As a company shareholder, you may be thinking about last minute profit extraction from your company before the end of the tax year. For many owner managers, that includes taking dividends and, while every case is different, dividends are usually more tax efficient than salary. Tax advantages include utilising the tax-free dividends allowance and taking advantage of the lower rate of tax (7.5%) on dividends.
So what could possibly go wrong? Several things actually, but if the paperwork isn’t right then the dividend could be invalid or fall into the wrong tax year. Few of us are keen on paperwork but, in this instance, getting it right is critical to any tax planning.
Dividends are taxable when received, not when declared, and a distinction must be made between these as HMRC may expect evidence of a dividend payment to include proof of payment.
The company must therefore have paid the dividend though not necessarily in cash; creation of an unconditional liability, by creating the right Board Minutes and ensuring that the dividend is credited to a loan account before 5 April, will do it, and, of course, an electronic payment or physical cheque being issued and cashed would leave no room for doubt.
Most of the dividends that our clients’ companies declare and pay will be interim rather than final dividends. If your company has standard Articles of Association, an interim dividend can be declared by the directors in a Board meeting. However, it will not necessarily be paid when it is declared.
In theory, the directors still retain discretion on whether to pay the dividend and they can elect not to exercise that discretion. Typically for an owner managed company the dividend will be posted as a credit to the director's loan account with the company. The director can then draw on the balance.
A final dividend is approved by the members, typically at the Annual General Meeting. The directors have no authority to withhold payment of a final dividend, so this is fine if the company is prepared to pay out the dividend in cash, but this option lacks flexibility.
What this means is that, if you want to ensure that dividends from your company fall into the 2018/19 tax year, then you should get the paperwork right and create evidence of payment. If that payment isn’t going to be immediate and in cash, then the same effect can be achieved by means of a contemporaneous journal entry to your directors’ loan account.
Prioritising compliance and ensuring formalised paperwork is in place, may seem like an over-cautious hassle, but disregarding it as such may prove to be an expensive mistake. HMRC have been known to challenge the classification of dividends, arguing that they are in fact salary or loan drawings, in which case it is important to be able to prove that a formal, set procedure declaring the dividends and establishing payment has been followed. A re-classification of dividends will result in the payments being subject to tax at a minimum rate of 20%, with the worst-case scenario being 45% and effectively a loss of the dividend allowance.
If you would like some guidance on year end tax planning including dividends, please contact Clare Munro.