Over recent years, we at Moore Hill Accountants of Warrington, like many other accountants, have advised certain clients to convert to limited companies to benefit from the beneficial tax treatment, which such legal entities receive. This advice remains good even in the light of tax changes already proposed, these include the 50% income tax rate and a 22% corporation tax for small companies. With this popularity of limited companies for tax reasons, there is little wonder that HM Revenue & Customs (HMRC) have become increasingly interested in aspects of company law relating to dividends.

If HMRC can show that under company law dividends paid at a point in time are illegal, they can argue that the money extracted was not a dividend but a loan. This loan is usually termed an “Overdrawn Directors Loan Account”. Many companies risk such an accusation due to the current poor economic climate. Many have continued to draw the same or even more dividends whilst profits have declined because of the recession. This is particularly common with small owner manager businesses.
If a Directors loan account becomes overdrawn, the following options are open to you, each of which has their own drawbacks:

1. Shareholder(s) repay the overdrawn balance. If this is done as soon as the payments are made there will be no tax implication.
   
2. The company can write off the loan and classify the payment as earnings, which will be subject to PAYE and National Insurance. The tax levied on earning is substantially higher than that on dividends.
   
3. If the director’s loan account remains outstanding, the company must pay yet more corporation tax (an additional payment equivalent to 25% of the loan). In addition to the additional corporation tax burden on the company the individual is deemed to have received a taxable benefit in the form of an interest free loan upon which the individual will have to pay income tax and the employer Class 1A National Insurance. The charge on the benefit can be avoided if the company charges the recipient interest at a rate equivalent to the statutory rate of interest for the time the loan is outstanding. The additional Corporation Tax can be reclaimed but only when the loan is repaid and proof in the form of a set of accounts is lodged with HMRC. As you can see this will take a considerable amount of time.

It is key that the company retains sufficient reserves to pay its dividends, particularly in the current draconian economic climate. Moore Hill Accountants envisage HMRC’s interest in dividend payments to continue. In addition to ensuring funds are available to pay dividends it is also key that Board Minutes proposing dividends and Dividend Vouchers are also maintained if dividends are to be perceived as legitimate.