It has long been a source of concern within HMRC that director shareholders of owner managed businesses prefer to take small salaries, topped up with large dividends, in order to minimise their tax liabilities. Over the years it has proved difficult for HMRC to counter this type of tax planning, so their strategy has been to increase the tax payable on dividend income. As a result, the tax savings are no longer so large and our earlier blogs explain how dividend income has been taxed since April 2016.
The way in which dividends are sometimes paid also creates a number of inherent tax risks. For example, director shareholders will often simply withdraw money from the company for their personal use, which then leads to an overdrawn loan account. The loan account is brought back into credit at a later date by voting dividends, which are credited to the loan account rather than being paid directly to the shareholder. The potential tax risks of doing this are:
- Personal income tax liabilities on the benefit in kind of such ‘tax free loans’;
- A temporary tax liability for the company if the loan is not repaid within a certain length of time; and
- The risk that on a PAYE visit, HMRC may take the view that the drawings are disguised salary rather than genuine dividends.
RJP’s best practice advice on taking shareholder dividends
It is good practice and our recommendation, that dividends are always voted at the beginning of a financial quarter, enabling the directors to ensure that the company has sufficient reserves. The dividends which have been voted are then credited to the director’s loan account, to be withdrawn as required. Voting and paying dividends in this way offers four key benefits:
- Overdrawn loan accounts are prevented from arising;
- Dividends are only voted which the company can afford based on its profits;
- All the necessary dividend paperwork is always in place; and
- The tax issues outlined above are prevented from arising.
What happens when directors take funds the company cannot afford?
In addition to the issues outlined above, other problems can arise when director shareholders take dividends. For example, what happens when they take funds from the company that the company cannot afford?
Company law states that a company cannot vote a dividend unless it has sufficient ‘reserves’ i.e. accrued profits, available to cover the payment of that dividend, based on the total shares in issue. A company can however pay salaries, even where payment of those salaries take it into a loss-making position. However, the payment of salaries does carry with it the burden of PAYE – income tax and both employee’s and employers’ national insurance contributions, and therefore an increased cash-flow burden for the company.
Two recent first tier tribunal cases, both of which covered similar situations, serve as useful examples which highlight the potential risks where director shareholders take salaries from a company which is unable to pay dividends, but do not take account of the PAYE burden.
In both these cases the company had insufficient reserves to vote dividends, so instead the companies paid large salaries to the director shareholders who had previously been in receipt of dividends. Although the salaries were paid to them, the PAYE due on those salaries was not paid to HMRC.
Although PAYE is a company liability, when the companies were unable to make payment, HMRC pursued the directors personally to recover the payment of the unpaid PAYE. HMRC argued it was justified in doing so because the directors took salaries despite the fact that the company was unable to support the payment of those salaries and the PAYE that was due on them. HMRC therefore concluded that both companies displayed a wilful failure to deduct PAYE and that HMRC was justified in pursuing the directors personally for payment of the tax outstanding. Appeals were lodged in both cases and although in one case the appeal was allowed, in the other case the appeal was dismissed on a split decision, meaning HMRC was able to recover the tax due from the individuals who had received the salaries.
What can company directors learn from these cases?
There are two important lessons to be learned here. Firstly, ensure your dividend policy is clear, correctly implemented and that all paperwork is in place. Secondly, be aware that HMRC is likely to pursue the argument that unpaid PAYE is payable personally by directors where they consider deliberate action has been taken to extract funds from the company without paying all tax liabilities arising on the payment of those funds.
The fact that one of these cases was successfully appealed does however suggest that HMRC may not have the full force of the legislation behind them, and further legislative changes to strengthen their position may be forthcoming. Keep a lookout for future developments on this issue.
If you run a business and would like to discuss any aspect of taxation, please contact Lesley Stalker by emailing las@rjp.co.uk.