efficient way) of providing additional income to an owner/manager. They can also be used to reward investors or to move money between company groups.

The most common types of dividends are:

• Final dividends - these are paid once a year after the annual accounts have been prepared. Typically they are recommended by the directors and "declared" (approved) by the shareholders.
• Interim dividends - these can be paid at any point during the company's financial year and are normally declared by the directors.

Declaring a lawful dividend

There are a number of legal requirements that must be met before paying a dividend.

1. The company must have sufficient distributable profits

The Companies Act 2006 requires dividends to be paid out of "profits available for the purpose". These are the company's accumulated realised profits less its accumulated realised losses.

If the available profits are not sufficient to cover the proposed dividend, then that dividend must not be declared or paid.

2. Dividends must be justified by reference to accounts

The directors need to have a set of accounts that show there are sufficient distributable profits.

The accounts must be either:

• The company's last annual accounts;
• If those annual accounts show that there are insufficient distributable profits, the dividend must be justified by reference to more up-to-date "interim accounts"; or
• If the dividend is being declared in the company's first accounting period, "initial accounts" must be prepared.

3. The directors must consider the company's current and prospective financial position

The accounts are only one part of the picture - because they will have been made up to a date before the directors make their decision on whether to pay a dividend.

Directors must consider carefully therefore the company's:

• current financial position at the time of their decision (in case anything has changed since the date of the accounts); and
• future financial position should the dividend be paid. Directors must be satisfied that, even if there remain sufficient distributable profits to pay the dividend, the company will still be able to meet its ongoing debts and liabilities.

The company must also have the cash to pay the dividend. The cash position is relevant to the issues mentioned in this paragraph.

4. Check the company's articles of association

A company's articles usually contain provisions about dividends.

For example, it may be that dividends can only be paid on fully paid shares. Or the payment of dividends may be restricted to a certain class of share. Usually, shareholders are entitled to receive dividends in proportion to the number of shares that they hold - but the articles should be checked. The articles may also specify a particular way in which dividends have to be authorised.

5. Comply with directors' duties

When the directors are deciding whether to declare a dividend they must have regard to their duties. These include duties to:

• act within their powers promote the company's success for the benefit of its members as a whole;
• exercise reasonable skill and care; and
• declare an interest in the proposed payment (this will be relevant, for example, if a director is also a shareholder).

These duties involve safeguarding the company's assets (see point 3 above).

6. Document the decision to declare

Directors should ensure that they prepare board minutes recording the process of declaring a dividend. This should include reference to the financial information relied on and the directors' duties that have been considered.

Consequences of declaring an unlawful dividend

If the correct process is not followed then the dividend will be unlawful and there can be potentially serious consequences including:

• A shareholder who received an unlawful dividend will have to repay it (or the portion of it which is unlawful) to the company if they know, or had reasonable grounds to believe, that the dividend breached the legal rules. If the shareholder is also a director, they will find it difficult to escape this liability.
• A director who authorised the payment of the dividend may be in breach of their director's duties and can be held personally liable to repay the company, even if they are not a shareholder.

If you require any advice on this matter, then please get in touch with your usual Brodies contact.