Understanding Dividends
Dividends create more confusion than any other area of accounting for our clients. In this blog we attempt to explain dividends.
Where the confusion starts
It is worth understanding where the confusion arises. The basic problem is that different people define dividends differently. The business owner often has an understanding of dividends that is very different to HMRC’s. Unfortunately accountants are not always consistent and as a result conversations about dividends often end up at cross purposes.
The Business Owner Perspective
To the business owner a dividend is often an amount of money that they transferred from the business account to their personal account that they decided to call a dividend.
HMRC’s Perspective
To HMRC a dividend is an administrative process by which retained profit after tax is distributed to shareholders.
As we will see the difference in definitions can result in some very different tax outcomes which makes it important for business owners to adopt HMRC’s perspective.
HMRC’s Definition unpicked
What follows is a more detailed explanation from HMRC’s perspective.
An administrative process
Here is what HMRC expects to happen to arrive at a dividend:
Directors hold a board meeting
Directors look at statutory or management accounts to determine what retained profit there is available (after tax)
Directors agree (or vote) a dividend
Minutes record the meeting
Dividend Vouchers are distributed to shareholders showing what the company owes them in terms of profit share
The evidence of Board Meeting Minutes and Dividend Vouchers is important because without the evidence, HMRC can challenge whether a dividend was voted and therefore assert that money paid should have been taxed under PAYE.
Retained Profit after Tax
A common misunderstanding for Business Owners is that the profit being distributed is the profit that was made in the year. In fact the Retained Profit is the accumulation of profit (and loss) that has not already been distributed. For example if a company makes a £5k loss in year one and an £8k profit in year two the retained profit is now £3k.
The retained profit is also not the profit before tax, it is the profit after tax. For dividends voted mid-year HMRC is expecting a tax estimate to have been made.
The following shows a model of how retained profit interacts with tax and dividends (NB the Corporation Tax rate has been set at 20% for ease of understanding the figures, it is however currently 19%) :
For most business owners, an accountant will be needed to calculate the tax due on profit. Dividends voted where there is no Retained Profit after Tax are called ‘illegal dividends’.
Distributed to Shareholders
To HMRC it does not matter if the dividend was paid to the shareholder or not. It is considered distributed if the dividend voucher has been generated showing that it is owed to the shareholder.
For personal tax returns the dividends to declare are the amounts shown on the dividend vouchers whether or not they have been paid by the company.
When dividends go wrong
Directors take too much money
One common problem that arises is that Directors working to their definition of dividend take sums out of the business in excess of the Retained Profit.
As a result it is common for Directors to end up owing the company money. S455 Tax at 33.75%* and P11d issues may ensue (see more information on these issues).
HMRC taxes payments as PAYE
Without Dividend paperwork (meeting minutes and vouchers) to support payments, HMRC can tax payments as PAYE coming to the company for unpaid PAYE and NI. Penalties may also be applied.
conclusion
Whilst conforming to HMRC’s definition can at first seem onerous, in practice, it is not a huge amount of work. Once bookkeeping is brought up to date, a tax calculation can be done quite quickly and the business owner can be informed of the dividends available. From there templates for meeting minutes and vouchers can take care of creating records.
There are additional advantages to following the process. The business owner will now have a tax estimate, other issues with the accounts may be ironed out in the process.
*Tax Rates are correct at time of writing.
